Coal and Mineral Sector Disinvestment – Challenges of Valuation

Recently the Government of India proposed disinvestment of 5% stake in Coal India Limited (CIL) along with dilution in stakes to the tune of 15% each in National Aluminium Company Limited (NALCO) and National Mineral Development Corporation Limited (NMDC). The government has also proposed disinvestment of 10% stakes in Neyveli Lignite Corporation Limited (NLC), which is the vertically integrated power producing company in India. The common thread that joins these companies is that they are profit making commodity companies, with the exception of NLC which feeds lignite into its pit-head power plants for energy generation. Due to political compulsions, the government, however, has decided to freeze the proposals for the time being. Disinvestment of stakes in these companies is in line with the agenda of reforms which are considered irreversible. Hence, current stay on the process may be regarded as temporary.

Disinvestment, through IPO path, will give higher visibility to these public sector behemoths. It will also lead to greater degree of transparency and corporate governance in Coal India Limited and other mineral sector companies. With the current scenario of acute coal shortage for power generation, accountability on part of the near-monopoly would be more than welcome.

The process of disinvestment in coal and mineral sector is fraught with risks, particularly, price risks. The critical first step in considering a potential sale of stakes is to know the current market value of the company. The questions raised in the aftermath of disinvestment of Bharat Aluminium Company Limited (BALCO) should be considered and thought through before the green flags are fluttered. With regard to the process of valuation, the stakeholders in general and the government in particular need to be prudent. Value appraisal with regard to discounted cash flows may not always be appropriate although the general idea is that the value of a company or an asset is what cash flows it can generate. Asset based approaches should also be considered due to the fact that the company has a huge under-utilized and non-operating equipments along with reserves which are not optimally tapped. There is substantial intangible asset base too, in terms of first right of exploring and exploiting any coal bearing property and huge workforce. The CIL workforce is a unique accumulation of geologists and mining engineers. The coal industry at the threshold of reforms will do good to value this manpower. Finally, the third approach of market based methods of comparable companies and comparable transactions may not be strictly applicable for CIL for lack of such data. However, a comparison of multiples of global companies like BHP, Anglo American and CVRD, to assess the efficiency and productivity in relations to value will be good enough a reason to carry on this exercise.

There is an absolute lack of standards with regard to valuation of businesses and mineral properties in India. Globally too, the mineral appraisals are not yet properly understood. According to a survey conducted by PricewaterhouseCoopers of the chief executives of top 20 mining companies in the world, it came out as a general consensus that the mining companies are generally undervalued. The reasons for such undervaluation may be ascribed to lack of reliable information on reserves and their values. Even the US GAAP and IFRS do not spell out in conclusive terms the processes and treatments for valuation, categorization and depletion of reserves; capitalization of exploration and initial development expenses; and impairment of associated assets. These issues are likely to manifest in more precarious forms in India since the companies have not been in a practice of disclosing, or even tracking, such assets and their values. The Indian accounting standards are silent on these issues.

The Standard of Value
The first and the foremost challenge in the disinvestment process is to determine the standard of value. The standards of value are fair market value, investment value and intrinsic value. The fair market value is defined as the value that any willing buyer in the market will offer for a business or asset without any compulsion with adequate information. The investment value on the other hand is the value for a specific investor and takes into account the synergy benefits that investor may have if the transaction is through. The intrinsic value is an ideal case value and is assumed to be the true value of business or asset. Whereas these definitions may be simple, the application of these standards determines their suitability and usefulness. Selection of unsuitable standards may lead to disputes. In case of disinvestments, the usual route is to consider fair market values. However, the experience of disinvestment so far, including the case of BALCO, is that the acquired entities have gone to become part of the conglomerates and the synergy benefits have accrued to the buyers. In case of dilution of stakes to an extent of 15% is concerned, such considerations may not prevail and hence, fair market value standard should be the chosen one.

The Application of Approaches to Value
The three approaches to valuation, namely, income, market and asset approaches have their applications. Income approach is considered applicable for operating businesses and assets. The concept behind the income approach is that business or asset values are the present values of all future cash flows. While income approach is widely applied in the industry, it is not free of flaws, particularly so in case of disinvestments. There almost always exists scope of improvement in efficiency and potential of optimizations in privatizations. Hence, projections made on as is basis may have a downside bias. The two generally accepted methods in income approach are discounted cash flow method and capitalization method. The capitalization method is applied for companies in steady state with regards to growth and expansion. Since there is a large scope of expansion of Coal India in light to the projected acute shortage of coal, discounted cash flows should be the preferred method.

