Two iron ore majors announce $10 billion capex plans. Should you invest?

Cyclical investors, it might be your time to shine! NMDC and Lloyds Metals , two major iron ore producers, recently announced grand capex plans to capitalise on the current upcycle in the steel industry.

NMDC, the iron ore producing PSU, will invest a staggering Rs 50,000 crore over the next five years to double its production capacity. Lloyds Metals has set aside Rs 33,000 crore for the same purpose.

Note that the combined capital expenditure of these two companies over the last ten years was just over 20,000 crore!

But are these plans enough to warrant an investment? To answer that, we must explore why they are investing such large amounts now.

Riding on the India wave

In the past few years, the Indian government has gone on a capex spree to improve infrastructure, leading to unprecedented domestic demand for steel. In fact, steel consumption in India rose 30 per cent in the last five years, whereas most developed economies witnessed a decline.

This trend is unlikely to hit pause in the near future, given that the National Steel Policy aims to increase India's steel production capacity to 300 MTPA by 2031 from the present 160 MTPA. For the uninitiated, you need 1.5-1.6 tonnes of iron to make 1 tonne of steel. Crunch the numbers, and you get to know that India needs to produce 450 million tonnes of iron ore per annum to meet its target.

This means that demand might not be a cause for concern for iron ore producers. Notably, the Chairman of NMDC recently said, " We are unable to produce...we are unable to satisfy our customers with the quantity of their demand, whether it is JSW, whether it is JSPL, whether it is ArcelorMittal, whether it is RINL, all of the customers are demanding much more from us, so I don't think the demand is ever a problem".

But do they have the funds to capitalise on this demand boom, or will these investment plans lead to a debt pile-up?

Finding the funds

• NMDC: For the government undertaking, capital is not a challenge. Strong domestic demand and elevated iron ore prices during the pandemic has seen the company post robust earnings growth in the past five years. In addition, NMDC has historically displayed strong cash generation abilities, with an annual CFO (cash flow from operations) run rate of Rs 7,000 crore in FY24. Given that its peak capex in a given year going forward would be around Rs 8,000 to 9,000 crore, it is unlikely that the company would require external funding. Also, NMDC plans to lower its average dividend payout ratio to 38 per cent from the current 45 per cent to play it safe. It also boasts a robust balance sheet, with cash reserves of Rs 12,000 crore and a low debt-to-equity ratio of 0.13 times.
  

The India factor

Strong domestic demand has helped both post stellar growth.

FY20-24	NMDC	Lloyds
Revenue growth (% pa)	15	101
Profit after tax growth (% pa)	12	150
5Y median ROCE (%)	22	24

• Lloyds Metals: Unlike NMDC, Lloyds Metals might need to raise capital to fund its capex plans. While it, too, has a robust balance sheet with negligible debt, its CFO run rate in FY24 was just Rs 1,700 crore. Consequently, the company has announced that it will raise Rs 1,200 crore through QIP (Qualified Institutional Placement) and Rs 700 crore through preferred warrants for capex. In addition, the company is focusing on reducing costs to boost the CFO run rate. It extended its lease on its existing mines in 2018 to 2057. Given that royalty fees have increased post 2020, competitors would have to pay higher fees than Lloyd going forward.

Hold your horses!

While it is true that rising demand and a robust balance sheet work in the favour of these two iron ore giants, there are uncertainties that you must not ignore.

• The upcycle might meet an abrupt end. In most commodity sectors, an upcycle ends when supply exceeds the demand. Given that most iron ore producers are amping up their production incrementally, a demand-supply mismatch cannot be ruled out.
  
• Steel makers are producing their own iron ore. The rising demand for steel has also motivated major Indian steel makers to invest in their in-house iron ore production capacity. Tata Steel is aiming to double its iron ore capacity to 60 MTPA. Also, JSW Steel has 24 iron ore mines in India, of which only 13 have been operationalised as of FY24, meeting around 33 per cent of its consumption. SAIL meets all its iron ore requirements in-house. This means that the trend of rising demand might not be impervious.

Overall, the current market environment is indeed promising for iron ore producers, and the capex plans of NMDC and Lloyd Metals may hit the bullseye. But without factoring in the above uncertainties, investing in them will be a shot in the dark.

Also read: Should you invest in cyclical stocks