Special Report: PSUS IN MINING AND DEFENSE CAN PROPEL YOUR PORTFOLIO

The Narendra Modi-led government is now looking poised to accelerate the slackening Indian economy. To do so, it has chalked out a clear strategy to push Big Bang reforms in almost all the sectors that can be helpful for the growth of the economy, including petroleum, banking, infrastructure, defense, power, coal, manufacturing, and mining. The government has not only announced its agenda but also started the execution of these reforms. Interestingly, the government is so serious about pushing the reformist agenda that it is not even bothered about the opposition it has been facing in the Rajya Sabha due to lack of numbers and has been going via the ordinance route bill after bill.

First, the Coal Mines (Special Provision) Ordinance and the Textile Undertaking (Nationalisation) Laws (Amendment and Validation) Ordinance, 2014 were pushed via the ordinance route and then it was the turn of one of the most awaited financial reforms in the history of India - the Insurance Laws (Amendment) Ordinance that was driven ahead followed by the Land acquisition Act Amendment Ordinance that has put reforms literally into a jet stream.

A closer look at the grit and conviction of the government clearly shows that it is in no mood to leave any stone unturned to ramp up the economic engine. This attitude of the government clearly indicates towards a paradise for investors who want to park their hard-earned money for the medium to long term. When DSIJ dug deeper into the various plans of the government in various sectors and the companies may especially benefit by the reformist agenda of the government, the two sectors that have come out on the top are defense and mining. Also, as the government is trying hard in debottlenecking the business process and instilling confidence into public sector companies, the PSUs in these sectors will surely provide good returns to investors in the medium to long-term horizon.

PSUs in Defense Look Promising

The amount of activity that has taken place in the defense sector over the last six months perhaps hadn’t happened since Independence. Quite notorious as a can of worms, this sector has so far remained in the news for all the wrong reasons, be it the Bofors scam in the 80s or the Agasta Westland deal recently. But the BJP government doesn’t seem to be perturbed by these controversies and at the onset raised FDI in the sector from a mere 26 per cent to 49 per cent and also revoked the ban on foreign institutional investors (FIIs). Now FIIs can invest up to 24 per cent in defense companies.

On a more aggressive note the government recently allowed representatives of foreign defense firms, almost “legalising” the lobbying done by the firms. This was a long-standing demand from suppliers who wanted a change in the defense procurement policy. Also, the government has given conditional approval to banned firms for future defense deals. Considering these developments there are two companies that look promising in the sector.

BEML

BEML | BSE CODE: 500048 | FV Rs.10 | CMP: Rs.721

As the government has lifted the ban on Tatra trucks partially, it will surely boost the fortunes of the state-run company BEML, since it is now allowed to supply spares for these trucks, as long as it is not dealing with the banned entity directly. Importantly, Tatra was banned in March 2012 following the then Army Chief General V K Singh’s allegations of being offered a bribe to clear sub-standard trucks. Since then BEML was in a soup because of its pact with Tatra UK to supply trucks to the Indian Army. This conditional approval to BEML is a great respite for the company, as the ban had hit its bottomline hard and it completely got derailed as an equipment manufacturer.

During FY10 and FY11 BEML earned a PAT of Rs 223 and Rs 150 crore respectively but that shrunk to a mere Rs 6 crore during FY14. It suffered a net loss of Rs 55 crore during the quarter ended September 2014. Though company has a book value of Rs 500, its EPS has remained weak at Rs 1.47 for FY14 while its EPS was at a whopping Rs 53.51 during FY10. Considering this, the partial approval for BEML can be a game-changer in the coming times as Defense Minister Manohar Parikar himself has indicated that the Indian Army is critically in need of Tatra vehicles. Already the company’s scrip is trading at around Rs 790 and with such positivity it may continue to show a decent run-up. Investors can therefore buy with a medium to long-term horizon.

Bharat Electronics (BEL)

BHARAT ELECTRONICS (BEL) | BSE CODE: 500049 | FV Rs.1 | CMP: Rs.3216

Another beneficiary of the defense sector reforms would certainly be the public sector equipment manufacturer, Bharat Electronics (BEL). Already BEL’s stock has had a dream run at the bourses during the last 6-7 months when it has spurted from around Rs 1,400 in May to an amazing Rs 3,140 on December 5, 2014. In fact the scrip has showed this kind of run-up ever since the 49 per cent FDI limit has been raised, the reason being that the company has the necessary know-how and expertise to capitalise on these defense sector reforms.

