Coalgate

Firstly, the disclaimer. The contents of this blog are the personal views of mine. They are not the views of the company i work for, nor of companies in this sector, nor would they necessarily my views when i am wearing official hat and they definitely dont have an official sanction. Nevertheless.

Recent months have had more than a few "breaking news" stories about "Coalgate" and the implications. Opposition and media have gone hoarse shouting about the crores and crores of benefit  gifted away to the corporates. Personally, well the hype is sickening but let us leave the cacophony of the issue and come straight to the point. Let us start by understanding how are coal blocks allocated and the coal laws of India

historically all coal mining in India has been done by Coal india limited (and some other govt entities). The law provides that coal mining can be done by a lot of entities but trading of coal is prohibited.  So technically you can mine coal if you get a mining lease..which you wont but then theoritically if u get a mining lease you could mine coal but not sell it.

So you had coal india and its subsidiaries mining coal (and no we wont get into the efficiency debates) and selling the coal. unfortunately the demand for coal was much higher than what would be produced by Coal india. So a mechanism was created to "allocate" coal to the industries which needed it. Its a system called "Coal Linkage". Now coal linkage is a system peculiar to India (to my knowledge...though this peculiarity isnt surprising). So if you are an industrialist and you want coal, you make an application to the coal ministry (and to a coal linkage committee). the linkage committee would then "consider" the application onj subjective merits - such as the credentials of the party,. credentials of the project etc and allocate it a linkage. That would mean - x million tonnes of production from X mine of Coal India limted (or its subsidiaries) would be provided to you at the linkage prices. The linkage price is the price charged by Coal india to the industry. Now Linkage price is a tricky subject. The base linkage price makes taking coal from coal india a very economic proposition for the customer. Now that works fine if the customer is a power plant such as NTPC or MSEB who are allowed a fixed return and thereby passing on the lower cost of coal to the ultimate consumer of electricity. Now whether that is a good thing or not is a matter of seperate debate. Nevertheless for a profit oriented industry, that Linkage a source of competitive and financial advantage.
However, coal india failed to keep up the supply in line with the demand for the linkages. So the government turned to the concept of captive mining of coal.

So what is captive mining
Well, if you are an industry which needs a lot of coal. you make an application to the ministry and another committee which allocates captive coal blocks based on a very subjective "merit" of the case. Now if you get alloted a few million tonnes of coal in coal mine. you apply for mining license, environmental clearance, forest clearance and then spend capital expenditure (minign and processing equipments, railway sidings etc) to develop the mine, remove the overburden (waste material) on top of the coal seams and mine the coal. Now indian coal is a extremely bad quality so you may also wash the coal before using it.
you ofcourse cant sell it. you can use it in your power plant or steel plant.
then one needs to consider is what price does the power plant sell. if it does below the market price (in line with the cost savings from coal block allocation or linkage) like say a NTPC or MSEB would, then perhaps it is not a major issue. but if the steel output or power output is  sold at the market price well then the country of india just handed over the profit on a platter to a private steel company or a power company to the detriment of the govt of india and by corollary the tax payers.

So what we have is a situation where a company does get a financial advantage as a result of either linkage or captive coal blocks.

There is ofcourse the other side of the coin too. The quantum of the advantage however needs to be checked in each case as it would depend on the complexity of the mine, amount of coal, amount of overburden, amount of forest, resettlement issues, diversion of rivers and nullahs, capex required for the railway siding etc. all of which affect the cost and timing of the coal production. so not all coal block allocations result in supernormal profits accruing to a company.  what also needs to be considered that mining coal (or even any other mining) is an expensive business. the exploratory drilling in itself could cost millions of dollars. coupled with other expenses, the coal could turn out to be quite expensive. The CAG figures needs to be evaluated in that context. I dont know about coal numbers but when it comes to Iron ore, people tend to overestimate the value of resource. Some people argue. Iron ore price is 100$, cost is 10$ to mine , so you get a profit of 90$. Super normal profit. well, most important 100$ is for a grade., so make an adjustment for indian grade. Secondly 100$ is price at port, so you need to deduct the cost of transportation to the port. Now there in lies the catch, Cost of transportation could range from 10$ to 70$ or more depending on location etc. and that doesnt include any capex or interest expenses.
Same thing works with coal. take a poor quality coal and add to that transport cost and the cost of building railway siding, cost of punitive railway charges etc and your profit could be overestimated by a large margin. And we havent started on the export duty ifany is imposed by govt.

