Our China steel analyst Scarlett Chen believes that current steel production in China, at about 55 million tonne per month, is way too high compared with demand. Production must be scaled back, leaving some time and room for existing inventory to be absorbed. She believes that value will emerge only when we see monthly production in China contracting to March 2009 levels of 44-45 million tonne.
Our earlier price forecasts were based on our expectations of 63.5% Fe (iron) content ore price. We had estimated that spot FOB prices for 63.5% grade would average $125-130/tonne in FY11 and $120/tonne in FY12 ($135-140/tonne currently). Based on these assumptions, we had taken a 65% increase in Sesa Goa?s average spot realisation for FY11.
We now revise our spot price forecasts for Sesa Goa, taking into account prices of both 58% Fe grade ore and 62% Fe grade ore,- given the widened discount of the 58% Fe grade to the 62% Fe grade. In FY10, 58% Fe grade ore traded at an average discount of 17% to 62% Fe grade ore (July-Aug 09, discount increased to 22-34%). The discount rose to 31% in May 2010 and is currently around 25%.
We believe that iron ore spot prices for 58% Fe will average $88/tonne in FY11 (against $93/ tonne currently) and $124/tonne for 62% Fe, ($129/tonne currently)?maintaining an average discount of 26% for FY11.
About 70% of Sesa Goa?s ore is 58-59% Fe grade, the rest being approx 62% Fe. We expect Sesa Goa?s spot realisations (standalone) to rise 45% in FY11 (against 65% earlier). We revise contract prices downwards in line with our spot price revisions. We also expect contract prices for Sesa Goa to rise 50% on an average for FY11 vs. our earlier estimate of 68%.
Volumes: We have reduced iron ore volumes from 25 mt for FY11 to 24 mt, ie, reduced the volume growth rate to 17% from 22% earlier, given our expectation of an expected cutback in Chinese steel production. The company expects volumes to grow 20-25% per annum over the next few years.
Royalty: We revise iron ore royalty downwards as we reduce our price forecasts.
Export duties: The government enhanced export duties to 15% on lumps from 10% earlier in April 2010. Export duty on fines continue to be 5%.
We rate Sesa Goa Sell/Medium Risk (3M). Profits are mainly driven by its iron ore business and the company exports more than 90% of its ore, with China the largest market (85% of sales). Spot ore prices have surged 103% in the last year, but are down 14% in May.
We calculate our target price of Rs 327 using a combination of (a) a valuation based on DCF (discounted cash flow) for Sesa Goa and Dempo plus EV /Ebitda (enterprise value/earnings before interest, taxes, depreciation and amortisation) for Sesa Industries (Rs216/share) and (b) a 8x core PE (price-to-earnings) (June 11) based valuation plus cash (Rs400/share) ?with a 40:60 weighting between each methodology. Our DCF value for Sesa Goa standalone is enhanced by 10% to account for potential reserves at Jharkhand (60 mt).