NMDC: Deep Dive Valuation – Wisdom of Crowds

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Commodity companies are generally prisoners to commodity prices. NMDC is no different in this regard with respect to iron ore prices, however it is trying to diversify in other areas. To see just how strong the relationship between iron ore prices and NMDC performance I plotted operating margins against iron ore prices in the last ten years.

As you can see that the two lines largely move together. On further analysis, I got a correlation of 0.82. This means that there has been a strong positive relationship between the two and operating margins have largely been a function of iron ore prices in the past 10 years. With diversification this is likely to reduce but the relationship should sustain. 

About NMDC:

NMDC is under the administrative control of the Ministry of Steel, Government of India. NMDC is India’s single largest iron ore producer, presently producing about 35 million tonnes of iron ore from 3 fully mechanized mines in Bailadila and Donimalai. This in spite of its mining unit in Donimalai, Karnataka being shut since November 2018 because of a royalty dispute with the Karnataka government.

The demand for steel will continue to grow in the years to come and this in turn would call for increased demand for iron ore. NMDC is gearing itself to meet the expected increase in demand by enhancing production capabilities of existing mines and opening up new mines. The production capability would increase to around 50-60 million tonnes per year in coming years especially if the Donimalai issue is resolved (contributes 7 MT). Besides this NMDC is also in the process of securing mining leases for other iron ore mines in Jharkhand, Karnataka and Chhattisgarh. 

Diversification Plans: NMDC is setting up a 3 MTPA Steel Plant at Nagarnar in Chhattisgarh. The project at Nagarnar is moving towards its commissioning stage and the progress of civil works, structural & equipment erection are in advanced stage of its completion. However there is credible evidence that the steel plant shall be privatized. In addition to this, NMDC is in the process of developing a 3 MTPA steel plant at Jagdalpur. The 2 pellet plants at Donimalai (1.2 MTPA) and at Bacheli (2 MTPA) are already operational. NMDC is taking up diversification activities through its intensive R&D efforts for production of High-Tech and High Value added products from Blue Dust like Carbon free sponge iron powder, Nano crystalline powder. NMDC is also investing in development of renewable energy resources as an environment friendly investment. A Wind mill project (10.5MW capacity) has been completed & commissioned at Karnataka.

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Past Performance:

In the last eleven years revenues have grown at 4% CAGR and have been extremely volatile because of the fluctuations in Iron Ore Prices. The operating margin has consistently stayed above 40% even iron ore prices were extremely low while net margins have stayed above 30%. Despite this Return on Equity has gradually decreased over the years from 45% in 2006 to 12% in 2020. This surprised me and I decided to break down the return on equity:

Return on Equity=Net Profit/Sales*Sales/Equity Capital

While the net profit/sales (net profit margin) hasn’t declined much, the ROE has. This means that the second term in the equation has been pulling the ROE back. Sales to capital basically is a measure of how fast or slow the company’s investments in projects generate revenue. As is evident by the fact that NMDC took ten years to bring the steel plant to its final stages, the company leaves much to be desired in this respect. 

NMDC: Valuation Inputs

In order to value NMDC, I need  to forecast the cash flows well into the future and discount it back to the present. In order to do this I need to estimate how the company is going to shape up in the future.

Rate of Growth & Period of Growth: Revenue growth is a function of price and quantity. While I don’t pretend to know future price changes I do know that NMDC plans to add to its existing capacity which can be further enhanced if the Donimalai issue gets resolved. NMDC has grown at 4% compounded annual growth rate even when iron ore prices have largely trended downwards. The demand for steel in India isn’t going to end anytime soon and will largely be supplied by Indian players considering anti dumping restrictions on steel import by the government of India. The high quality of iron ore produced from the company’s mines means that it will always be in demand. If the steel plant isn’t sold it should contribute to further growth, however it may hurt margins. Considering all this I choose a rate of growth of 4% over the next ten years, after which it will become a mature company and have a terminal growth rate of 1%.