Ok, all those arguments apart, there is still a quantum of profit associated with the allocation of coal blocks to "endusers". but does that imply there is something hanky panky? no not really, it could only be stupid policy. or even more likely, it could be a policy which was fine in a different environment where the coal prices were not that high. and that isnt that far back actually. the commodity price boom has started post 2005. not so much into distant path.

infact what one needs to also consider is the policies of the worlds major coal producers. there you just apply for an exploration license and if you get a license you explore . if you are lucky you strike coal and if you are not well you lost your money. do it a few times and you wil average out to normal profits. india somehow seems to shy away from this concept of exploration for minerals which seems to have worked very well for australia, USA, Canada etc pretty well.

 And one needs to consider the policies applied for oil exploration and 3G. May be just look at only auctions. Agreed large upfront payments could lead to problems, so do a profit share based bid. that should work well earning profits in the future if the prices rise abnormally.
 One also needs to ensure that we have enough competition for the bids( so as to earn as much money as possible for the govt) by not keeping any restrictions. If one puts end use restrictions or any other restrictions on the sale of the output, the bids will be of smaller value and result in a low return to the GOL. Do enough market auctions and there will be enough supply in the market to cause the prices of coal and other commodities to fall.
Lets face it, minign is an industry which has historically done 10 years boom and 30 years of oversupply and depressed prices. the prices would fall eventually coz of oversupply.

and i can go on and on typing. but its enough for tonight. may be will continue with my incoherent blabbering on this topic later

Introduction to valuation

Have jotted down a few pages on how to value mining companies over my few years of dabbling with it. have put them up on a blog in case someone finds them useful. The pages do not claim to be an expert treatise on the subject (and could hv errors), they are just guidelines, eyeopeners, best practices call it what you wish which are essentially tips for the geologists and the miners get a practical intro the valuation and for fin pros to get a practical idea of how to model mines.

will add more details (hopefully) for each of the areas in the years to come.

Alternative Valuation methods

While the various chapters above describe the various aspects of “discounted Cash flow” method of valuation, There are other complementary methods of valuation which a smart valuer should also consider (if only as a cross check). These would include

1. Comparable multiples method - a comparison of valuation ratios of comparable listed firms. For mining companies, the ratios could include EV/EBITDA, Price /Earnings, Enterprise Value/ ton of Reserves and Resources, Enterprise Value/ Ton of Capacity, EV/Sales etc
2. Comparable transactions – similar to the above but considers valuation for the assets which have been recently sold or bought
3. Book value - valuation basis of the value in the accounting books of the assets of the company.
4. Real Option valuation – estimation of the “option” value of the assets under consideration. A method not popular due to its complicated formulas and non intuitive nature.

It is important to consider the comparable multiples and comparable transactions esp for assets which are still in exploration and development stage as typically they trade at values different from the net Present value estimates due to Uncertain nature of the cashflows and potential to add further resource.

Valuation : WACC

Discount rate

If you recall the introductory principle, Valuation (NPV) = Sum of all the cashflows weighted by a factor for time value of the money (aka Discount factor)

Where Wi = 1/(1+r)ⁱ

Theoretically, the Discount factor is a rate (similar to Interest Rate) which is a function of the risk of a project (Expected Rate of Return). For eg A low risk project will carry a discount rate of say 10% while a high risk project will carry a discount rate of 15%.

