16 November 2022
Not financial advice, for entertainment and research purposes only
Thesis in a nutshell
Yancoal is Australia’s largest pure play coal producer (and the 3rd largest producer overall behind BHP and Glencore). It has an interest in 7 producing coal mines and attributable production capacity of ~40m tonnes of saleable coal. ~80% of this production is high calorific value thermal coal, with the balance being metallurgical.
Historically, Yancoal has traded with a substantial overhang, as a result of a debt heavy balance sheet, a Chinese owned controlling shareholder, and the ESG concerns associated with its core thermal coal operations. As a result, following a period of strong coal prices created by the Ukraine war energy crisis, Yancoal is now priced at <1x CY22 EV/EBITDA, is in a net cash position and is primed to pay highly attractive dividends over the medium term (~3 years).
Conservatively, based on Yancoal’s 3Q 22 production update, shareholders can expect a $1.00-$1.40 dividend for the 2022 final dividend (assuming 50-75% payout ratio). Notably, this represents ~20-30% of current equity value. Beyond this, I forecast capacity to pay a cumulative ~$4.0-5.0 per share in dividends out to 2025, while accounting for a 25% annual decrease in coal prices. In other words, Yancoal can realistically return the lion’s share of its market cap in dividend distributions to shareholders by 2025.
In my view, Yancoal presents significant value at its current price point (A$5.00 per share), and I expect it to rerate upon the announcement of its 2022 final dividend in Feb 2023. To demonstrate this value on a relative basis, Yancoal had ~70% higher FY22 EBITDA than WHC (a direct competitor with a ‘clean’ register), but is currently trading at a market cap that is ~20% lower.
Despite reaching record levels of profitability / cashflow and net cash, Yancoal is trading at a substantial discount to its historical levels (see Figure 1 below), which also featured a significantly less constructive coal price environment.
Further supporting Yancoal’s valuation is my view that the transition to clean energy is currently based on overly optimistic targets. The European response to their energy crisis (extending nuclear power, capping energy bills etc.) has shown that Governments become significantly less squeamish about power sourcing when their citizens are feeling the pinch of rising prices. More practically, coal is a critical bridge fuel to provide consistent baseline supply before renewables such as solar and wind can be fully relied upon.
Additionally, very little new investment in thermal coal mines is being undertaken given the political sensitivities globally. This will serve to further support the coal price in the medium term.
In my view, there is significant value (and a margin of safety) in this stock at a price point of up to A$6.00 for investors who can stomach the risk of; a majority shareholder who is a Chinese SOE, a coal price that is expected to steadily erode, and the capital return risk associated with a management team that has professed an interest in expanding into renewable energy projects.
I have entered a position at A$5.00
Figure 1: Yancoal is heavily undervalued relative to historical, particularly given coal price environment
(Credit to Raper Capital for the inspiration on this chart)
Why is it trading so cheaply?
‘Hairy’ story
Yancoal for its size has minimal broker coverage and institutional investor interest as a result of;
ESG concerns from its industry (thermal coal) have blunted investment demand from typical institutional sources, and;
Majority shareholder Yankuang Energy Group (62% shareholder), is a Chinese SOE who has previously considered a $5.27 per share takeover offer for Yancoal, which was subsequently dropped in Sep 2022
Expected Coal Price Reversion
General market sentiment expects coal prices to rapidly revert to longer term averages as the Ukraine war induced energy crisis is resolved
Macquarie is forecasting ~25% YoY declines from spot prices out to 2025
La Nina Impact
Mine flooding and from the La Nina rainfall has placed significant strain on Yancoal, reducing coal production ~20%, and spiking operational costs.
This has impacted supply around Australia, so when resolved further price pressure may be placed on coal prices.
Catalysts for Price Improvement
Feb Dividend Announcement
Yancoal is a thinly traded and covered stock, with many fund managers placing it in the ‘too hard basket’ as a result of its coal-focused business and Chinese majority shareholder
However, cash is king, and I expect Yancoal to receive a repricing when an expected $1+ DPS is announced in February 2022. This has been demonstrated in YAL’s two prior dividend announcements, with the stock rallying strongly post announcement.
In the Aug 22 $0.5 dividend announcement, YAL rallied ~30% in the two weeks following
Weather Improvement
Yancoal’s production has been hampered in 2022 by excessive rains caused by the La Nina weather pattern.
With the La Nina now expected to have been largely played out, Yancoal is positioned to increase saleable production in 2023 materially above 30m/t, noting average production from 2019-2021 of ~36mt and the capacity to produce 40m/t without material changes to current operations.
