Gujrat NRE Coke Ltd

Gujarat NRE Coke (GNCL) the largest non-captive metallurgical coke producer of the country with plants located in Gujarat and Karnataka also owns three coal mines in Australia. The company has coke manufacturing capacity of 1 million tonne which it plans to increase to 1.33 million tonne in a phased manner from April 2008. The company also has a steel unit of 0.3 million tonne p.a. capacity in Gujarat. Improving coke realizations on the back of strong demand from the domestic steel and cement industries as well as favorable global dynamics are likely to drive future growth in the company. Moreover, captive power generation capabilities and ownership of high quality coking coal mines in Australia are likely to improve the margins as well as ensure supply of quality raw material over the long term. Presently, Gujarat NRE Coke trades at a FY09E PE of 14.9, Market cap to sales ratio of 5.0 and Price to Book ratio of 3.6. We expect improving realizations and sustained availability of power and quality raw material at cheaper prices should drive growth for the company in the future.

Industry

Global steel industry has been in an uptrend with steel production growing at a CAGR of 6.54% during the six year period ending 2006. Iron and steel production is further expected to grow at 6-7% p.a. for the next 5-7 years on the back of robust demand from the rapidly growing BRIC (Brazil, Russia, India and China) countries. World crude steel production is on track to grow by 8% in 2007 having already grown at 8.1% yoy in the ten month period Jan-Oct 2007. Though declining consumption in North America and moderating trends in Europe have led to deceleration in global demand growth in 2007, robust consumption in rapidly expanding emerging economies, especially in Asia, is seen counterbalancing the loss in demand. Indian consumption, too, is increasing at a double-digit pace leading to rapid capacity expansion. From being the 7th largest producer of steel in the world in 2006, India has become the 5th largest in 2007 (till Oct 07). Global steel production is dependent on coal – around 68% of total global steel production relies directly on coal inputs as about 0.6 tonnes of coke are required to produce 1 tonne of steel. Expected growth in steel production would ensure a sustained growth and demand for coke in the near future.

Domestic coke scenario: Rapid expansion of steel manufacturing capacity in India is expected to put pressure on coking coal reserves. India is already a net importer of coking coal as the one available in India is high in ash content (18-22%) as against the coking coal found in Australia & New Zealand (ash content – 10-12%). Indian coke producers have thus embarked on a coal mine buying spree, buying mines in Australia, the largest producer of coking coal in the world in order to ensure regular supply and to protect themselves from rapid price fluctuations. India is expected to emerge as the second largest coke producer, next only to China over the next decade as coke manufacturing units get increasingly relocated to Asia amid shut down of obsolete capacities in OECD countries due to environmental constraints and high replacement costs. Coke is manufactured by a number of producers in India, primarily for captive consumption. As a result, the Indian coke industry is dominated by integrated steel plants that possess captive coking facilities.

India's growing demand for coking coal is presently addressed through imports as there is a shortage of coke capacity in India. In the long term, India is expected to remain dependent on imports. It is estimated that the total coke availability in India will be 21 million tonnes in 2007-08. The domestic demand for coke in the same period is expected at 26 million tonnes. The national shortage of coke is estimated at 5 million tonnes for the year 2007-08. The demand for steel in the Indian domestic market is likely to be buoyant as a result of sustained growth of major steel-consuming sectors like infrastructure and automobile and overall industrial growth. Also important is the fact that the domestic per capita steel consumption currently stands at 39 kg, whereas the global average is 150 kg and that of developed countries is 400-650 kg. Even if a conservative estimate of reaching the world average by 2020 is taken, India's demand must burgeon to 194 million tonnes of steel at a CAGR of 10% over the same period on a higher production base. The strategic decision of Gujarat NRE coke to focus on quality business has resulted in Company becoming a significant player in the industry globally, inspite of dominance of China in the global coke market. China dominates the global coke market due to the fact that the country, besides being the largest steel producer and consumer, is also the largest producer, consumer and an exporter of coke.

Company

Gujarat NRE Coke, engaged in the business of coal processing, manufactures low-ash metallurgical coke (LAMC). LAMC, mainly used in soda-ash plants, cast iron and brass foundries and the blast furnaces of steel plants, is largely imported into India. Gujarat NRE coke is the first company to acquire coking coal mines in Australia. The total reserves of the two mines acquired is 374mn tons.

