Cockatoo Coal ready to fire

One of the unfortunate legacies of the global financial crisis for the resources sector has been investors viewing junior miners with a more sceptical eye, rarely convinced of the value of their projects and their ability to successfully commercialise them.

However, among the wreckage of the once-thriving small-cap resources market, one particular company is on the cusp of rediscovering its mojo and offering compelling long-term value. That company is Cockatoo Coal, a producer of PCI coal (pulverised coal injection) that is increasingly used in blast furnaces to make steel.

Debilitating floods that halted production for near-on nine months, a collapse in global coal prices, a soaring Aussie dollar, and a last-minute cancellation of a significant capital placement to a strategic investor, are just some of the headwinds this company has confronted over the last few years. While each of these is a story in themselves, they are now in the past, and over the last six months the company has undergone a major metamorphosis.

In October 2013 Cockatoo completed a $153 million capital raising that was far more than a much-needed cash injection into the company. SK Networks (a South Korean energy conglomerate) and Harum Energy (a leading Indonesian thermal coal producer) increased their existing stakes in the company. But perhaps more importantly, Hong Kong-based global energy trading house Noble Group came onto the register and also vended in its controlling interest in listed junior coal explorer Blackwood Corporation (BWD) (see the diagram below).

The register now sees Noble Group and SK Networks each holding 23.2% of the company. Both companies offer numerous intangible benefits to Cockatoo, ranging from industry knowledge and partnering opportunities to sales and marketing. Additionally, the strategic benefits of the Blackwood acquisition, as yet, seem unappreciated by the market. As a result of the merging of Blackwood into Cockatoo, the company now has one of the largest tenement holdings in Queensland and, importantly, is the only coal player with a footprint in the state’s three major coal basins – the Bowen, the Galilee and the Surat. Down the track, these tenements hold significant development and corporate opportunities.

Cockatoo’s current market value ascribes no value to these tenements, so would-be investors are essentially buying exposure to these assets for free.

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Management

The restructuring of the company’s shareholder base has resulted in a logical evolution of the board and senior management team. Several founding directors have stepped down in recent months, making way for board representatives from Noble, SK Networks and Harum, who will join in a non-executive capacity.

Rounding out the board are a new independent non-executive chairman and two further independent non-executive directors. Non-executive chairman Peter Richards has more than 30 years of experience in the mining services and industrial sectors, including time at BP plc, Wesfarmers and Dyno Nobel, and currently serves as a director of several ASX listed companies including Sedgman, Emeco Holdings, Bradken and NSL Consolidated.

Managing director, Andrew Lawson, joined the company as CEO in December 2011 before stepping into his current role in April 2012. Lawson has more than 15 years of experience in the coal industry, having previously worked for Glencore’s International’s coal division. During this time, he was actively involved in acquisitions, investments, operations and marketing. He is therefore well qualified to lead Cockatoo through its current growth phase.

Importantly, the company’s recently retiring directors have retained their significant personal stakes, with some having topped up their holdings in the October 2013 investor placement. While investors should be very comfortable with Cockatoo’s board, they should also be impressed with the high-calibre of management expertise that has come across from the Blackwood acquisition. Senior management is now peppered with ex-Glencore and ex-Xstrata backgrounds, with there being no better pedigree in the coal space. Most importantly from an investor point of view, the management team is highly in sync, unified in its vision, and committed to the ‘on-time, on-budget’ execution of the Baralaba expansion.

Baralaba

Cockatoo’s flagship project is the Baralaba expansion, a brownfields development project in the Bowen Basin approximately 143 kilometres inland from Rockhampton that will see production transition from the Baralaba central pit to Baralaba North, with saleable tonnage scheduled to ramp up from current levels of 750,000 tonnes per annum to 3.5 million tonnes pa by 2016.

From an investment perspective, there are a number of notable characteristics that help Baralaba stand out from other projects.

• its coal product is ULV PCI coal, not thermal or coking coal (more on this below)
• its mine is open pit (surface), not underground,
• its project is a brownfield as opposed to a greenfield development (with much of the required infrastructure and logistical necessities already in place).

These characteristics have allowed the project to secure project funding in a tough market where many others have struggled.

The metrics

The capital intensity of the project is impressive and highly competitive, with the $300 million expansion to be completed at a cost of about $100/t, less than a third of the cost BHP paid to complete its $1.4 billion, 4.5mt pa Daunia development.