Practically the estimate of Discount Rate (expected rate of return) is drawn on the basis of Weighted Average Cost of Capital (WACC). WACC is simply weighted average cost of Debt and Equity

• Cost of Debt is rate of interest on loans of the company
• Cost of Equity is the rate of return “expected” by the shareholders of the company
• To sum it up simply, the determining the valuation or the Net Present Value(NPV) is only a matter of forecasting the cashflows from the Mine and then discounting it with the WACC of the company.

The cost of debt is the easier of the two factors to determine and can be estimated from

1. Interest rate on the debt which the company already has or other companies with similar projects have
2. Yield (based on the Market price) of the debt held by the company. Say Company has a bond of USD100 maturing after one year, which is currently trading at 88 USD. It would imply a yield of (100-88)/88 = 13.6% which can be then considered a cost of debt

The Cost of equity is determined by a formula called Capital Asset pricing mechanism (CAPM)

E(R) = Rf +Beta*(E(Rm) -Rf)

E(R)is the expected return on the capital asset

Rf is the risk-free rate of interest such as interest arising from government bonds

Beta (the beta) is the sensitivity of the expected excess asset returns to the expected excess market returns, or also ,

Rm is the expected return of the market

(Rm - Rf ) is sometimes known as the market premium (the difference between the expected market rate of return and the risk-free rate of return). and is also known as the risk premium

Typically, beta is calculated over a 5-year period (A number of websites will provide you the Beta information) and usually an average of companies in the industry is considered.

Risk premium is considered by different entities at different levels such as 4.5%-5%. A good reference for Beta and Risk premium information is Aswath Damodarans webpage (Damodaran is a prof at stern business school, NYU).

Rf is taken as yield on the 10 year government bond.

Valuation: Taxation

Taxation

The Valuation of mines for acquisition is done on the basis of the discounting of the post tax cash flows. Each country has its own peculiarity of corporate taxation. For the purpose of taxation, web based query will provide the rate of taxation application for that particular country. A good source for the tax information is a guide to taxation for mining companies published by the big 4 accounting firms. That will usually give a guide to the taxes which are applicable. As per materiality and the detailed working needed (at different stages) the tax department website needs to be studied thoroughly.

Tax = Profit Before Tax X Tax rate

Where Profit Before tax = (Revenue – Cost – depreciation) and Tax rate is the rate applicable for Mining companies. In India, the tax rate is currently, 32.445% (30% *(1.05)*(1.03))

Valuation: Depreciation

Depreciation

For the uninitiated, Depreciation is a term used in accounting, economics and finance to spread the cost of an asset over the span of several years. That is depreciation is method of attributing the historical or purchase cost of an asset across its useful life. The rate of depreciation (usually a % of the asset value) differs by asset class and depending on whether it is for accounting purpose or for tax. i.e. there would be a tax depreciation and a different Book(accounting) depreciation.

Depreciation is a non cash expense. It doesn’t affect the cashflow and hence the DCF directly. However, the tax depreciation is deducted from the taxable profits so it affects the tax directly and hence the DCF.

The typical methods of depreciation used for tax or accounting purposes are as follows

1. Straight line method (SLM) – where the asset is depreciated in equal installments over the life of the asset. i.e depreciation for the year = (cost of asset – salvage value)/(life of asset). For eg. If an equipment is bought for USD 100 and depreciated at 10% to USD 10 Residual value under SLM. Depreciation for the year = 10% *(100-90
   ) = 9 USD
2. Declining balance method (Written down value WDV) – where the depreciation for the year is equal to a fixed percentage of the book value of the asset at the start of the year. For eg for the above example, the depreciation for the first year @15% rate of WDV = 15%*100 = 15. The Net book value at end of year 1 is 100-15=85. WDV for year 2 = 15% *NBV =15%*85 =12.75.
3. Unit of production – very commonly used method where the depreciation is equally divided over the unit of production. In case of mining, where the above depreciation methods are not clear, the Unit of production provides a fair estimate of the depreciation.

