This week we return to the far eastern country of Mongolia to find what we believe are excellent short-term, high-yielding U.S. dollar corporate bonds relative to the amount of risk that investors typically find in much more common or more popular domestic U.S. corporate bonds. Increasingly known for its vast mineral resources, Mongolia is the fastest growing country in the world with an amazing 17%-a-year growth rate. As the Mongolian economy transitions away from a long history of oppression and into free markets, the sheer abundance of its very low cost resources has unlocked great market opportunities for their county.
One of the companies leading this charge is Mongolian Mining Corporation, a high-quality hard coking coal producer and exporter. Although the currently indicated 7.5% yield to maturity of this bond is lower than some of the double-digit yields that we have presented recently, the following review shows why we believe adding these short four-year, 8.875% high coupon Yankee bonds from Mongolian Mining to our Foreign and Global Fixed Income Portfolio offers great cash flow and helps to lower overall portfolio risk through a broad and diverse investment strategy.
An Updated Look at the Issuer
Cayman Islands based Mongolian Mining Corporation (MMC) is the largest producer and exporter of high-quality coking (metallurgical) coal in Mongolia. Metallurgical coal is a fuel with few impurities and high carbon content, and 60- 70% of the steel produced today uses metallurgical coal. Its two large open pit mines enable MMC to be one of the lowest costs, high quality metallurgical coal producers in the world at around USD23.9 per ton.
In an effort to improve coal quality, Mongolian Mining Corp has invested in building a coal handling and preparation plant (CHPP) that will allow it to process and wash coal. The CHPP Module II came to full operation in 2H 2012, increasing its total processing capability to 10Mtpa. CHPP product tonnage for 2012 increased 175% over 2011. The CHPP Module III has been completed, and its commissioning is expected in 1H 2013. This will increase the total processing capacity to 15Mtpa starting in 2H 2013.
Through steadily increasing volume over the years, China has become the number 1 global producer of steel, and has become a net coking coal importer. China imported 53.5 million metric tonnes of coking in 2012, compared to 44.7 Mt in 2011. Mongolia preserved its position as the largest supplier of coking coal to China with approximately 35.6% share by volume in total Chinese coking coal imported in 2012. Mongolian companies enjoy the lowest production cost due to thick coal bed and open pit mining, and supplies coal at a discounted price to China. Thus, Mongolian coal will be least affected by decline in global coal prices and is able to provide high quality coal at about ½ the price of its Canadian and Australian based competitors. The graph below helps to demonstrate how its low production costs allow MMC to provide high quality coal at about half the price of its Canadian and Australian based competitors. MMC is the dominate Mongolian coking coal provider.
The Group's gross profit for the year ended 31 December 2012 was approximately USD54.1 million, representing a decrease of USD152.1 million, or 73.8 %, from gross profit of USD206.2 million recorded for the year ended 31 December 2011. In 2012, gross profit margin was 11.4%, compared with 38.0% in 2011. The decrease in gross profit and gross profit margin was mainly driven by 1) a decrease in the average selling price (ASP) of coking coal products supplied by the Group due to challenging market conditions in China as demand from steel mills and coke plants was affected by global economic conditions, and 2) costs related to coal transportation and stockpile loss totaling USD19.5 million, which was one-off recording at the end of the year. The global economy in 2012 went through a challenging period amid a slower than expected recovery in the USA and the uncertainty linked to the European sovereign debt crisis. Affected by declines in the export sector, and also by the Chinese government's continuation to tighten policies designed to curb inflation in the property sector, the Chinese domestic economic growth rate slowed down to 7.4% in the third quarter of last year and stood at 7.9% as at the end of 2012 compared to 8.9% reported in the fourth quarter of 2011.
Average Selling Price per tonne (USD, washed hard coking coal)
Hit by a steep decline in coal's ASP in 2012, MMC ended the year with revenues of $475.5 million (a 13% decline from 2011) and a net loss of $2.5 million compared to a profit of $119.1 million a year earlier. Arch Coal's (ACI) recent forcasts call for Asian met coal demand to pick up in the second half of 2013 in spite of still weak steel markets in Europe. Still, BHP Billiton Ltd. (BHP) has identified about 10 noncore businesses it could exit as it too seeks to cut costs, including its Gregory Crinum metallurgical coal mine in Queensland. So, while the low ASP for Mongolian Mining's met coal remains a concern, we are impressed with its relatively low cost of production and (EBITDA) generation, and see that the biggest risks to earnings and cash flow is not likely to be big fluctuations in the demand for their products, but rather, in transportation issues and production costs.
MMC is headquartered in Ulaanbaatar, Mongolia, and employs over 2,400 people. By providing a profitable low cost service with limited direct competition, it appears that Mongolia Mining is well positioned as a vital component to the Mongolian economy and we anticipate that it will its large economies of scale will continue to show improvement in costs savings and solid earnings and cash flow going forward. Therefore, it is our opinion that the poor earnings of 2012 last year is likely to turn around in 2013 and is now presenting us with a good opportunity to acquire these bonds at at an even more favorable yield than they were trading at three months earlier.
Interest Coverage Ratios
The major contributing factors of the Group's net loss position are a decrease in the ASP of coking coal products, costs related to coal transportation and stockpile losses totaling $19.5 million (which was one-off recording at the end of the year), and an increase in the Group's finance costs due to the issue of guaranteed senior notes and other facilities, bringing total net finance cost to $11.4 million. Gross profit for the year was $54.1 million, while profits from operations was $12.4 million. While this is certain farther removed from the normal criteria we strive to achieve and indicative a higher risk, MMC also stated that coal inventories in China have returned to normal levels from the fourth quarter of 2012 and "re-stocking activities are expected to positively influence coking coal prices in the short-term."
