This week, I watched Barry Schwartz's TED talk on The Paradox of Chioce. This thought provoking talk delivered in 2005 (the year before TED decided to offer its content online for free viewing) is a simple but groundbreaking observation on how choices actually make us dissatisfied and paralysed. I highly recommend it if you have 19 minutes and 25 seconds to spare.
On that note, unlike our usual Sunday weeklies, this week's newsletter offers no choices of reading sections. There is only one topic we look at and we dive deep into it. Hope you enjoy it!
IN THIS NEWSLETTER
Stock Story - The Sandur Manganese and Iron Ores Ltd. (Minting Money, Mining Manganese)
Stock Story - The Sandur Manganese and Iron Ores Ltd.
Take this from me - You want to get into a business with the fewest number of variables. Think: Apple. They design products, which is entirely under their control. They outsource production to a company like Foxconn in exchange for a contractually stipulated fixed price, which is also under control. They run content platforms, like the App store & iTunes where sellers list their products for buyers – again, under their control. Their only real variable is the number of buyers for their products and services. And pretty much all of their effort goes into controlling this variable in making their products more and more sticky.
Imagine now for a moment that you are running steel production business. What do you think are the variables in your business? For your customers, steel from your factory is exactly the same as steel from elsewhere. There is hardly a way to increase stickiness to your product. So, customer demand is definitely a key variable. Anything else?
To fully appreciate how many variables are involved in running a steel business, we will have to understand how steel making really works. Here is a chart showing the steps involved in the dance.
The process starts with securing iron ore, a commodity whose price is fixed in the commodity markets. This price changes every single day. Limestone, which goes into making sinter iron ore (a lumpy version of iron), and coking coal, which is used in making metcoke, similarly are also globally traded commodities. It is not just price, but it is also the supply of these mined commodities which is subject to the vagaries of government actions, weather, natural calamities, environmental restrictions and so on. Once secured, the raw materials will have to be transported to the steel factory and this is again subject to a number of other variables.
Once it is all in, a whole host of highly volatile processes need to work in sync on expensive machinery often prone to failures. You can see what I am getting at. Every business variable is exposed to risks and an agglomeration of an enormous number of risks frequently leads to inefficiency and breakdown of systems. It is not very surprising then that the average steel business in India makes an after-tax profit of 3.5% while Apple makes an after-tax profit of 21%.
Let's talk a bit about mining first...
Before we go further, we need to take a minute to understand how mining works in India. All land that have proven reserves of natural resources belong to the government. This is true in most countries. The government leases out mining rights through an auction and the highest bidder typically gets the right to extract ores from a specific mine for a specified period of time (typically 20 years). In exchange, the mining company promises to pay a % fee on the basis of its total sales of ores. For instance, if the price of iron ore is Rs.2,000 per tonne and if the mining company is required to pay 25% of selling price, then the state earns Rs.500 per tonne of iron ore sold. When the price of iron goes up in the commodity exchange, the government makes more money and so does the mining company. And vice-versa. But when prices go up significantly, like it did for iron ore quite recently, mining companies tend to make a heck of a lot of money. The government obviously does not like that. So they have been pushing miners to pay a bigger chunk of sales prices as royalty payments. To give you an example, the Karnataka government asked NMDC in 2018 to pay them 80% of sales price as royalty for their mining activities in Donimalai hills. NMDC of course said no and the resulting disagreement let to their mine being shut down for over 2 years till the issue was resolved. They ultimately agreed to pay 22.5%.
There is typically a cap applied on how much ore can be extracted from the ground each year. Sandur Manganese and Iron ores limited for instance has proven iron ore reserves of about 140 Million metric tonnes of which maximum permissible annual production (MPAP) is about 1.6 Million metric tonnes. Their MPAP for manganese is about 0.6 M tonnes.
