Sesa Goa

   THE last few months have witnessed a sharp rise in commodity prices. The movement is even steeper in the case of iron ore. For instance, Chinese iron ore prices (both fines and pellets) have shot up by 35-40% in the last two months. While this is definitely good news for the companies selling iron ore, investors should be very careful of a sudden spike. Concomitantly, there has been a sharp rise in the stock prices of such companies. Sesa Goa is one such company whose stock price has surged more than one-third in the last two months. With this phenomenal rise, the stock is currently trading at its highest level in the last three years. Though the optimism about economic growth worldwide has improved, it will still take some time before the global economy returns to where it was during 2006-07. The recent run-up in the stock price has stretched the company's valuation and investors may consider exiting this stock at this level.

BUSINESS:

Sesa Goa is mainly into iron ore mining, it produces small amount of pig iron and met-coke though. While iron ore accounts for 85% of its consolidated revenue, pig iron contributes only 12%. The company has mines located in Orissa and Goa, among others. But bulk of its mining activity takes place in Goa. The total estimated mining reserve under the company's control is around 310 million tons.
   It exports around 90% of its iron ore to countries like China. Also the company sells iron ore mainly in spot market. In 2008-09, the company sold around 15 million tons of iron ore. Last year Sesa Goa acquired a mining company called VS Dempo, and is also looking for more such acquisitions to expand its mining capacity.

FINANCIALS:

The company's topline has more than tripled in the last 4-5 years to around Rs 5,000 crore in FY 09. Its bottom line, however, has grown at a faster clip due to reduced cost of production. The company has a strong operating cash flow and it has spent little amount in capex. As a result, there is little debt on the company's balance sheet. It has liquid investments to the tune of Rs 3,000 crore at the end of March '09. It leaves enough rooms for the company to expand its capacity in future. Its operating margin usually revolves at around 40-50%. This could, however, change significantly depending on iron ore prices, export duty and freight rates, among others.

GROWTH OPPORTUNITIES:

The company has hinted at expanding its mining capacity—both through organic and inorganic routes. Recently it acquired a small mining company, called VS Dempo, in Goa. This acquisition is likely to add 5 million tons of mining capacity annually. The company recently raised close to $500 million through foreign currency convertible bonds (FCCB) to acquire new mining assets. It also plans to increase its pig iron and met coke production capacity in near future. Since these two lines of business account for small percentage of overall revenue, the rise in production capacity will not impact the profitability significantly

VALUATION:

There has been a sharp rise in iron ore prices in last few months. Currently, the prices are hovering at around $140/tonne. If one were to look at historical price chart, it appears that there is little upside potential. On the other hand the downside risk is slightly more. The prices beyond $120-130/tonne are usually not sustainable, even in the medium term. Further, the stock has reacted much more to this recent iron ore price rise and is currently trading at a trailing price-earnings multiple of close to 22, one of the highest in last four years. 

   Also at the current market cap, the enterprise value (EV) of the company per tonne of mining reserves works out to be little more than $25/tonne. This is more than five times of what Sesa Goa paid for VS Dempo this year. Both of the companies have similar quality of mining assets though. Recently, the Government of India increased the export duty on iron ore by another 5% and this is also going to hurt the company's operating margin. Considering all these factors, we believe that even if there is minor correction in broader stock market indices, the stock is likely to fall much more. Investors may consider exiting the stock at this point before entering at a suitable price in future.