Depreciation for the year = (cost of fixed asset – residual value)*(annual production/total production over life)

Practically for calculation purposes for mining, Opening book value*(annual ROM production)/(Mineable Reserves) can be used for the estimating the annual depreciation.

Please note, the aim is to match the tax depreciation as per the tax laws of the country as applicable to the mine under evaluation. A study of tax depreciation should be used for determining this. Certain countries provide for “capital allowances” for the capital expenditure instead of depreciation. For the purposes of calculation, the nomenclature is immaterial. Capital allowances can be considered same as depreciation.

Alternatively, depreciation for the last financial period as percentage of the opening book value can be used for simplicity sake.

Opening Book Value + Capital expenditure - Depreciation for the year= closing book value for each period.

Gross fixed assets - accumulated depreciation = Net Fixed Assets (Closing book value)

valuation: Mining costs

Costs

Costs related to mining are broadly classified under the following heads.(which may change in importance depending on the type of mine being considered and locational factors.)

1. Mining costs
2. Processing costs
3. Logistics costs
4. Royalty – paid to the government or someone else

Mining, processing and logistics costs are determined based on either first principles (wherein we work out each individual component) or thumb rule (broad average costs for the whole mine based on similar mines ) or a mix of both the methods. First principles based cost estimation is generally considered to scientific but need not necessarily lead to a better estimate as a number of explicit assumptions need to be made for doing the same. Nevertheless, for a new large mine in a new location should be worked out based on first principles. It is critical that inputs from Experienced Mining and Procurement persons are taken while using first principles.

When using the thumb rule/historical costs estimates from another mine, it is critical to make adjustments for the Strip ratio, amount of blasting/ripping required, processing peculiarities (extra crushing and differences in processing methods), haulage distances, pumping requirements etc. Of these, haulage distance will change for sure with all mines and has to be critically evaluated always. The Processing and blastin/ripping is dependent on the material in the mine.

The amount of waste being mined in any mine is a cost which gets loaded on to the Ore costs. The Strip ratio is used to model the amount of Waste being mined each year. Ideally the waste to be mined should be determined by the technical team for each year (or financial period used in the financial model) and the cost of mining waste and hauling waste should be worked out based on that. The Haulage distance for waste will normally be different from the haulage distance for Ore as they are taken to different locations and the different densities of ore and waste.

As a practice, as the mine is being developed, the mine development expenses, pre-stripping expenses are considered to be a part of the capital expenditure in a mine. For the purpose of the financial evaluation, it is irrelevant as to whether they are capex or opex. What is critical is capturing the cash flows correctly and the tax implications of considering it as capex or opex. One cashflows are correctly considered, one has to look at the Tax depreciation impact of considering them as Operating or capital expenditure. The Tax laws of the particular country need to be looked at while looking at the tax impact.

Using average strip ratio: A lot of miners tend to use Average strip ratio over the life of mine for determining the cost of mining. As far as DCF models are being considered, it is not preferable to use average strip ratio over the life of mine as the strip ratios tend to vary substantially over the life of mine and therefore the timing of the cash flows related to waste removal will be inaccurate if average strip ratios are used. Due to the time value of money, the timing of cash flows will not average out. It is better to forecast the strip ratios on a yearly basis.

Generally logistics will always play a critical role in the cost estimates of any mining operation. However depending on the mineral and processing involved, the importance of Ore logistics, logistics of intermediates (semiprocessed ore/Concentrate) or finished product.

For iron ore, generally since FOB prices are considered, the shipping logistics will not come into picture and only costs till loading on the ship need to be considered. In case of other metals like Copper etc, cost of moving finished product isn’t as critical as the cost of moving concentrate (though depends on the mine location).