The iron ore reserves in Karnataka are typically of lower quality. This quality level is measured by iron content in the ore. The highest-grade iron ore contains about 65%+ iron. The lower grades contain anywhere from 40% to 55%. And depending upon the size of the ore as it naturally occurs, it is classified as lumps (the larger ones) or fines (the smaller ones). Lumps typically command better prices than fines since they can be directly introduced into the steel blast furnace. Fines on the other hand have to be processed before they can be used for steel production. Sandur’s iron ore mines roughly carry about 33% lumps and 67% fines.
The Sandur Manganese and Iron Ores Limited (SMIORE)
SMIORE is a Karnataka based iron and manganese ore mining company which owns the right to mine over an area of 3200 hectares till the year 2033. It is majority owned by a royal family in Karnataka. Y.R Ghorpade, the former Maharaja of Sandur, was awarded a mining lease over an area of 7,500 Ha when his ‘kingdom’ was merged with India post-independence. He founded this business about 70 years ago. This lease that he was originally awarded was later renewed in 1974, 1994 and then in 2014 and almost every time the land allocated for mining was reduced. Today, his successors hold just one third of the original lease area. And why was it reduced? To get public sector enterprises involved in mining activity. NMDC for instance holds leasing rights in Donimalai, which is roughly an hour’s drive from Sandur’s mines. State government owned mining company Mysore Mines/Karnataka state minerals corporation limited also own rights in the area today.
The Bellary district is known for its rich mineral resources of iron, manganese, gold, copper and lead. Where wealth is endowed in the form of natural resources, there is almost always evidence of corruption. Popularly known as the resource curse, this is extensively studied and contains lots of anecdotal evidence (Nigeria and oil, Congo and diamond and more recently South America and the Lithium Triangle). In the first half of last decade, rampant corruption and illegal mining in several different areas of Karnataka led to a complete and total ban on mining. The supreme court shut pretty much every single mine down to investigate irregularities. Take a look below at the quantity of iron ore that SMIORE extracted over the last decade. You can see a massive dip in extraction in 2012 and 2013.
At the end of the trials, the supreme court ordered Karnataka government to re-auction a number of mining leases and laid a total and complete ban on exporting iron ores from the state, which exists till date. All sales of iron ores in Karnataka happens through a centralised e-auction system which the government organises. Only end users of iron ore can participate in this auction. While it is possible for steel manufacturers in Karnataka to import iron ore from elsewhere, sellers of iron ore have been left with no other medium to sell/market their product.
But in spite of all of these restrictions, SMIORE has resurfaced from this crack-down with just a scratch. This rebound was only possible because of how clean SMIORE has been over decades. The company proudly keeps saying that the founders returned 1,600 acres of their personal land to the government for conservation efforts. The business employs 4,000 people and all of them have access to subsidised food grains at 1972 prices. A package of 16 essential food commodities is offered to the employees at a cost of Rs.145 as against the actual cost of Rs.3,250. The royal lineage looks after its subjects and its land. As against a mandatory requirement of planting 1.11 Lakh trees, the company has planted 35 Lakh saplings in the mining area. No wonder then that SMIORE was awarded 5-star rating to their mines by the ministry of mines, Government of India based on an assessment of parameters of sustainable development framework for three years in a row (2014 to 2017).
SMIORE operates in 3 different segments today -
They mine iron ores (~60% of their revenues) - About 1.6 Million tonnes each year against permitted maximum of 1.6 Million tonnes.
They mine manganese ores (~20% of their revenues) - About 0.28 Million tonnes each year against permitted maximum of 0.6 Million tonnes
They produce a ferrous alloy (Silico Manganese)(~20% of their revenues) - About 30,000 tonnes each year. While this part of the business is not regulated by the government, the alloy production process is extremely energy hungry. So, they have an internal captive thermal power production plant which uses Rs.90 crores worth of coal each year. This high energy cost has consequently made the alloy business loss-making.
Here is a look at the net profit margin across the three lines of business.
If you are like me, you are probably wondering how in the heavens are they making 50% net profit after tax on a commodity business like iron/manganese ore mining where there is massive competition.
Well, here is the story.
