A deep dive into an undervalued coal stock

As most readers of Livewire would be aware, the coal sector has been a huge outperformer on the ASX in the last 12-18 months. Whilst the stock prices of virtually all ASX listed coal stocks have re rated materially over that period, there is still one stock in particular we continue to see significant value in due to the quality of its assets and attractive valuation.

Company overview

• Stanmore Resources (ASX: SMR) has been listed on the ASX since 2009 (then called Stanmore Coal) so is not a particularly new company, however the big change in recent times was the acquisition of BHP’s 80% share in the BHP Mitsui Coal (BMC) assets for cash consideration of up to US$1.35B.
• The purchase price consisted of US$1.1B on completion, US$100m in cash six months later, and potential for up to US$150m in a price linked earnout payable in 2024. Ex the earnout, the price translated to an EV/EBITDA multiple of 6.9x.
• The two main mines acquired were South Walker Creek (SWC) and Poitrel, both located in Queensland’s Bowen Basin. The two mines (SWC in particular) are attractively positioned on the Australian coking coal cash cost curve, which means they should be profitable at most points of the coal price cycle. In addition, SMR picked up significant coal handling infrastructure at SWC (8.4mtpa) and Red Mountain (9mtpa). BMC also owns the large scale undeveloped underground Wards Well coal project.
• Post the BMC acquisition, SMR is now the fourth largest coking coal producer in Australia and seventh largest globally.
• The acquisition of the 80% stake in BMC was funded by an equity raising at $1.10 (which Glenmore participated in), with the stock quickly rallying as investor awareness grew of SMR’s company changing acquisition and cheap valuation. SMR also took on US$625m of debt as part of the purchase.
• SMR is run by CEO Marcelo Matos, who has been at SMR since 2020 and has over 25 years of mining experience including almost 20 years at Brazil headquartered mining giant Vale.
• Regarding ownership structure, SMR is 64% owned by Singapore-listed investment group Golden Energy and Resources (GEAR), which is in turn 87% owned by Indonesian conglomerate Sinar Mas Group. The acquisition of the BMC assets at such an attractive price was a shrewd move by SMR but it should be flagged that a key potential risk for SMR investors would be if GEAR were to pursue any new investments or M&A that diluted the quality of its existing asset base, particularly outside of the coal sector.
• In the US$506m capital raising to fund the BMC acquisition, GEAR subscribed for US$300m, which was ~59% of its share of the raising, hence it continues to be materially committed to SMR.
• A more recent positive development was the acquisition of the remaining 20% of BMC by SMR for just US$270m (after adjusting for dividends), which was finalised in October 2022, giving SMR 100% ownership. The price paid for the remaining 20% was extremely attractive in our view.
• On the topic of M&A in the coal sector, we believe it is likely that BHP will also look to divest its Daunia and Blackwater mines at some stage and SMR would be a strong candidate for both if a sales process were to occur.

Asset overview

South Walker Creek (SWC)

South Walker Creek is an open-cut mine in Queensland’s Bowen Basin. The mine has been operating since 1996 and has a mine life of more than 25 years. SWC is a genuine tier 1 asset and produces high-quality low volatile PCI coal which is sought after in a steel blast furnace given its low volatility matter. SWC produced 4.9mt of PCI coal in FY21 and is a low-cost mine with cash costs of FOB US$78/t in 1H22. Cash cost guidance for 2H22 is US$75-80/t.

Poitrel

Poitrel is an established open-cut coal mine also located in the Bowen Basin. The mine produces a mix of hard coking coal (HCC) and pulverised coal injection (PCI) coal and has a mine life in excess of 10 years. In FY21 the mine produced 3.9Mt of product, comprising ~65% HCC and 35% PCI. In 1H22, cash costs FOB were US$110/t. Cash cost guidance for 2H22 is US$100-105/t.

Isaac Plains Complex

Isaac Plains is a coking coal complex located in the Bowen Basin. Mine life is ~20 years, with production capacity of 2.4mtpa, whilst cash costs were FOB US$84/t in 1H22. Cash cost guidance for 2H22 is US$68-73/t. SMR acquired Isaac Plains in 2015, after it had been put on care and maintenance in 2014 by the previous owners. Mining restarted at Isaac Plains in 2016 and transitioned to Isaac Plains East from July 2018 through to January 2019. Note most mining operations now occurs at Isaac Downs. Isaac Downs was approved for construction and operation in mid-2021 and is targeted to produce up to ~35Mt of coal over 16 years.

Millennium JV

SMR and M Resources own the Millennium and Mavis Downs Mine in a 50/50 JV having acquired the asset from Peabody Energy Australia in 2021. Current operations are open cut with underground mining operations planned to commence in 2023. The two mines produce a mix of low-ash hard coking and PCI coals. The project is adjacent to Poitrel and shares access to Red Mountain coal handling and preparation plant, and coal loading and transport infrastructure. Cash costs FOB at the JV were US$122/t in 1H22.

