New Hope prepares for the worst

Used to fuel power generators, thermal coal was once considered a stable, even boring, commodity. Yet as Chinese coal demand surged, old ideas began to crumble. After years of steady prices around US$50 a tonne, thermal coal prices surged to US$190 in 2008.

Coal producers, New Hope Corporation among them, saw optimism spread and profits soar. In 2009, New Hope reported pre-tax profits from coal mining of over $200m and the company sold an undeveloped mine for $2.45bn. New Hope’s management always understood what markets often forget – that this is a cyclical business.

It used to be, in any case. Today, coal prices appear to only have one trajectory: down. From those pre-GFC highs, thermal coal prices crashed to US$60 a tonne in the depths of the crisis. They now hover around US$80 a tonne today (see Chart 1).

 If it was right to sell miners when prices boomed, is it right to buy them now when they are low?

More than the cycle

As we explained in Coal: A dark future ahead? on 11 Jul 12, the thermal coal market may face structural, not merely cyclical, impediments. Chinese coal demand, which accounts for over half of global demand, has probably peaked. From building a new coal power plant every week, new plant construction has ceased as the government seeks to limit catastrophic levels of particle air pollution.

The supply side bodes even worse for prices. Output from Indonesia, Mongolia and the US has surged as infrastructure constraints ease; American coal exports have doubled over the past few years because cheap gas has replaced coal as the primary generation fuel for electricity (see Chart 2).

Thermal coal supplies have flooded Asian markets and, as Australian costs are now twice as high as the next most expensive producer, local miners have borne the brunt of the pain.

Last year, New Hope reported pre-tax profits of just $60m from coal mining and, in typical fashion, gave candid, almost dire, warnings about the state of coal markets. Recovery, says management, will be far ahead and will depend on slashing costs and increasing efficiency. The belief in cyclicality is wavering and management appears to agree with our view about thermal coal: the good times aren’t coming back.

An investment decision about New Hope would appear easy, then. Sell and forget. If coal prices are low and expected to stay that way, why buy a coal miner?

More than a miner

New Hope is, however, more than just a coal miner. The company also owns Queensland Bulk Handling (QBH), an export terminal at the Port of Brisbane with a capacity to export 10m tonnes of coal a year. The business thus has an outlet for its own production and generates cash by exporting the output of peers.

In 2012, New Hope earned pre-tax profits of $60m from its logistics division. In 2013 it earned $50m. Profits, although dependent on volumes, are impressive. On the balance sheet, the asset is worth just $200m, but this reflects the fact that QBH is a fully depreciated asset of 30 years. In reality, QBH is worth far more than its book value. Assuming average earnings of $40m a year, we estimate the logistics division is worth about $400m, or close to 50 cents a share.

Cash is the other asset that New Hope holds in abundance. When the company sold the Saraji mine to BHP, it pocketed over $2bn. Management has shown great restraint by feeding cash back to shareholders via dividends and not rushing to make an acquisition. The sum has whittled down to $1.2bn now, but it’s still worth about $1.45 per share. This hoard is the company's largest asset.

Although it owns several promising coal properties, the New Acland mine accounts for almost all its current production and, being close to the QBH export terminal, is the most likely source of production growth. New Acland is the only coal property we value.

Management has been stripping costs out of the asset but margins have still fallen. We assume coal prices of $70 a tonne, suggesting that New Acland can generate pre-tax profits of $60m for decades.  Under those conditions, the mine might be worth about $500m, or 60 cents a share.

Price premium

Adding the three assets together, we estimate that New Hope is worth about $2.60 a share (see Table 1), a 28% discount to today’s price of $3.63. That assumes a poor, but not dire, outcome for coal. If thermal coal prices rise beyond $100, the company has the cash and infrastructure to increase output and lift profits significantly. It is, unusually for a low-cost miner, highly leveraged to prices. This makes it an attractive option on the coal price.

Although New Hope is the best coal exposure on the market, it’s still not cheap enough to pique our interest. High-quality assets, conservative management and a bullet-proof balance sheet keep it on the radar and, at lower prices, we would be buyers; but for now we recommend you SELL.