Peculiar to the mining business is the concept of Royalty payment to the government. In lieu of the right to mine minerals in the ground, the govt of the region is paid a “royalty” by the mining company. This is an unavoidable cost and must be considered in the financial model. Generally royalty is easy to determine as it usually based on simple formulas linked to marked price or as % of revenue. In India for example, royalty of iron ore is 10 % Advalorem (i.e. Value of the Ore at the mine gate …essentially Revenue – Logistics costs). Base metals are generally linked as % of the LME price as those commodities are heavily traded and London Metal exchange price is a widely accepted benchmark. (infact most sales in these commodities are a function of the LME prices )

In addition to the royalty paid to the government. A “Royalty” is at times paid to non-government parties. These are essentially a part of compensation paid to a mine seller for purchasing a mine. This will be in different form depending on the structure of the sale deal. It can take various forms such as Net profit interest (% of profit), % of sales, Price participation ( Fixed amount linked to the price of the metal) etc

Valuation : Forecasting of Revenues

Forecasting of Revenues

Revenue from a mine is determined from 2 essential factors (or for that matter in any business). The first is the quantity of Saleable product produced and sold. The Quantity produced will be determined as per the mine plan for the particular mine. For the purpose of valuation the full mine plan till the end of mine life must be determined. It is essential to model the year wise (or quarter wise or month wise as may be possible) production quantities as any variations in the level of production is likely to have an impact on the cash flows of the project and the NPV.

A detailed long-term production plan for the mine is essential for the purpose of determining the cash flow forecasts for any mine or a project. Few key points that are critical to determination of the cash flows is to account for

• the appropriate losses (handling and processing losses).
• Variation in grades year on year – which will result in variation in the final production levels of saleable product
• Variation in strip ratios over the mine life – this will result in substantial variations in the cost of mining over the life of mine.

The Second factor in the determination of Revenues is the Selling Price. As a thumb rule, producers/miners remain one of the worst forecasters of the future market price of metals. Though neither have the analysts done any better in doing the same. There are certain alternatives available for forecasting the selling prices for the metals/intermediates/ore.

Consensus forecast - One of the safest and easily defendable assumptions is to take a consensus of a number of analyst’s forecasts. Either mean or mode can be taken or mean after removing the outliers can also be taken as a safe assumption. I personally do not recommend too much of “cleaning” the data to remove outliers as it tends to be get biased in either direction depending on the person doing the cleaning.

The consensus forecast for exchange traded metals are available on Bloomberg and Reuters. Reuters also runs a series of half yearly surveys of forecasts for traded metals. Other alternatives to get consensus forecasts are to service providers such as consensus economics or to collate the forecasts individually from the research reports/data sites of each analyst/forecaster though its an extremely tedious exercise and prone to selection bias.

Economic Forecast – A detailed economic forecast for the price of the metal/ore can be drawn based on

1. Supply demand situation
2. Proxy pricing with alternatives
3. Cost curve analysis – marginal cost of production

While these methods constitute entire subjects unto themselves, we will look at these in brief. Metals are linked to the economy. Demand for all metals is driven primarily arising out of consumption patterns and growth. Consumption is metal specific (due specific usage of each metal) but is driven by consumerism and infrastructure spends in different proportions. The economic forecasts will begin with a forecast of the economic growth of the world economy and in particular the major regions of consumption, followed by sectoral forecasts for consumption of the finished product and backward calculation being down to the level of consumption of primary metal. This alongwith the forecast of secondary metal consumption (scrap etc) and supply will provide a full forecast of the demand situation for primary metal.

On the supply side of the equation, a forecast of mine wise production (this data is generally collated by data suppliers like Brookhunt( for base metals) etc ) from existing as well as planned projects needs to be drawn. There are generally variations in the year wise production levels from existing mines, as well as delays in projects, project cancellations and extensions of mine life which all need to be factored in. Many analysts such as Brookhunt tend to classify projects as probable, possible etc to draw a probability based expected production level and supply for the future.