The removal of flooding impacts will also result in lower operating costs for Yancoal, which have increased from $64 m/t to $89 m/t since 1H21
This view is reaffirmed by management commentary in their most recent quarterly update “Despite the ongoing operational challenges Yancoal has never been in such a strong position. The Company has transformed its financial position, has the capacity to pursue new endeavours, and will ultimately deliver a production recovery once the heavy rains cease”
Coal Prices
The market is pricing in a bearish view of Coal prices going forward, and while clearly the current crisis elevated prices won’t continue indefinitely, we expect strong prices to persist in the medium term.
There has been a raft of announcements in recent months of extensions to coal powered stations in Asia and Europe, as various nations grapple with the far reaching impacts of energy insecurity
China is investing heavily into new coal power plants “The chairman of China Energy Engineering Corp.,has forecast the country could add a total of 270 gigawatts in the five years to 2025 — more than currently exists in any other nation”
Germany has increased its coal power by 17% in 1H 2022, with it now accounting for ⅓ of total supply.
Gas prices are expected to remain more expensive than coal, thereby providing a further buffer, as countries (particularly in Europe) will seek to preserve gas for other uses, such as residential heating, where substitution to alternative fuels is not possible, and thereby increase their thermal coal usage.
Key Risks
Chinese Controlling Shareholder
Risk: Yankuang Energy Group (majority shareholder) could seek to exert undue influence on Yancoal operations (or mount a takeover) that does not properly accommodate minority shareholders
Mitigant: Australia has a strong regulatory regime that protects minority shareholders from unfavourable compulsory acquisition terms. All assets are located in Australian jurisdictions (NSW & QLD), and the Board and Management are credible operators. Additionally, Yankuang has already tried and failed a takeover attempt that would not have delivered a fair outcome to shareholders.
Coal Prices / Stranded Asset
Risk: there is a near global commitment to the eventual deprecation of coal as a source of fuel for power plants. As a result, it is likely that demand for thermal coal will steadily decrease over time, as coal power plants are shuttered and replaced by renewable or more environmentally friendly alternatives. It is possible that Governments become more aggressive in halting the use of coal as public pressure to global warming risks continues, this is a major unknown.
Mitigant: Addressed previously
Capital Allocation
Risk: Yancoal has announced on multiple occasions their willingness to pursue acquisitions and growth, particularly in the event they can obtain exposure to assets in the clean energy space (see news link)
Mitigant: Yancoal has a policy that recommends a 50% dividend payout of net profit, and management have shown good discipline in recent years with the paying down of debt and announced dividends and special dividends (see capital return section below)
Government Intervention
Risk: if the elevated coal price environment continues, governments will be incentivised to place additional royalties on Yancoal coal production, as recently evidenced by the QLD state Government’s decision to hike coal royalties for sale price s>A$175
Mitigant: NSW government (which has jurisdiction for the vast majority of Yancoal production) has commented on the record that it has no plans to match the QLD government’s tax increases.
Historical Capital Return / Discipline
Asset Overview
Yancoal has a high quality, long-life asset base, predominantly composed of the former Coal & Allied / Rio tinto mine portfolio which it acquired in 2017 (and which yours truly assisted in the equity raising on
Export Markets
Strong exposure to markets with a growing requirement for energy fuels
Coal Pricing
Yancoal’s operations are heavily weighted towards thermal coal, which represents 80% of production in 2022 YTD.
Coal pricing is majority based off of the All Published Index 5 (API5) 5,500kCal index, with the remainder sold at the NEWC 6,000kCal NAR index. Generally speaking, achieved sale price tends to lag index movements, so Yancoal is expected to benefit from strong 3Q coal prices over the course of Q4 and beyond.
Yancoal recorded a realised thermal coal price of A$489/t and a realised metallurgical coal price of A$434/t in 3Q 2022. The overall average sales price in 3Q 2022 was A$481/t, compared to A$368/t in 2Q 2022 and A$155/t in 3Q 2021.
Financials
2H 22E Dividend Model
Simple Forecast Model
Key assumptions
Highly simplified balance sheet / cashflow, just focused on dividend payout for simplicity’s sake
Blended Thermal / Met coal prices falling 25% YoY in line with Macquarie Group forecasts
Saleable volumes increasing 15% YoY to 41m/t maximum as La Nina production impact rolls off
Opex reducing 5% YoY to FY21 average (pre La Nina)
No major growth CAPEX / acquisitions, and a 75% dividend payout ratio, which is the average of the last 2 dividends issued (noting policy minimum of 50% payout)
Disclaimer
Do not interpret anything above as financial advice. This article has been prepared for informational & educational purposes only. The writing contains certain forward-looking statements and opinions which are based on the Author’s analysis of publicly available information believed to be accurate and reliable. These statements and opinions are subject to unknown risks, uncertainties and other factors that could cause actual results to differ materially from those projected. As of the date the Report is published, the Author may or may not hold a position in the security mentioned. Nothing in this Report constitutes investment advice. Readers should conduct their own due diligence and research and make their own investment decisions.