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What SC verdict means for power, metal, banks and investors

A look at the impact on key coal-dependent sectors and how CIL becomes an indirect beneficiary of cancellations...

The Supreme Court judgement makes it increasingly clear that unless the law allows it, natural resources can be given away only in public interest. Private enterprise can use these resources, but by paying a price that is determined in a fair and transparent manner. Secondly, government decisions can be questioned and challenged even 20 years later if the law hasn’t been followed, casting the onus on business to ensure that the government’s decisions have a legal backing. In its order, the apex court has upheld the allocation of only four operational blocks where coal was being mined by government companies or was being used to supply cheap power (the public interest argument). The leases of the remaining 42 blocks that were either operational or ready to start operations have been cancelled. All other 176 coal block allocations have been cancelled. In the short term, there is good and bad news. The good news is that the 42 cancelled coal blocks can continue operations till 31 March 2015 The companies get a window to keep earning revenue by running their end-user operations (such as making steel or power). They can make alternative arrangements for coal supplies and also understand how the government will proceed, from April. The bad news is an additional levy of Rs.295 a tonne, on both new output and all coal mined till date. The levy on coal already mined has to be paid by 31 December, making for a likely significant hit to both cash flows and profits in the coming quarter. But what happens April onwards for these 42 mines? Coal India Ltd (CIL) is expected to run them. But will the current operators be compensated for their irrecoverable investments? Will CIL own the leasing rights in perpetuity or is this is an interim arrangement till the government takes a final call? Will CIL agree to supply coal to the linked plants, so that output does not suffer? Investors in these companies will be anxious to get answers. As for the cancelled mine allotments, the government is expected to allocate them afresh after deciding on the process. Government companies could still get some mines for free (or concessional rates) while the rest will go for auction. One thing is certain. The cost of coal is going to balloon for making non-public goods. CIL is likely to sell coal at market-linked rates from the 42 mines. New captive mine owners will pay a price to get mining rights. The amortization of that investment will reflect in the cost of coal mined by them in addition to the extraction cost and state royalties. There is one aside here. State-owned entities are getting an unfair advantage over private producers, even if they are selling a non-public good at the same price—in steel, for example. Expect private sector producers to lobby against this anomaly. Here’s a look at the impact on key coal-dependent sectors and how CIL becomes an indirect beneficiary of the cancellations.

Metals: profitability gone soft

Coal is the life blood of metal companies, used not only in the metal-making process but also to run captive power plants to generate cheaper power. The immediate impact of the cancellation of the 42 coal blocks will be felt by a clutch of companies, including Jindal Steel and Power Ltd (JSPL) and Hindalco Industries Ltd, whose mines figure in the 42 operational mines that have been cancelled. Smaller names such as Jayaswal Neco Industries Ltd, Prakash Industries Ltd and Monnet Ispat Ltd will also be hit. But Steel Authority of India Ltd has been spared and allowed to retain a mine at Tasra, which produces 2 million tonnes of washed coal, according to an Espirito Santo Securities research report dated 26 August. The impact is expected to be felt most by JSPL. Espirito Santo estimates its fair value estimate of Rs.375 a share for the company to decline by Rs.160-165 a share. The impact on Hindalco is expected to be marginal. The levy payment too will result in lowering profitability further. A pertinent question is what happens to all their investments in these mines and whether anything can be recovered. But the bigger picture is the road ahead for domestic metal companies for their future expansion plans. They are facing a situation where they will be paying a much higher price for mined coal, even if it is from captive coal mines. That will mean a higher cost of production than envisaged earlier when these mines were allotted and consequently lower profitability. The products sold by them are typically pegged to the landed cost of imported metals, which means just because their coal cost has risen, they will not be in a position to increase product prices. While the more efficient and large players will be able to survive, the smaller and inefficient players will find the going gets tougher. Power: projects could get delayed A look at just Wednesday’s stock price movement for power companies might mislead one to the conclusion that the electricity sector is unaffected by the Supreme Court judgement. That’s because the mines under production (or about to start) that were cancelled belonged mostly to state public sector units. NTPC and Reliance Power’s coal blocks escaped the axe. Even in the case of CESC Ltd and Jaiprakash Associates Ltd, whose mines have been taken away, there are six months to make alternative arrangements. Thus, coal supply couldn’t possibly get worse in the short term than it already is. International prices are falling and imports have become a more viable substitute. However, in the medium term, things have got murkier. The ball is in the government’s court now. Obtaining mines at a higher price will increase electricity generation costs. Will electricity boards allow companies to pass on the rise in costs? In theory, yes, but there could be periods when cash flows could get squeezed as states drag their feet on tariff hikes. In any case, the coal block cancellation will act as a drag on fresh investment. Clarity would emerge only when new auction norms for the 42 blocks are finalized and the rest are again auctioned off. It’s anybody’s guess when the government will notify those. Thus, there will be delays in adding new generation capacity. Money already sunk in projects will affect power firm’s leverage, thus affecting their ability to raise fresh debt. While the immediate impact is not huge, things just got worse for the power sector.

Banks: loans at risk

The Supreme Court judgment is a new headache for banks. Total bank credit to the mining, metals and power sector is Rs9 trillion. Of course, not all of this will turn bad at the drop of a hat, but risks have heightened. These are industries that have borne the brunt of the ongoing economic slowdown. A squeeze on power and metal companies in multiple ways also adds to pressure for banks. Profitability could be reduced for these firms and their debt servicing ability could go down. More importantly, the money already sunk in these coal and end-use projects is in danger. Typically, loan repayments start only when projects are commissioned. If projects get stuck, there could be delays in servicing this debt too. In the worst case scenario, companies might just abandon some projects. This could lead to a fresh pile up of bad loans and restructurings. If you take the State Bank of India group’s numbers as a proxy, then 4.5% of loans given to the coal and mining industries have turned bad, says Kotak Institutional Equities. Similarly, the iron and steel sector has a 5% bad loan ratio. These numbers could get worse by the end of this financial year. Moreover, it is not only state-owned banks that are at risk here. Some private sector banks also have a close to 10% exposure to these industries. Clarity will emerge only when banks come clean with their exposure to these coal block-linked projects. So far, only IDBI Bank has said it has a Rs2,000 crore exposure.

CIL: investors buy brighter picture

Coal India Ltd (CIL) is likely to manage the 42 cancelled coal blocks after 31 March. More clarity on this process will emerge with time and so too the quantum of benefits that will accrue to CIL. Nevertheless, the company can be expected to gain from managing these blocks. The CIL stock gained 5% on Wednesday as investors seem to be assuming the best outcome, which is getting ownership of the mines. “While the cost of extraction and quality of coal varies across coal mines, in best case scenario (ownership transferred to CIL with realisation and cost in line with company’s existing parameters) we expect a valuation impact of (positive) 16%,” wrote JM Financial’s analysts in a note on 18 September. However, investors should proceed with some caution as this development doesn’t erase all of CIL’s existing problems. After all, a bigger obstacle to CIL improving its valuation is the firm’s ability to boost output at its existing mines. It has consistently fallen short of production targets in the past few years.

Source: www.livemint.com