A $2 billion resource company with no research coverage

Wednesday, April 2: There's no lack of stockbrokers in the world and no lack of analysts. That is why when we find a $2 billion market cap company with no research coverage it attracts our attention. When we find a $2 billion market cap company with only one Australian institutional investor, it attacks even more of our attention. When we find the $2 billion market cap company is in iron ore and coking coal it's like finding a trifecta of "interest" ticket that nobody has cashed in yet. The success of recommending Fortescue Metals (FMG) from an early stage has taught us not to be scared of looking at growing market cap companies that haven't yet received mainstream analyst coverage or mainstream institutional investor interest.
At Southern Cross, we are true believers, perhaps the last true believers on our side of the fence, in the structural repricing of commodities driven by increasing demand from the BRIC economies (Brazil, Russia, India and China) and supply side constraints. Bulk commodities are clearly major beneficiaries from this phenomenon, and in spectacular fashion. As we all know, Vale has recently settled with the Asian buyers for iron ore, up 65% and the Aussie producers, BHP Billiton and Rio Tinto are holding out for more in their negotiations with the Chinese. FMG will be a beneficiary of the BHP-led re-pricing of Australian iron ore. Price increases for coking coal contracts look as though they may be even more spectacular with many industry participants now talking of the possibility for a 150-200% increase. These are amazing figures.

Aquila Resources (AQA)

There are limited "pure" opportunities to play the coal and iron ore space in the Australian market, however one stock that has caught our eye is Aquila Resources (AQA). Aquila has a growing market cap of $2 billion, yet is another classic example of an emerging mining house that no one seems to know much about. There is no broker coverage, as we mention above, and it attracts little financial press attention.

However, it has attracted a number of well-respected investors to its register including the private mining group AMCI Investments; the UK-based specialist mining funds of the Blackrock Group and the US-based specialist mining funds of Gabelli & Co. Chief executive Tony Poli owns just over 30% of the issued capital, and with other board members that ownership level moves to just over 50% (sound familiar?). From this perspective it is very similar to Fortescue Metals; management are extremely geared to delivering successful outcomes for all shareholders and this has led to a determined focus. Aquila does suffer from a lack of trading liquidity, however, as Fortescue has shown with its successful 10:1 share spilt, that trading illiquidity can be addressed.

Aquila has a balance sheet that is in excellent shape with approximately $200 million in cash and liquid investments. What has caught our attention is the strong pipeline of projects that gives the company leverage to coal and iron ore in quite a meaningful way. It has adapted a portfolio approach with very strong and well credentialled partners. It has the Isaac Plains Coal Project in production; the Peak Downs East underground coal project; the Belvedere Coal underground project and the West Pilbara Iron ore Project in pre-feasibility; scoping studies under way on the Washpool Coal Project, the Red Hill Coal project, the Northern Cape Iron ore Project and the Thabazimbi iron Ore projects; and in exploration stage are the Asenjo Energy coal project, the East Pilbara Iron Ore Project and a number of licences in the Bowen Basin. As this pipeline of projects matures, it should unlock significant value for shareholders.

The iron ore market is becoming quite well understood, with BHP and Fortescue doing an excellent job in educating the market. My view is that the market is not as well educated on the current tightness of the coal markets, but if you listen to the producers, it is quite clear that a new pricing paradigm is emerging as we wrote about yesterday.

When looking at coal producers the key points to consider are the type of coal produced, production growth opportunities, and the extent to which expansion options are backed by proven resources and access to infrastructure. The diagram below differentiates the Aussie producers by volume growth planned and by the percentage of met coal planned to be produced. Where you really want to be exposed is to the top right hand corner – strong growth in high-quality met or coking coal. That is exactly where Aquila is.

Aquila has in its coal portfolio five projects in various stages from scoping to production, as well as a large exploration portfolio. Ownership of these assets varies between 24.5% and 100% and Aquila is in partnership with Vale in coal, which is clearly looking for expansion opportunities, and AMCI in iron ore, which has also signalled that it is keen to expand in Australia.