Why is Ore Mining So Profitable?
Iron ore mining has been super profitable in India for two primary reasons.
Ore prices track international commodity index prices - Iron ore prices in India do not entirely track the global commodity prices, but they are loosely tied to it. Here is a chart showing global iron ore price this year and its price in India. While there is a disconnect, they are both trending upwards.
Contrary to popular belief, Iron-ore mining is a less resource intensive process - I have done the math in so many different ways. And they all tell the same story when it comes to unit economics. The actual cost of extracting iron ore from the ground is only about Rs.400/ton. Add to it transportation cost, royalty payment to the government, overheads etc., the total cost of mining ore is about Rs.1,000. The commodity price on the other hand has varied between Rs.2,000 to Rs.3,000 over the last few years. The current price is about Rs.5,000, thanks to a massive supply dislocation in the international markets. Hint – China.
Add to this, the third dimension - Ever increasing demand for steel in India and China and consequently for iron ore. Remember, steel builds literally everything in our world. From bridges to houses, cars to paperclips – literally everything! A liberal pricing environment and an increasing demand environment have both made iron ore one of the hottest commodities to be mining right now. Perhaps just after Bitcoin 😉
Why not then just keep mining more and more iron ore?
And that’s what SMIORE wants to do. They want to increase their maximum permitted iron ore mining limit from 1.6 M tonnes to 3.5 M tonnes. Their application seeking approval for this is pending environmental clearance for the last 10+ years.
But there is a danger is being the company that only just mines iron ores. Remember the lease I talked you about? That is about to expire in 2033. And when that happens, there is no guarantee that it will be renewed. Remember NMDC who are an hour’s drive from SMIORE? They are hungry for more iron ore. Their Donimalai mines will be all out of iron ore at the rate they are extracting within the next 20 years. They will want a piece of it. And so will the other tens of mining companies that exist in Karnataka. So, what happens if SMIORE does not manage to secure a renewal? Well, they will go from a company who primarily mine iron ores to a company who primarily do nothing. And this scares them.
So, what are they doing about it?
Over the years, there has been a trend of companies moving up the value chain in the mining business. SMIORE wants to do just that. They want to go from a company that ores iron ores to a company that makes steel. To that end, they have put about Rs.600 crores on the table as part of Stage 1 expansion and built a met-coke plant, the second key ingredient that goes into the making of steel. This they claim will increase their revenue from about Rs.700 crores now to Rs.1,700 crores.
They want to build a pig-iron production plant as part of Stage 2 expansion (the penultimate step before the finale) and once that is done and dusted, they want to build a 1 Mtpa steel plant. And this expansion will take their revenue from Rs.1,700 crores to close to Rs.5,000 crores per year. Now all of this is going to cost about Rs.8,000 crores. The market capitalisation of the company as of last week was only just about Rs.1,000 crores. How are they going to fund all of this? - Through a combination of debt and the enormous amounts of cash the iron ore business is coughing up.
Here is a business that is looking to increase its size by about 7X within the next decade. How exciting!
Shouldn’t we be buying all of their stocks?
Well, not just yet! Remember how I told you about not getting into a business which has too many variables. SMIORE is an example of a business that is in a journey to go from 1 variable (ore prices) to enormous amounts. And this journey is fraught with risks. Not just that. Ore mining today is a very high return on capital employed (ROCE) business. And this is great for investors, till so far as the money is returned to shareholders in the form of dividends or redeployed in an equally high ROCE business. When it is not and is reinvested by the management on lower margin businesses that are frail in nature, it becomes a trap. They are on a decade long journey to go from a business making Rs.700 crores in revenue and 25% in net profit to probably Rs.5,000 crores in revenue with an industry average of roughly 3.5% in net profits (full business cycle). Do the math.
P.S: I hold positions in SMIORE. But my holding in the company is short-term tactical asset allocation as part of my momentum portfolio. Please do not consider this to be a stock recommendation. Please do your own due diligence before making an investment.
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