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Friday, September 11, 2009

Sesa Goa Ltd:Is it a buy/hold or sell?

Scripscan:Sesa Goa Ltd

Story:Iron ore mining major Sesa Goa?s story is on the same line. Sitting on a cash pile of little more than Rs 4,000 crore, the Vedanta Group firm didn?t have to think twice when another Goan mine called V S Dempo (VSD) came its way. Sesa Goa acquired VSD for Rs 1,750 crore on a debt-free and cash-free basis including a net working capital of Rs 145 crore. This is an all-cash deal and to be financed through the internal accruals of Sesa Goa, and at a time when the commodity cycle has reached the trough, the acquisition appears to be timely, cheap and synergetic.

Business: Exports form the mainstay of Sesa Goa, with China as a major client. It sells iron ore in spot market and export accounts for around 90% of its revenue. However, VSD has an almost 50:50 mix of spot and long-term contract sales. It has a long-term contract with Japanese steel maker, Nippon Steel, to supply one million tons of iron ore every year. Sesa Goa sold around 15 million tons of iron ore in last fiscal year whereas VSD reported a sales volume of 4.4 million tons. Going forward, Sesa Goa expects to maintain a 22% organic growth rate and along with this acquisition, the total growth rate in annual sales volume would be in the range of 40-50% next year.

Financials: VSD reported net sales of around Rs 976 crore during fiscal year 2008-09 and this will add around 20-25% to the Sesa Goa?s consolidated annual revenue. The operating margin of VSD is in the range of 43-45%, which is little lower than Sesa Goa?s operating margin of around 50-52%. However, this can be improved considering the Sesa Goa?s higher economies of scale in operation and synergy in logistics and transportations between the two entities. The Sesa Goa doesn?t have any debt on its balance sheet and the current acquisition is also not going to bring in any debt. This would provide sufficient room for Sesa Goa to go ahead with capex plan to increase its mining capacity.

Synergy and growth opportunities:The new acquisition will bring in 70 million tons of iron ore reserve, thus taking Sesa Goa?s total reserve to 310 million tonnes. Both the entities have significant operations in Goa and their mines are located close to each other. This would help in reducing the operating costs related to mining by optimal utilization of plants and machinery and transportation vehicles. After acquisition, Sesa Goa?s existing transshipping capacity would almost double. Also, VSD?s current mining capacity seems to be underutilized and can be exploited to the fullest after acquisition.

Valuation: The current acquisition has valued VSD at $5.3 per ton of its mining reserve and resources. This is relatively cheaper considering the fact that Sesa Goa itself is valued at an enterprise value of $9.3 per ton of its mining reserve and both of them have almost similar quality assets. At the current production rate, the mining reserve of VSD will last for another 15 years. The iron ore prices seem to have reached the bottom and one can assume the current operating margin of VSD to sustain in coming years. In that case, Sesa Goa would be able to recover its investment in next 5-6 years from the operating cash flow of VSD. Finally, Sesa Goa has been sitting on a huge cash reserve and it makes more sense for it to invest in businesses where returns are higher. The cash flow yield from the current acquisition turns out to be around 18-20%, which is definitely much higher than the return generated from treasury operation. Considering all these facts, we believe that current acquisition is going to be beneficial for the Sesa Goa and long-term investors can consider accumulating this stock further.

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