The market approach on the other hand is applicable for similar companies with operations of similar nature and dimensions or similar transactions. These methods are called the comparable company method and comparable transactions method in the business valuation fraternity. This approach is simplistic but has a degree of subjectivity involved in selection of comparable companies and transactions, applicable multiples and reconciliation of values arrived from these multiples. In the case of Coal India Limited, Neyveli Lignite and NMDC, there is a lack of comparable companies and there are no comparable transactions either. However, for NALCO disinvestment BALCO and HINDALCO provide a benchmark. However, the population size being small, and also the valuations being disputed, the method may not indicate an acceptable value.

The asset approach is applicable for asset intensive businesses. It is also the preferred approach for liquidation. The most common application of this approach for a going concern is observed in the application of net asset value (NAV) method. For asset intensive mining companies like the Coal India Limited, asset approach may be a supplement to the income approach. The company may have assets under-utilized and non-operative. Their presence will make application of asset approach mandatory to supplement the value arrived at by income approach. The asset approach also incorporates valuation of intangible assets. The Coal India Limited being the de facto lessee of all coal bearing properties in India according to Coal Bearing Areas (Acquisition and Development) Act, 1957, should indicate existence of intangible assets. The valuation of such assets is, however, challenging and may involve use of highly analytical methods of real options.

Counting the Discount Rate
The discounting rates are manifolds in any valuation exercise. In the discounted cash flow method and the capitalization methods, the discount rates are the expected rates of returns. The discount rates should, however, match the cash flows being subject to discounting. If the cash flows considered are the benefits to equity holders then the discount rate should be the expected rate of return on equity, and if the cash flows are cash flows to the firm, then the weighted average cost of capital is applicable. Mathematically, these are mundane but the analysis to arrive at these rates is rigorous. The computation of market rates of returns for debt and equity in mining industry is challenging since a large number of such companies are closely held government companies. Many of these companies take pride in carrying zero debt on their balance sheets even in light of assets worthy of being secured against cheaper debts. Formulating, thus, the industry prevalent capital structure, as is required for the application of income approach, may be a tough task.

For Coal India Limited, benchmark discount rate may be arrived at by taking a look at the industry premiums in the global markets and adding adjusted premiums to the Indian risk free rates. Adjustments must be made to accommodate the Indian stock market scenarios to arrive at justifiable premium.

Discounts for Marketability and Minority
The closely held businesses do not offer returns as publicly listed companies. The liquidity incorporated in the securities by means being actively traded in exchanges or over-the-counter markets reflect in the values of the securities. Hence, when drawing conclusions for value of a closely held company, the discount for lack of marketability (DLOM) is applied. Similarly, discounts are applicable for lack of control. A minority stakeholder is not expected to make significant decisions for the company and hence, lack of control is reflected in the value of securities. This is evident from the premiums acquiring companies pay for acquiring controlling stakes. The discount for lack of control (DLOC) may be applied to values arrived at by any of the three approaches to valuation. This is dependent on the cash flow projections. If the income and cash flows are projected based on the lack of control basis and normalizations are not made for controlling interests, the DLOC is not applicable.

For Coal India Limited as with other companies on the anvil, the stakes are minority and hence, DLOM is applicable. From the USA experience, the discount ranges from 5 to 30 percent and hence, may significantly lower the value conclusions. However, since the IPO is likely to compensate for this lack of marketability, the DLOM may not be applicable and if applied, may have lower extents.

Conclusion
The disinvestment process may have price risk for the government and hence, prudent valuation is a must. The risks are two prong, if the value arrived at is low, the government may sell stakes cheap and thus, end up being deprived of much needed resources, and if the value is high, it may not attract investment. By setting floor prices for a book building process of IPO, the valuation exercise will help assess the proceeds from sale and may help the government decide whether to go ahead with the proposed sale. The other challenges associated with the process are also to curb vested interests. The investment bankers and brokers who get paid for “doing deals” may have vested interest and hence, may not advise on the appropriate timing of sale to optimize disinvestment. Valuation from the market perspective that optimizes government returns and satisfies the disinvestment objectives should be done taking extreme care, particularly in the light of challenges such exercises pose.

Lastly, it's imminent for the government to initiate the disinvestment processes in coal and mineral sector. Let's hope that good times roll for Indian mineral industry.

(This article was published in the Analyst magazine.)