Isaac Plains coal mine: Aquila 50%, Vale 50%

Isaac Plains Coal Mine has resources of 140 million tonnes and reserves of 65.5 million tonnes of good quality metallurgical coal, (75%), and thermal coal 25%. It has a 17 year mine life, ramping up to 3.6 million tonnes per annum (mtpa) ROM (run of mine) to produce 2.8mtpa of product. The key constraint is port capacity at Dalrymple Bay and production ramps up as capacity becomes available. They are expected to do 1.2mt in 2008; 2.2mt in 2009 and 2.8mt in 2009. Clearly those expansion targets are not without risk as it assumes the bottlenecks at Dalrymple Bay ease up and the expansions at that port open up new. There is no need for additional capital to ramp up production at this mine as the plants have been built with the expanded production target. The asset is capable of generating EBIT of $US90 million in 2010 at current coal prices for 100% of the project.

Belvedere underground coal project: Aquila 24.5%

The joint venture partner, Vale, holds an option to acquire the balance of Aquila's 24.5% interest at a fair market value post the completion of the pre-feasibility study. This fair market value could be quite significant, given that the project has a 2.7 billion tonne resource of hard coking coal. The pre-feasibility is currently under way based on two long walls producing 9mtpa. Port capacity has been applied for at Wiggins Island. The project has a mine life in excess of 40 years. Belvedere is clearly the largest coal opportunity in the Aquila portfolio, but given it is high quality hard coking coal with low phosphorous, sulphur and ash leading to good yields of 80–90%, it would be amazing if it is not developed, (and if the Vale option is not exercised). This is a potential operation larger than Wesfarmers Curragh operation, (6mpta), which most analysts think is worth more than $5 billion.

I note CVRD has taken out two exploration licences that have been granted surrounding Belvedere, that is a good sign of CVRD's intentions. Aquila sold the original 50% stake to CVRD for $US90 million and the agreement for the rest is a "fair market price clause", which includes a number of different factors. In light of the recent run in hard coking coal prices and an expected increase in the contract rate by in excess of 100%, there is a potential windfall gain coming Aquila's way from this asset. By way of example, if you use Xstrata paying $278 per production tonne for the Tahmoor mine recently and then run that over the 9mpta of production expected from Belvedere and it gives you over $600 million for Aquila's 24.5% stake, which is about one-third of the company's current market cap. Not a bad option to have up your sleeve.

Eagle Downs East underground coal mine: Aquila 50%

Peak Downs East is another large coking coal opportunity for Aquila in Queensland. The asset is adjacent to BHP`s large Peak Downs operation and has 780 million tonnes of inferred resources. A concept study was completed in July 2007. The plan is to progress with two long walls with the potential to produce 7mtpa. The initial capex is estimated at $600 million with operating costs estimated at $US50 a tonne. The mine life is in excess of 30 years. A mining lease has been applied for with port capacity allocated at Abbot Point.

Washpool coal project: Aquila 100%

The concept study for Washpool is to be completed by the end of June. It is close to regional infrastructure and is in a shallow coal basin with a maximum depth of 55 metres of cover. Port capacity has been applied for at a rate of 2mtpa at Wiggins Island. The scope of the concept study will take in an initial resource statement, the preferred route for mining and infrastructure and market assessment of the product.

Red Hill coal project: Aquila 100%

Red Hill is also in concept study, which is expected to be completed by June. Again, it is close to regional infrastructure and 2mtpa of capacity has been applied for at Abbot Point. It is planned to be an open cut, then moving underground. In the concept study, there is expected to be an initial resource statement, the preferred option for mining and processing, the infrastructure options and a market assessment of the product.

