Black clouds clear over Whitehaven

For the first time in two years there are signs of sustainable life in the share price of the biggest pure-play coal miner listed on the ASX, Whitehaven Coal (WHC).

An end to the uncertainty associated with its former major shareholder, Nathan Tinkler, is one reason for the revival that has seen Whitehaven’s share price rise by 34% over the past two months.

The falling value of the dollar is also improving the financial performance of a business exposed to one of the mining world’s worst performing (and least loved) commodities, coal.

But the more important reasons for Whitehaven’s improved investment appeal is that final approval for its biggest mine development, the Maules Creek project, is expected soon, as is a fresh takeover bid.

In a curious way, Whitehaven’s new-found appeal has little to do with the only commodity it produces, coal.

Chronic over-production, rising competition from alternative fuels such as natural gas, and increased government regulation of the industry bearing most of the blame for rising levels of carbon dioxide in the atmosphere have made coal a virtual no-go investment topic.

Not only is coal being buffeted by a conventional cyclical commodity downturn but it is also being hit by structural changes to the industry, which are forcing widespread production cutbacks, employee redundancies and mothballed projects.

It is the combination of cyclical and structural changes, along with Tinkler’s ham-fisted management style, which caused Whitehaven’s share price to crash from a high of $6.70 just over two years ago to a low of $1.77 in early May.

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Since hitting its May bottom, and since Tinkler’s June exit, Whitehaven’s share price has stabilised and started what could be a reasonable rise despite the ongoing doubts about global demand for coal.

Once you cut through the layers of negatives around Whitehaven you find a stock that has already been heavily discounted, a point underlined by the high level of active short-sold positions recorded by the ASX.

Over the past 12-months the “short position” in Whitehaven has exploded from 3.5% of the shares available for trading (the free float) to 17%, one of the highest proportions on the ASX.

Recovery prospects ahead

Despite all of those good reasons for investors to take a negative view of the stock it did not stop the company’s major new shareholder, Farallon Capital, from paying handsomely above the ruling price for a big slice of Tinkler’s stake in Whitehaven.

Perhaps Farallon paid $2.96 for the Tinkler shares, when the stock was $2.20, was to help create an exit route for the heavily indebted entrepreneur. But it’s equally likely that Farallon sees the opportunity for a share-price recovery once Whitehaven gets clear air and is able to focus on its core operations.

Whether a share-price rise is achieved by increased coal production and rising profits or by a corporate deal that sees Whitehaven acquired by another coal miner, such as China’s Shenhua or Yancoal, is irrelevant.

The point is that Farallon is not a natural long-term investor in an Australian coal miner. It is a fund manager that has almost reluctantly emerged as Whitehaven’s biggest shareholder and which will now be seeking a way to convert a loss-making position into a profit. This will be either by engineering a bid, or by selling after the stock is re-rated with the launch of the Maules Creek mine.

The first step in the re-rating, or a takeover bid, will be receipt of final approval for Maules Creek, a mine which will dramatically enhance the size of Whitehaven’s annual coal output.

Until the new mine moves ahead, Whitehaven is not a particularly interesting stock. It has a number of relatively small mines in the Gunnedah Basin of NSW and annual production which is moving up from 5 to 8 million tonnes a year, and a forecast of 11 million tonnes in the current financial year as the Narrabri mine boosts output.

What Maules Creek does as a world-class (tier one) mine is elevate Whitehaven to the status of a globally important coal producer, with its first year of production in 2015 lifting Whitehaven’s total output to 17 million tonnes, rising to 23 million tonnes in 2017.

As well as boosting production, the new mine will help lower the average cost of production thanks to its size and relatively low operating cash cost. This is an important change given that Whitehaven is expected to report a loss of around $55 million in the year which just ended, and only a modest $13 million profit in the current year.

Future annual profits look better, but will depend heavily on Whitehaven being able to continue driving down costs and for the coal price to recover. In the 2015 financial year, if all goes well, profit could be back up to $90 million.

The Whitehaven recovery play

What’s happening to Whitehaven, and a reason for some stockbrokers recommending the stock as a buy despite the poor outlook for coal, is that it is seen as a recovery situation with a number of future events that could unlock value.

As mentioned, the first of those will be a government go-ahead decision on Maules Creek, the final step in a tortuous process that has lasted three years thanks to multiple layers of red (and green) tape. It still could face one more hurdle with the appointment of a new Environment Minister in Mark Butler, who takes on the role in the second government of Kevin Rudd.

Construction starting at Maules Creek will trigger fresh interest in the stock, and as the mine is “de-risked” it will gain more appeal to other coal producers, especially those in the Gunnedah Basin able to create more value through shared services.

It’s the recovery potential from two horror years that has caused brokers such as UBS, JP Morgan and Capital Resources to tip Whitehaven as a buy, and for other brokers such as Goldman Sachs and CIMB to rate the stock as neutral, when a sell might have been the view before Tinkler’s exit and Farallon’s rise to the top of the share register.

UBS, after Tinkler departed, noted that that removing the Tinkler “overhang” earned Whitehaven a buy recommendation and a $2.80 share price target.

JP Morgan says it does not see Farallon seeking a quick “flip” by on-selling its Whitehaven shares soon, and like UBS welcomes the removal of the Tinkler factor.

“Whitehaven can now get back to the business of exploiting the substantial growth on offer from its coal assets,” JP Morgan said in a note which put $2.65 as the price target.

Meanwhile, Capital Resources has maintained it “buy” recommendation on Whitehaven, with a price target of $3.

CIMB is less impressed but says it has turned a little more positive even though it retained a neutral rating and a $2.30 price target. Goldman Sachs has $2.25 as the target, with concern about “the lack of profitability and weak outlook for thermal coal”.

On balance, Whitehaven deserves a buy tip thanks to a combination of factors, including its heavy fall over the past two years, the removal of the Tinkler overhang, the go-ahead for Maules Creek (barring more political interference), the falling value of the Australian dollar, and the near-certainty that Farallon will seek to engineer an exit at a price higher than the $2.96 it paid for half of Tinkler’s stake in the stock last month.