Baralaba also has the benefit of a relatively low strip ratio (the volume of overburden tonnage required to be removed to extract a tonne of coal) of sub 10:1 versus an industry average of 12-14:1, allowing it to sit among the lowest-cost PCI coal producers in the market. With FOB (Free on Board) cash costs expected to range about $A96-$A98/mt, the recent SBFS (Supplementary Bank Feasibility Study) suggests a project net present value (NPV) of $1.13 billion over a 20-year mine life (expandable), with a payback period of six years. Management, however, is not sitting still. It is continually looking to optimise the project’s metrics by deferring capex where possible to improve front-end operating cash flows.

PCI market dynamics

What sets Cockatoo apart from the rest of the coal market is that it is essentially a PCI producer, or ULV (ultra-low volatile) PCI producer to be more precise. Without going into too much detail, PCI coal is an increasingly important input into the steelmaking process. More expensive coking coal (used to make coke for use in blast furnaces) is increasingly being substituted by PCI coal due to its lower costs and enhanced productivity. While the Japanese and Koreans are already wide-scale users of PCI technologies in their blast furnaces, the technology is only now starting to gain a real footing in China.

The current global demand for PCI coal is about 49mt pa, which noted research and consulting firm Wood Mackenzie estimates growing to 84mt pa by 2023. A vast majority of this demand growth forecast is pinned to China.

With Cockatoo being one of the few companies in the space, with a funded development project underway and producing one of the highest-quality low cost PCI coals in the market, the company could well find itself in a market ‘sweet spot’ in the coming years just as a projected supply deficit begins emerge.

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On a relative basis, Cockatoo’s exposure to the PCI stream of the coal market has protected it from some of the more severe headwinds faced by thermal coal producers. Even at today’s depressed CPI prices of US$112-US$114/mt Baralaba is able to generate positive cash flows.

The valuation chasm ... the opportunity

For investors looking for exposure in the coal space, outside of behemoths such as BHP, Rio Tinto and Xstrata, there are a handful of producers in the $1.5 billion - $2.5 billion market cap bracket. Whitehaven and New Hope immediately jump to mind.

At the junior end of the market there is no shortage of microcap/small-cap players struggling to make ends meet, faced with depressed thermal coal prices and mind-boggling greenfield project development costs that are simply untenable in the current environment.

As such there is a large valuation chasm between this bracket and the $1 billion-plus club. Cockatoo is ideally placed to fill this valuation void.

As a near pure PCI producer, Cockatoo has no real direct peer in the local market. For those able to cast their minds back a few years the last predominantly PCI producer was Macarthur Coal, which in late 2011 was snapped up by Peabody Energy for $4.9 billion. While acknowledging that transaction took place in a far more bullish coal environment, and that history is not about to be repeated, it is worth noting that at the time when Macarthur was acquired it was producing approximately 4mt pa of saleable PCI (with upside), with its ULV PCI quality and strip ratios perhaps slightly inferior to that of Cockatoo’s.

With Cockatoo’s market cap currently sitting at around $170 million it has the realistic potential to grow several fold as sentiment improves and Baralaba’s increased PCI tonnage comes on stream.

Environmental permitting

Cockatoo presently has the environmental permissions in place to mine up to 1mt pa, and is currently in the process of completing its Environmental Impact Statement to ramp this up to saleable coal tonnage to 3.5mt pa. Worthy of note is that the Baralaba expansion has been given “prescribed project” status, meaning the Queensland government has deemed the Baralaba expansion a priority project due to its economic and social benefits to the state.

Port and infrastructure

As a foundation member of WICET (Wiggins Island Coal Export Terminal) stage 1, Cockatoo has secured a valuable 3mt pa of port capacity to go along with its existing 500,000 tonne pa that it currently ships out of the neighbouring RG Tanna.

With no new port capacity planned in the foreseeable future, Cockatoo should be immune to future supply bottlenecks and is thus in an enviable position. Also, as a brownfields development project, much of the required road and rail infrastructure required to transport its product to Gladstone for export is already in place.

Summary

While many are currently shunning the coal investment sector, investors should always remember that sentiment and cycles are temporary, they do change, and this time will be no different.

With Cockatoo’s major expansion project now essentially funded and supported by long-term strategic investors, its PCI coal forecast to benefit from favourable supply/demand fundamentals, and with an economic infrastructure solution in place, this well-managed company is strongly positioned for future success.

At around 4 cents, and with a $170 million market cap, this company is cheap on nearly every metric.