Pilbara iron ore tenements: Aquila 50%, AMCI 50%

The Australian Premium Iron JV, in which Aquila has a 50% interest, cover approximately 11,000 square kilometres and include the largest exploration acreage position located in the West Pilbara, at 9000 square kilometres. Aquila's objective through phase one of the development is to bring into production a 30mtpa operation with FOB operating costs in the order of $US15–20 a tonne. The pre-feasibility study is due in April. I see the potential for the company to add significantly to the current 493 million tonnes of JORC compliant resource overtime given the acreage position and commitment to exploration. The environmental impact study is due to be submitted in the September quarter of this year, and government approvals are expected by the December quarter. The definitive feasibility study is to be completed in the June quarter of 2009, with construction hoped to commence early in 2010 and first production in early 2012. The rail distance to port is 160 kilometres to Cape Preston and 240 kilometres to Dixon Island. Metallurgical and sinter test work is under way. Phase 2 expansion work has also commenced, with strong potential to extend the project life by at least 15 years and/or to facilitate an expansion to 40–45mpta.

South African iron ore projects

The other part of Aquila's iron ore plans is South Africa. Aquila has picked up tenements close to some very large iron ore producing areas controlled by Kumba. While Aquila will tell you that South Africa does not have the quality of Pilbara infrastructure, all the infrastructure in South Africa is state-owned and expandable. The South African Government has announced plans to spend money on energy, rail and port infrastructure to boost South African exports.

Aquila seems to be most excited about the tenements it controls around Kumba's huge Thabazimbi iron ore mine, which sells all its production (2.5mpta) to Mittal in South Africa for cost plus 3%. Thabazimbi is declining in production and thus Mittal will be looking for new sources of ore for its large South African mills. Aquila has a 26% BEE partner in Rakana and is a clear opportunity to tie into that existing infrastructure.

The longer-term plan, if they find what they expect to find in terms of iron ore around the current Thabazimbi area, is sell ore to Mittal at more commercial rates or export up to 3mpta out of the Maputo port in Mozambique. Remember it’s coal from Mozambique that has excited stocks like Riversdale Mining (RIV) from $2 to $9 in three months because it is so close to the Indian steel mills, which are all short coking coal and iron ore. India is the logical destination for this ore.

Aquila's other South African assets are exploration ground around the Northern Cape area. It is exciting exploration acreage, located next to the giant Kalahari manganese deposit that supplies 70% of the world's manganese and just up the road is the huge Sishen iron ore deposit with its two billion tonnes of resources.

Significant opportunity for cashflow and value to build

As these projects progress, it is possible that the company will be producing in excess of $US1 billion in revenue by 2013, based on the 2007 contract prices for both coal and iron ore. With Australian iron ore producers looking set to lock in at least a 75% increase in iron ore prices this year and a coking coal settlement significantly in excess of 150% on the cards, these estimates clearly look very conservative.

If you are bullish on coking coal and iron ore as I am then the scale of projects, and the partners they have, make Aquila a stock I want to have a stronger look at. Aquila has the potential to be a large scale "pure play" bulk commodity stock and the current $2 billion market cap may well prove a bargain. I am going to do more fundamental valuation work and modelling on Aquila but today I just wanted to point out that it has large-scale assets and large-scale partners in the two best commodities in the world: coking coal and iron ore.

While the short-term contract price outcomes for both iron ore and coking coal will be spectacular to the point of almost disbelief, the bigger question you have to ask yourself is whether this is a step change in pricing that the market is discounting as a "one-off"? If I am right and this is a step change – as in structural change – then emerging companies such as Aquila with large scale assets in politically stable countries will be aggressively re-rated. You could argue that Aquila is a pure-play "option" over structural pricing change in coking coal and iron ore. That could well make it a corporate target for its project "optionality" alone.

I reckon 99% of you hadn't heard of this $2 billion company until today and that in itself is interesting. If you believe in structural change in bulk commodity pricing then this won't be the last you hear of Aquila.