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Finance Friday: The Fate of Low Floating-stock Counters – Valuation Crunch in NMDC FPO

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The Follow-on public offer (FPO) of the largest iron ore producer in the country National Minerals Development Corporation (NMDC) is currently open for subscription with a price band of Rs. 300-350 wherein the government plans to divest 8.38% stake in the market. The last date for subscription is today.

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Markets Way of Assigning Valuations

The stock price of NMDC has witnessed a drubbing on the bourses from its recent peak of Rs.571 on January 19 and 20 to Rs.380 for its closing on the first day (March 10) of the opening of NMDC FPO. The stock is down by a whooping 33% from its recent peaks, almost wiping-off a third of the market capital of this state-owned company.

After a recent subdued response to follow-up offerings from the state-owned companies NTPC and REC, the government has rightly chosen to do away with the ‘French Auction’ methodology of issuing shares to the subscribers.

However, the non-ability of stock price of NMDC to sustain at the higher levels of Rs.570 just before the announcement of FPO, is a clear cut signal from the market that the valuations of the NMDC are at a higher side. Another pointer to the high valuations for this stock could be its low floating stock.

Valuation Analogy of Low Floating Stocks

Low floating stocks are those stocks where a majority of the stake is owned by promoters and its group, thus limiting the scope of shares open to trading in public. Take, for instance, listed government owned companies like NMDC (98.38%), Hindustan Copper (99.59%) & MMTC (99.33%) where the Centre has a whooping over 98% stake in each of these companies, leaving little scope in the hands traders or investors to think about.

In such companies, the stock in float for retail investors and institutional investors is very low and limited. The stock price and valuations of such companies are based on a low floating stock in public, thus making investment and trading in such stocks susceptible to high volatility and lower average volumes on the bourses more often than not.

The excess valuations and speculative interest that such counter received till now based on its low float, could gradually lose the sheen with higher float in the domain of public / institutions with dilution of the promoter’s (Government in case of NMDC) stake post follow-on public offering.

As per latest available data on the NSE website regarding NMDC FPO subscription details, the QIB quota is over-subscribed by 1.55 times. Participation from other parties like retail investors (0.02 times), FIIs and HNIs were negligible with no contribution from Mutual fund industry as yet.

My question to our readers is,
if the stock had the demand and appetite from the investors while trading at astronomically high levels of Rs.570 few months back… but have no takers from the retail and HNI categories now, even at a lower band of price offering at Rs.300; where was the demand for the stock fuelled from at that time- Investment or Trading Speculation?

Valuations of NMDC

At the stock price of Rs.380, NMDC is valued at 43 times its earnings based on an annualized EPS of 8.7 for FY 2010. The valuations which are not cheap by any means but hardly fairly valued based on the strong financial performance by the company over the last few quarters.

As per one of the Economic Times news article, the price of NMDC is clearly way above its fundamentals when compared to the valuations commanded by its global peers:

NMDC is overpriced by most valuation parameters when compared with larger global miners such as BHP Billiton and Rio Tinto and even local peers such as Sesa Goa controlled by Vedanta Resources.

“At Rs.300, it (NMDC) is trading roughly 13 times its FY11 earnings. So, there is very little upside left,” said Paresh Jain, analyst at Angel Broking. “In sharp contrast, global peers like BHP Billiton, Rio Tinto and Vale are trading at around 7-9 times their FY11 earnings, while pure iron players like Kumba and FMG (Fortescue) are trading at 8-9 times their FY11E. One could say all of them are trading at around 7-10 times.”

While NMDC may be more efficient when it comes to cost of production and the quality of ore it mines may be superior, but the price may still not be justifiable for global investors given its tiny size compared to BHP or Rio. NMDCs revenue is at about $2 billion, BHPs is at $51 billion and Rios is $41 billion.”

Demand Supply Scenario

The intent of this post over here is not to discourage readers planning to enter low floating stocks or encouraging them to exit such counters if they already hold them. Also, it is not necessary that all low floating stocks ought to be expensive. At times, there could be counters where the float is low but the volumes are healthy.

The valuations in stocks with low float may find it difficult to sustain at higher levels as the floating stock and volume increases for trading in the open market during the longer time span.

The simple logic that could apply over here is that with low floating stock the demand for the stock far out-strips the supply in such counters. However, post increased floating stock; the demand-supply scenario rationalizes on the back of higher participation by market participation leading to better price-discovery mechanism.

My Views on NMDC FPO and Valuations

Personally, I feel even NMDC may manage to scrape through with the issue backed by government-owned institutions like big-daddy LIC and other state-owned banks like SBI, BOB, etc. But, in spite of the government’s pricing of the issue at a steep discount to the market price before the opening of the FPO, the issue may not garner run-away subscription figures from retail investors.

Long term investors with moderate to high risk appetite can subscribe to the issue at the lower band of Rs.300. In fact, the retail portion of the investors would be privileged to a discount of 5% of the offer price determined pursuant to the closing of the book building process.

Take, for instance, if the issue price is fixed at Rs.300 the retail investors would be allotted the shares at a discounted price of Rs.285. Chances of allotment could stand to be strong in retail category, as response from retail investors is expected to be subdued. After all, it could be with buying some shares at Rs.285 from long-term perspective of this biggest iron ore company in India.

On the other hand, investors with short to medium term view or those who are risk-averse need to wait for listing of government divested stake in public. Later, over a period of time, if and when the valuations come down to more sober levels on the back of higher volumes and better price-discovery mechanism, low risk investors can grab shares from the open market.

Will the follow-up issues of other low floating counters like MMTC and Hindustan Copper receive same treatment valuation crunch from investors?

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