Of the four assets discussed above, SWC and Poitrel are by far the most material, making up 85-90% of our SMR valuation. Note, with the move to 100% ownership of BMC, SMR have recently commenced selling cargoes of coal blended from its various mines, which may be a source of earnings upside.

Key risks

• Lower coking coal prices are the obvious earnings risk, though we do note SMR has low-cost mines and hence is better positioned than many of its peers on this issue
• Any M&A that dilutes the quality of SMR’s existing asset base would be negative for SMR investors
• Market unfamiliarity with majority shareholder GEAR
• Some investors may be disappointed if SMR prioritizes growth ahead of dividends
• Cost inflation - which is expected to remain high in Queensland coal mining for the foreseeable future

Valuation

A key attraction of the stock in our view is SMR’s valuation. The company has mines that are established, in production and well positioned on the cost curve for coking coal producers.

Group production is expected to range from 12.5-13.0mtpa for the next 5 years (barring any additional M&A), so SMR is not a production growth story but more one of (a) attractive valuation, (b) cash generation and (c) debt reduction.

Across the four operating assets, unit costs are forecast to average ~US$92/t (ex royalties) over the next 12 months, and whilst the recently introduced higher royalty regime in Queensland will cap upside (particularly at times of high prices), it is not a deal breaker in terms of the investment case for SMR.

Our earnings forecasts for SMR have the company generating EBITDA of US$1.0–1.2B in CY22-23, before falling to ~US$550m in CY24 driven by expectations of lower coking coal prices. The assumed hard coking coal (HCC) prices for those forecasts for CY22-24 are US$360/tonne, US$270/t, and US$190/t. For context, the current HCC price is US$310/t.

At a stock price of $2.90, SMR trades on low EV/EBITDA multiples of 2.0-2.5x in CY22-23, which seems too cheap given the quality of its asset base, in particular SMR’s position on the cost curve.

SMR’s strong free cashflow generation should lead to a rapidly improving balance sheet, with a net cash position expected sometime during the second half of 2023 (depending on what coal prices do over the next 12 months). This reduction in debt should be supportive of SMR’s valuation. It is possible that there are cost savings at Poitrel and SWC under SMR ownership vs under BHP, so that is an issue that investors should look out for over the next 12-18 months.

With regards to dividends, it is not clear what SMR’s intention is on this issue, but we would not be surprised if the company favours debt reduction and then growth (if opportunities arise) ahead of dividends.

It is important to note as opposed to Whitehaven Coal (ASX: WHC) and New Hope Corporation (ASX: NHC), which are thermal coal producers and hence benefitting from extremely high thermal coal prices vs historical averages, SMR is a coking coal producer, where coking coal prices whilst admittedly elevated, are not as high vs historical averages as thermal prices. In our view, this makes coking coal stocks somewhat less exposed to falls in the underlying commodities, though it should be remembered commodity prices can be very volatile so investors should be prepared for coal price volatility if history is any guide.

An interesting issue to consider with regards to coking coal stocks such as SMR, is that despite coking coal being essential to the steelmaking process (with steel being a critical input into a wide range of applications), new mine supply and even expansions of existing mines have slowed materially in recent years, due to the ESG movement bracketing coking coal in with thermal coal (which does have alternatives such as natural gas, hydro and uranium). Whilst it is hard to quantify this impact on coking coal prices going forward, it is not unreasonable to think it has the potential to see higher prices than forecast by market participants. In particular, we continue to see very bearish long term coal prices being modelled, which seem at odds with the financial cost and general difficulty in getting financing/permitting for new coal mines in virtually any country in the world now. Ironically the decarbonization of the global energy mix is likely to be positive for steel demand - as an example, a single wind turbine requires 170 tonnes of coking coal.

Summary

• Overall, we believe SMR is a strong investment candidate on the basis of its quality assets, forecast cash generation and attractive valuation. In a challenging overall equities market, we believe the stock is well placed to outperform over the next 2-3 years. Also, because of SMR’s relatively low cost mines, we believe it can still generate profits in periods of much lower coking coal prices.
• With that said, investors should expect the coking coal price to be volatile over the next few years, with any material decline likely to see the stock prices of producers such as SMR impacted, especially in the short term. Given the current weakness in the iron ore price, it would not be surprising if the HCC price was impacted in the coming months, though to date the HCC price has been surprisingly resilient despite a subdued global steel market.
• Further M&A (eg. if BHP were to divest its Daunia (which neighbours Poitrel) or Blackwater mines in Queensland) could provide further upside for SMR but is hard to predict and likely to be sold at a less attractive price (for the buyer) than was the case in the SMR/BMC transaction.