BEL is already successfully carrying out the prestigious Akash Missile Project and in all probability it will receive one of the first FDI tie-ups in this space. In a complex domain like defense we have to keep in mind that it isn’t easy for a new company to perform from day one as the gestation period is quite long. On the other hand, companies like BEL could be a prize catch for strategic investors as it has the necessary domain knowledge, government backing, and experience in the sector, not to forget a kind of monopoly in this critical sector.

While FIIs currently hold just 1.85 per cent (September 2014) in the company and DIIs hold 17.76 per cent, looking at the investment potential, FIIs may jack up their stake. In terms of valuation, BEL is trading at a PE of 23 while its EPS is 119, which surely is not cheap. However, consider the company’s operating profit margin and net profit margin which is at 14 per cent and 15 per cent respectively, indicating the high margin business it is into. The company also has a robust book value of Rs 903, displaying its strength. As such, BEL can be a good pick for your long-term portfolio that you can systematically accumulate by buying on dips.

Mining Sector Offers Good Value Picks

While the defense sector provides good growth picks like BEL to investors, mining is another promising industry that has on offer a bundle of investment opportunities in the form of value picks. In fact the government seems to be quite serious to give a fillip to mining activity in the country as it contribution to the GDP ranges from 2.2 per cent to 2.5 per cent, while it is around 11 per cent of the GDP in the industrial sector. It is also one of the biggest employers in the country. Considering this the government has already marched ahead with its reform agenda in the form of the passage of the Coal Mines (Special Provision) Bill that has been framed to tackle the situation arising out of coal block cancellations by the Supreme Court. This bill has allowed the firms to again bid for captive mines, barring of course the companies convicted of offences related to the allotment.

The government is taking various steps to iron out the wrinkles in the mining sector and is therefore also allowing private firms to carry out mining operations in the country. In fact in the coal mine bill a section has been inserted that states: “A private company may carry on coal mining operations in India in any form, either for own consumption, sale or for any other purpose, in accordance with the prospecting licence or mining lease, as the case may be.”  In addition, the government is going ahead with various other mining and mineral reforms that may prove beneficial for the sector as a whole. Some of the PSU stocks will therefore be positively impacted due to these reforms in the coming years. Some of these are listed below.

Coal India

COAL INDIA | BSE CODE: 533278 | FV Rs.10 | CMP: Rs.374

Though the reforms may lead to an end to Coal India’s (CIL) monopoly in the sector, it will certainly benefit it in the long run as its efficiency will improve due to competition and new technology interventions. There is another aspect to the mining reforms in the coal sector. As private and foreign companies will be allowed into mining, everybody expects the price of coal to increase though the government is silent on this aspect. As private entities will be allowed to take part in e-auction, they will certainly want to recover their mining cost, which clearly means that coal mining companies, including CIL, will get a higher price for coal in line with international standards.

Interestingly, today CIL has lowest cost of production globally as reserves are given almost free of cost but with auction coming into play, companies will now have to meet the auction price. Presently the government has planned to dilute 10 per cent stake in CIL that may give around Rs 23,000 crore to the government exchequer. As such, the scrip seems to be under pressure due to this divestment plan but it may be a temporary phase.

On the other hand, the government’s strategy to increase the efficiency of CIL also seems to be working as already production has increased by 10 per cent during the current year. Therefore, the target to double its output by 2019 seems quite a reality. In terms of valuations, CIL is trading at PE of 16x and its consolidate PAT during FY14 was at Rs 15,112 crore whereas its topline reached Rs 68,810 crore. An interesting part of CIL’s performance is that the company’s topline has almost stagnated over the last couple of years owing to stagnated output and lower realisations and if coal sector reforms take the expected shape, CIL has great potential to yield sustainable returns to investors in the long run

NMDC

NMDC | BSE CODE: 526371 | FV Rs.1 | CMP: Rs.135

In line with CIL, NMDC also looks interesting as it is available at attractive valuations and lots of positives are favouring it. First of all the government has given clear direction to its management to increase its iron ore production to 75 MT by FY19 from the current level of 30 MT, and touch 100 MT by FY21. If these targets will be met then clearly NMDC would become a real mining global powerhouse. In addition to this, in a major respite, a loss-making bilateral pact to export iron ore to Japan and Korea has now ended.