Net Profit Margin:

In my valuation I don’t intend to speculate on Iron Ore prices. I want to make my valuation independent of iron ore prices. This is why I chose a modest growth rate of 4% over the next ten years because the company has grown at 4% CAGR even with falling iron ore prices. Similarly, when iron ore prices slumped to 52 dollars per tonne the company still managed to have a net profit margin of 30%. When prices were high, the net profit margin went upwards of 55%. To make my valuation independent of fluctuations in the iron ore market, I assumed a net profit margin of 30% because that’s what the company has managed to sustain even during extremely low prices. If the steel plant doesn’t get sold and the company diversifies into other areas I further expect the margins to drop to 22%. The simple assumption being that the company wouldn’t be able to sustain such high margins in other businesses and would eat into its current margins. For example, the pellet plants haven’t been very profitable even after three years.

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Sales to Capital Ratio and Return on Equity:

This is where I expect the most improvement. In the past the sales to capital ratio has dropped from 0.9 to 0.2. It has recently recovered to 0.42. As mentioned earlier the investments that NMDC has made in working capital or capital expenditure hasn’t generated enough revenue. This is epitomized by the fact that it has taken ten years for the steel plant to become fully operational & the Donimalai mine hasn’t been operational. I expect this to change in the next 10 years with the sales to capital ratio going back to 0.9 in the next ten years. This is because I expect investments to start generating revenue in the next ten years. Even if the steel plant gets sold it will generate cash which will add value to investors. 

As mentioned earlier, Return on Equity is the product of sales to equity capital & net profit margin and is calculated as such in my valuation. 

Reinvestment: The reinvestment rate is a critical piece of valuation. Growth comes from the choices a company makes. Here, I introduce you to a formula that value investors are very proud of:

Growth Rate=Equity Reinvestment Rate*Non-Cash Return on Equity + Efficiency Growth

How to think about this is that growth in profits will need to come from whatever is reinvested into the company multiplied by the return on that investment added to the increase in efficiency from existing assets. Hence my equity reinvestment rate for a particular year will be the growth rate that year after subtracting the growth rate due to efficiency divided by the return on equity that year. In my valuation, the reinvestment rate for the first five years is negative because of growth due to increase in efficiency. Negative reinvestment means no capital expenditure and decrease in non cash working capital.  

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Cost of Equity:

·         The cost of equity is my measure of risk. It is the discount rate I use to discount my future cash flows. I use the CAPM i.e. Capital Asset Pricing Model to estimate my cost of equity. It is given by:

Cost of Equity=Risk Free Rate + β*(Equity Risk Premium)

The risk free rate is the latest yield on the ten year government bond which is 10% currently. I assume my equity risk premium to be 5%. Beta is my measure of systematic risk. Since commodity stocks are a good source of diversification as they tend to be counter cyclical to the economy my Beta is relatively low. Given the negligible debt to equity ratio I estimate my beta to be 0.8. Plugging in the values I arrive at a cost of equity of 10%. 

I now have all my input valuations. The inputs to my valuation and my valuation sheet are given below:

Valuation Inputs
Valuation Sheet

Valuation is a probability

The value per share that I get for NMDC is 138.36. But valuation is a probability based on certain assumptions. Let’s look at other scenarios. What if the steel plant gets sold? If it gets sold then three things will happen to my valuation:

  • Cash balance will increase by 7500 crores at least
  • Compounded annual growth rate will go down to 2.5% from 4%
  •  Net Profit Margin will increase to 24% from 22% because steel production is likely to bring down net profit margins

 My value per share will increase to 168.3. This increase in value is because as of now the steel plant is a huge drag on NMDC and converting it into cash will provide immediate relief to investors. What if iron ore prices trend upwards in the next decade? Well then net profit margin will rise to 35%. and the value per share jumps to rs. 213 per share. 

Conclusion:

Given that valuation is a probability, my valuation is a conservative estimate and even a conservative estimate shows that NMDC is undervalued. Considering that the stock pays out consistent dividends, NMDC seems to be a good opportunity at the current price level.



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Himanshu Sinha
Himanshu is hugely into Value Investing, Complex Adaptive Systems, Business Analysis, Behavioral Finance, and Spotting Market inefficiency.
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