Proxy pricing – while in itself it is not a complete forecast, it also forms one of the inputs a jigsaw puzzle (which hitherto no one has solved entirely) of forecasting the pricing. Proxy pricing forms one of the reference points to ensure we are not straying too far from what might be the reality. It is also a powerful tool for derivatives of primary metals such as deriving a petrol price forecast on basis of Crude oil forecast.

Cost curve analysis is also one of the major inputs on the supply side. Cost curve is a chart of cumulative production vs. the cost of production. It is essentially a sorted list of all producers from low cost to high cost. The supply from mines is highly dependent on the current cost of production and the price of the finished product. There is substantial variation in the cost of production from various mines on account of intrinsic factors – technology, strip ratios, logistics costs etc which cannot be in most cases reduced with reduction in the selling price. As mines begin to run cash losses, they tend to shut down the operations resulting in drop in supply. Also with change in prices, the investments into capex and new projects tend to dry out resulting in reduced supply in the years to come. Generally, a baseline price for all commodities in the long term is drawn at 75-80 percentile position of the cost curve. This baseline price can be viewed as a long-term forecast for the price of the particular metal. Any drop in price below this level will generally tend to start bleeding even the efficient suppliers and will result in noticeable drop in production levels balancing the supply demand situation. Suppliers such as Brookhunt tend to provide cost curves (with forecasts/sensitivity) at a fee of course.

Flat forecast – One alternative for assumption for sale price is to assume a flat single price, usually the current price. While this may seem unscientific, it is a reasonable assumption to make if the cost of inputs and the output have a strong correlation over a period of time. It also makes sense to have a sensitivity built into the financial model for running a flat price forecast at long-term price levels.

The Miners introduction to Valuation

The Basic principles

From financial perspective, the valuation of any company or a mine is not different from any other financial asset. It is essentially the sum of all the Cashflows (Money) that is expected to be received over a period of time.

Time Value of Money – Putting it simply, Money today is more valuable than money in the future. Eg. Hundred Rupees today is equivalent to 110 Rs one year later. (10% interest rate assumed)

This principle relies on the opportunity cost (also known as Cost of Capital or Cost of Carry) of returns to be generated from Cash in hand over the period of time.

Valuation (NPV) = Sum of all the cashflows weighted by a factor for time value of the money (aka Discount factor)

Where Wi = 1/(1+r)ⁱ

Theoretically, the Discount factor is a rate (similar to Interest Rate) which is a function of the risk of a project (Expected Rate of Return). For eg A low risk project will carry a discount rate of say 10% while a high risk project will carry a discount rate of 15%.

Practically the estimate of Discount Rate (expected rate of return) is drawn on the basis of Weighted Average Cost of Capital (WACC). WACC is simply weighted average cost of Debt and Equity

• Cost of Debt is rate of interest on loans of the company
• Cost of Equity is the rate of return expected by the shareholders of the company
• To sum it up simply, the determining the valuation or the Net Present Value(NPV) is only a matter of forecasting the cashflows from the Mine and then discounting it with the WACC of the company.
  
  
  Formula Refresher
  Selling Price x Production = Revenue
  COP x Production = Cost
  Revenue – Cost = EBITDA
  EBITDA – Depreciation = PBT
  PBT – Tax (33.99%) = PAT
  PAT + Depreciation = Cash Profit
  Cash profit less Capex less Increase in Net Working Capital = Net Free Cash Flow
  Net Free Cash Flow when Discounted at Discount Rate (say 14%) = NPV
  NPV should be +ve so that the project is viable
  IRR should be at least  equal to WACC for the project to be viable
  NPV and IRR are related- IRR is that discount rate at which NPV becomes Zero
  Discount rate is determined as a WACC - weighted average of cost of Debt (interest cost) and Cost of Equity (Expected rate of return of the shareholders).
  NPV of a company is same as Enterprise Value (EV) of that company
  NPV + cash – Debt = Market Cap = No. of shares x value of each share