We like companies with lower debt to cash ratio. The consolidated debt of Mongolia mining at the end of 2012 was $1,009 million, primarily attributed to the 2017 Notes. Cash and cash equivalent at the end of 2012 was about $284.3 million, giving them a debt to cash ratio of about 3.5 to 1. Considering its reasonably strong cash flow and sound cash position, we remain of the opinion that it is a lower fiscal risk.
We like companies that have good balance sheets. Mongolia Mining's total debt appears to be trading at about 64% of its currently indicated enterprise value of about $1.568 billion. While this may appear higher than we typically like to see, its cash position of $284 million represents over 18% of the valuation given to it by the capital markets and adds reasonably sound resiliency to its balance sheet.
We like higher yields. In March 2012, the Group successfully issued $600 million Guaranteed Senior Notes at 8.875%, maturing in 2017. Although the credit ratings of B+/B1 assigned to this debt are widely different than that of our government's sovereign debt, when set in comparison to the paltry 0.74% yields of longer five year U.S. Treasuries we believe this nearly 7% difference in yield represents a savvy opportunity for higher rewards given the level of risks that we can identify.
The default risk is Mongolian Mining's ability to perform. As most rating agency still rating Mongolian sovereign debt at single B, the country's low rating pretty much ensures that MMC's rating has a glass ceiling equivalent to the only nation it operates within. Considering their historical and recent performance, their sound cash position, balance sheet and the excellent cash flow that is projected to service their interest bearing debt, as outlined above, it is our opinion that the default risk for this short to medium term bond is minimal relative to its more favorable return potential. Furthermore, it is our opinion that if or when the credit ratings of Mongolian sovereign debt rise, it increases the possibilities of a more favorable rating for MMC.
The hardest risk for us to identify is the geopolitical risk. Considering how difficult it has become to understand many of the political changes and potential changes for bondholders (a la General Motors) in our own country, we again suggest that the uncertainties of changes on a foreign soil are much less formidable than in times past. With that said, it is our opinion that diversification into other forms often serves to reduce risk. Our strategy here, as with other Yankee bonds, is to focus on unique or required services that can be seen as adding key economic value to the society it's associated with. Mongolian Mining is a low cost supplier for the steel industry, and it is highly regarded as one of the best operators in its homeland.
Expressing confidence in the potential and future economic growth in Mongolia is Rio Tinto (RIO), one of the world's largest mining companies, which recently spent over 6 billion dollars to buy out Turquoise Hill Resources (TRQ) stake in the project and build the new Oyu Tolgoi copper and gold mine. The impact of this spending was significant in this country of only 3 million people, expanding Mongolia's GDP by 17.5% according to the International Monetary Fund. In passing the Strategic Foreign Investment Law last May, the Mongolian Parliament positioned itself to intervene in approving foreign takeovers of assets in strategic sectors like mining and banking. Subsequently, new foreign direct investment stalled and the law's lack of clarity remains a concern. However, it was recently announced that this may soon be amended to restrict only foreign state owned or directed entities. Furthermore, although Mongolian Mining Corporation is listed on the stock exchange of Hong Kong Limited (since 2010), it remains largely in the control of natives Odjargal Jambaljamts (43.45%) and Dr. Oyungerel Janchiv (11.42%).
Water extraction and power generation are costs that are subject to large variances for Mongolian Mining Corp, but a greater risk resided in the transportation of it product to market. MMC plans to have railway access to the Chinese border by 2015, but for political reasons it will not match the gage of the Chinese rail lines and will end at the border. Until this rail line is done they are forced to continue using an existing network of roads which it has helped to build and maintain for years. Other Analysts that we follow have indicated that they believe the transportation concern is the largest single risk, and have stated that this should be mitigated when the railroad becomes operational. The President of Mongolia has stated that a top priority of his country is to build a rail line to both China and to the Pacific Ocean.
Mongolian mining corporation is relatively small compared to other coal companies and their subsidiaries, such as BHP Billiton, Rio Tinto , and Arch Coal, and may face increasing competition from substantially larger and better financed companies as Mongolia mining. However, it often appears that companies outside of the United States might have an internal cash flow advantage. Consequently, we see these MMC bonds as having similar risks and maturities to other Yankees bonds such as Bio PAPPEL (OTCPK:CDURQ), Vedanta Resources (OTCPK:VDNRF), or Georgian Railway, which we have reviewed previously on our Bond-Yields.com blog.
Summary and Conclusion
All things considered, it is our opinion that MMC has established itself as a low cost leader in the supply of coking coal to the World and to the Chinese steel market. It has a good cash position, a reasonably sound balance sheet, and is evidently very well connected both politically and socially for continued growth within one of the key and vital economic industries of Mongolia. Consequently, we think these MMC bonds represent both sound diversification and a high yield relative to the fiscal risks that we can identify, and believe that their lower "B" ratings are largely attributable to the sole country that they currently operate within. Therefore, we are adding these high yield, short maturity, Mongolian Mining Corporation USD (Yankee) bonds to our list of Foreign and World Fixed Income bonds.
Yield to Maturity: ~7.5%
Disclosure: Durig Capital and certain clients may have positions in MMC 2017 bonds. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.