Significantly, NMDC had been exporting 5 per cent of its total iron ore production at low margins owing to this bilateral pact between the three governments. As per a brokerage research report, NMDC had a commitment to export 2.8 MT annually under the MOU and was incurring USD 20 per ton of EBITDA loss due to fall in iron ore index to USD 79 and increase in royalty from 10 to 15 per cent. With this pact ceasing this year, the margin will surely be jacked up from the next fiscal. Recently the company’s CMD, Narendra Kothari, also indicated towards the loss that the company suffered due to this pact.

In addition to this, NMDC is also eying various opportunities overseas like picking up stakes in coal mines; the potash manufacturing firm Acron; and mines in Indonesia, US, Brazil, South Africa and South America. The company is also erecting a 3 MT steel plant in Bastar and has acquired 50 per cent stake in Legacy Iron Ore in Australia. These combined activities coupled with an array of mining reforms will certainly boost the topline and bottomline of the company in the long term. NMDC is actually working on a kind of monopoly in iron ore and currently trading at PE of just 9x.

Despite having operating profit margin of 64 per cent and net profit margin of 53 per cent with book value of Rs 76, the scrip is trading at around Rs 144. Though the company has shown some decline in topline due to disruption in mining activities owing to environmental clearances, the future of the company seems to be bright and we believe it will be a good pick in the medium to long-term horizon.

GMDC

GMDC | BSE CODE: 532181 | FV Rs.2 | CMP: Rs.123

If NMDC is a large-cap that is offering a good opportunity to investors, Gujarat Mineral Development Corporation (GMDC) is a mid-cap in the mining segment that can give you robust returns. In terms of valuation, GMDC is on a very sound footing with its CMP of Rs 131. It is trading at PE of 9x and its book value (BV) is Rs 90 whereas its price to BV is just 1.45. On the operational front, this Gujarat state company is a real gem as it has exclusive rights to mine lignite, bauxite and manganese in Gujarat. Though the company faced some decline in lignite output during the last fiscal owing to heavy monsoon and stagnant reserves, the output at its Umarsar mine in Kutch can reach 10 mtpa during FY15.

During FY14 its output declined to 8.4 mtpa. In addition to this, the company is all set to get clearances for its 5 mtpa Lakhpat, Ghala and Damalai Padal mines in Kutch. The company is also quite strong in the power generation segment as it operates a 250 MW thermal power plant and is also planning to set up another 500 MW plant under JV in Bhavnagar, Gujarat. It also has a 150 MW wind power plant and a 5 MW solar power plant. Considering the mining reforms, if the price of coal goes up it will have a direct impact on the fortunes of GMDC as it earns 80 per cent revenue from mining operations.

The best part of GMDC is that it has a robust operating profit margin of 47 per cent while its net profit margin stands at 34 per cent. Considering all this, GMDC is a good buy for the long term at its current valuations with additional capacity likely to lead to more benefits.

Mining and Mineral Auction Gets Cabinet Nod

In line with the auction of coal blocks, the Union Cabinet has cleared the Mining and Minerals Development and Regulation (MMDR) Amendment Act to go forward as per the ordinance route. This ordinance will mark huge mining sector reforms as it will facilitate more competition and efficiency in mining and also allow the entry of private and foreign entities into this sector via transfer of lease. As per this ordinance, iron ore and other non-coal mines will be auctioned via competitive bidding.

This will pave the way for private and foreign investments and latest technologies into the sector that is otherwise marred by legal cases and administrative delays. To ease out delays in mining projects, the creation of district mineral funds is being proposed for the welfare of people who get affected by mining projects. First, the auction of minerals such as iron ore, manganese, limestone and bauxite will be done. According to government sources, though on one hand it will increase the efficiency of the mining sector, there won’t be any impact on PSUs like NMDC, GMDC, NALCO and SAIL.