The company has also made strategic investment in Pike River Coal Company Ltd. in New Zealand from where it will get low-ash premium quality coking coal. These acquisitions have added great value to the company and also insulates it from adverse price movements in both coke and coal markets. Adding further to the improved coke realization, input prices have also come down paving way for significantly better margins in coming times. Internationally the coking coal prices have come down from $115/ton to $90/ton. Company has seen aggressive growth in the last few years which was derived through a robust five-year expansion programme which more than five-folded the company's coke making capacity from 1.30 lakh MTPA in 2001-02 to 6.82 lakh MTPA in 2006-07. With the additional capacity of 3.24 lakh MTPA created at Dharwad, under its subsidiary, Bharat NRE Coke Limited (BNCL), the Company now controls around 1 million tonne of coke capacity. With the Indian economy now expected to report a sustainable annual growth beyond 8%, the demand for coke from core industries - steel and cement - is expected to increase sharply, creating a wide foreseeable gap between supply and demand. Gujarat NRE Coke is also in the process of commissioning two captive 15-MW power plants for generating power from waste heat, emanating from its coke plants situated in Bhachau and Dharwad (BNCL)

Key Investment Arguments

Gujarat NRE coke has a market cap of Rs. 3393.4cr, average daily volume of 1382200 shares for the last six months and net sales of Rs. 672.77cr during the trailing twelve months ended Dec 31, 2007.

It’s EBITDA and Net profit margins were at 19.9% and 10.8% resp. in FY07 and at 35.6% and 21.3% resp. in the nine months ended Dec 31, 2007.

The company has achieved a 5½-year CAGR of 49.4% in revenues, 46.4% in EBITDA and 60.2% in Net Profits.

Gujarat NRE coke trades at a PE multiple of 21.7 based on trailing twelve month (TTM) earnings, Price to Book ratio of 3.6 on FY07 book-value and Price to Sales ratio of 5.0 based on TTM net sales.

Debt-equity ratio of the company was at 1.2 in FY07. However, its interest coverage ratio stands at a comfortable 3.8 in FY07.

Expansion plan: GNCL plans to increase its overall coke manufacturing capacity to 1.25 mtpa by Q1FY09 from the current capacity of 1 mtpa. This capacity expansion is planned at its Dharwad plant. It also plans to increase its coking coal mining capacity from current 1 mtpa to 4 mtpa by 2011-12. The company is also setting up 45MW waste heat recovery plant which will help reduce cost. The total capex planned for this expansion is about $40 million.

Improved Coke Realizations: Coke prices have moved from $160/ton in Q2FY07 to $270/ton in Q2FY08. Going forward the company is expecting coke realizations to range from $300 to $340 per tonne for remaining two quarters.

Proposed merger of two Australian subsidiaries: Gujarat NRE Coke owns three coking coal mines in Australia through its listed subsidiaries India NRE Mineral and Gujarat NRE Resources Pty. The three mines: NRE No.1 colliery, NRE Avondale colliery and Elouera mines have a combined reserve of 456 million tones. The company has recently proposed a merger of its two subsidiaries, which will substantially improve valuations. The company also has strategic investments in Ray Resources and Pluton Resources in Australia and Pike River Resources, New Zealand. This vast captive source also acts as a buffer against coking coal price volatilities which is mainly determined by Chinese demand and supply. Currently the captive coking coal cost for the company is $ 90-100 CIF whereas for other players it is around $ 120-130 CIF.

The increasing demand from India has been the main driver of the coke market in 2007. With new steel capacities announced the demand is going to increase more within the country. China initially was keeping the coke prices lower than the fair value but now Chinese players have preferred to keep the coke prices firm.

Key Concerns

The demand for coke is directly linked to the fortunes of the steel industry. Any slowdown in the steel industry can affect the fortunes of the company. However, the growth in steel-making capacities is expected to be the highest in Asia, particularly China and India. Besides, the Government of India expects India to emerge as the world's second largest steel producer by 2016 with a production volume of around 120 million tonnes. This will adequately cover the demand for coke over the foreseeable future. Though coke prices are determined by China, the largest coke producer in the world, the Company endeavours to maximize margins and profitability through a steadfast focus on minimizing the cost of production.

The principal raw material in the manufacture of coke is coking coal, whose availability is critical for sustaining production. Coking coal prices have moved up recently amid huge demand and limited supplies. To ensure its availability, the company possesses a prudent sourcing mix of captive mines as well as other suppliers. The Company intends to meet 100% of its coking coal demand from its captive mines by 2008-09.

An increase in shipping freight rates on the one hand and suboptimal utilization of bulks on the other could escalate costs. Gujarat NRE coke has entered into long term contracts for charter of vessels at very competitive rates to guard itself from this.

Latest Developments

Gujarat NRE Coke has completed the acquisition of Elouera mine from BHP Billiton, a part of the Illawarra Coal Business located in New South Wales, Australia. The acquisition was made by Gujarat NRE Resources NL (Gujarat), the Australian subsidiary of Gujarat NRE Coke. In view of a global surge in demand for coal, the acquisition is expected to benefit the company. Post-transfer, the mine would be re-christened NRE Wongawilli. Large reserves of coking coal exist in the combined Wongawilli and Avondale leases that would provide over 20 years of mine life. _ Gujarat NRE Resources intends to start mining from February 2008, with development work on the first of the three blocks commencing with immediate effect.

Conclusion

On the basis of research, we feel that this is a good stock to buy at the current market price of Rs. 109.7. If everything goes well, the price is likely to appreciate to Rs. 157.0, within 12 months, translating into a gain of about 47%.