The following in-depth interview was conducted by Peter Epstein with the CEO of SouthGobi Resources, Alex Molyneux. Paid subscribers to a premier coal industry newsletter published by Doyle Trading Consultants received this interview on February 10th. As the author of this content, I have been permitted by Doyle Trading Consultants to distribute this interview. Subsequent to its posting here on Seeking Alpha, this article will not appear anywhere else.
Alex Molyneux: Canadian company SouthGobi Resources (SGQRF.PK), located 45 km from the Chinese border, is 1 of just 2 dominant Mongolian coking coal exporters. We are in the 3rd or 4th inning of explosive organic volume and earnings growth. Within 3 years, SGQ will be exporting 10 mm MT of coking coal. Our cash costs, averaging in the low US$20's per MT, are among the lowest in the world. China's 12th 5-yr plan clearly focuses on building out inland Chinese provinces where we have a distinct transportation advantage.
We have 535 mm MT of coal resources, which give us a +25-year mine life and we are actively exploring for more coal. SGQ is building a paved haul road to the Chinese border that will be able to transport in excess of 20 mm MT/year. Unlike many global players, SGQ effectively has no capacity constraints. Despite minor setbacks from time to time, we have to date delivered the volume and margin growth that we advertised when we listed in Hong Kong in May 2010.
Peter Epstein: Let's start with a recap of 2011, a year in which SouthGobi exported 4mm MT of coal. What was accomplished and where is SouthGobi headed?
Alex Molyneux: 2011 was an important year for us. We reached the 4 mm MT mark in sales and we made a lot of progress on de-bottlenecking our border crossing at Ceke. Four dedicated coal lanes into and out of China will be available to us this year. We got our paved haul road approved and formed a JV with a Mongolian partner to start building it this year. Most of our dry handling facilities were installed last year and we are weeks away from commissioning them.
We signed an important agreement with a Chinese partner to wet wash roughly half of our coal, giving us a nice boost in margins on those tonnes. We now have our fifth fleet of equipment in service and have excess capacity to satisfy our growth plans in 2012. We had another great year of exploration, which you will hear all about in March. And we had a good year on the safety front.
Peter Epstein: There are reports that demand for seaborne coking coal is weak. Peabody, Rio, Teck, Alpha Natural Resources and BHP have discussed this on recent earnings conference calls. Are you seeing the same thing?
Alex Molyneux: Yes, demand for seaborne coking coal is weak, and prices have fallen a lot. But, what's happening in our neck of the woods is totally different. Our prices are running flat to Q4 2011 and we've had no push back from customers on deliveries. We're not experiencing declines in our volumes. The benchmark Bowen basin coking coal index is down about 35% from its peak 3 quarters ago, but we have not lowered our prices at all since then, which we think is pretty amazing.
In the 12 quarters going back to the beginning of 2009, the price we've received for our raw semi-soft coking coal has increased with relatively low correlation to the ups and downs of the index price. For the full year 2009 our average sales price averaged 24% of the index price, in 2010, 26% and in 2011, 31%. We exited 2011 with our coal ASP at 36% of the benchmark semi-soft index price. We will continue to close that gap going forward.
Peter Epstein: You shipped 4 mm MT in 2011, that's a pretty good year and you expect to sell 5.0 - 5.5 mm MT this year and 6.5 - 7.0 mm MT next year. And, I guess that's your run-rate, 7 mm MT of semi-soft coal from 2014 on?
Alex Molyneux: I can't speak to the exact timing, but 7.0 - 7.5 mm MT is achievable. Assuming we reach 7 mm MT, that would imply a run-of-mine 5-yr CAGR of about 30%. Then you could add to your figures production from our new Soumber premium hard coking coal mine from 2014 on. We're assuming Soumber will produce 3 mm clean MT per year.
Peter Epstein: In our last interview you said, "And with some re-planning, I think we can get Ovoot Tolgoi and Soumber to 12 - 13mtpa, but we haven't completed those studies." What's your latest view?
Alex Molyneux: Once open-pit mines like ours are running smoothly, it's almost always feasible to increase production. We would be more likely to expand beyond 10 mm MT if we could get some incremental tonnes from Soumber.
Peter Epstein: Are you experiencing any delays or setbacks in obtaining a water license for Soumber?
Alex Molyneux: No, no problems, we remain on track.
Peter Epstein: Roughly what margin could you get if you were selling the Soumber coal today?
Alex Molyneux: As you can imagine, we're doing a lot of work on that, but Soumber is a good quality coking coal that will command a premium price. In today's market, I'm guessing it would generate a margin of about $100/MT. But, please don't try to extrapolate costs or realized pricing from that figure, it's just an estimate.
Peter Epstein: Switching gears, when will the on-site dry crushing/screening facilities be commissioned?
Alex Molyneux: We experienced a delay due to faulty equipment. But we expect it to be commissioned by the end of the month.
Peter Epstein: What impact will this have on your operations?
Alex Molyneux: It will be significant. Right now, our run-of-mine coal comes out as 8%, 13% &18% ash. Roughly speaking, after screening & crushing, our 18% ash might become ~15% ash, our 13% ash ~11% ash and our 8% ash ~7% ash. Today, about 30%-40% of our run-of-mine coal is blendable to the 8% spec, about 30% to a 13% ash level and the remainder is the 18% ash product. After on-site dry handling, approximately half of the coal will be blended to a semi-soft coal with 9.0% or 9.5% ash and will be sold as is. The other half will get sent to China for wet washing. Importantly though, the ash reduction is only half the story, delivering more consistent ash levels AND consistently sized coal means a great deal to our customers.
Peter Epstein: When will third-party wet washing in China commence?
Alex Molyneux: By the end of March.
Peter Epstein: What margin uplift do you expect from the wet washing?
Alex Molyneux: If half of our ROM coal is first sent through dry handling on-site and then sent to China to be wet washed, the impact on the overall margin line will be about $7.5 per MT.
Peter Epstein: Can you touch upon liquidity? You burned a fair amount of cash last year. Will you need to raise debt of equity capital in the future?
Alex Molyneux: No, we still have ample liquidity. 2011 was by far our biggest cash burn year. We try hard to run a tight ship, we're budgeting 2012 to be a cash neutral year.
Peter Epstein: When will we get an update on reserves/resources?
Alex Molyneux: An update will be released in March. We're excited about the continued success of our exploration efforts. We think we will be able to report a meaningful increase. We've pushed back our work on an underground mine plan at Ovoot Tolgoi due to our findings in and around Soumber. It's possible that Soumber will be a bigger mine than we expected.
Peter Epstein: How much bigger?
Alex Molyneux: It's hard to say, but we're excited about what we're finding. As we prove up additional tonnage at Soumber, we can either extend the projected mine life or increase annual production. Equally important, we think we will be able to extend our Ovoot open-pit mine life at by several years.
Peter Epstein: You said that your 20% stake in Mongolia's Aspire Mining could become very valuable as Aspire could be producing up to 20mm MT of premium hard coking coal by 2020. Can we get your latest thoughts?
Alex Molyneux: We're very pleased with our investment in Aspire. They remain on track to becoming a truly world class producer. Since our investment, the Company has confirmed the very superior quality of its coal, identified a new, nearby, highly prospective exploration target and signed a comprehensive marketing, logistics and off-take agreement with Noble Group. Aspire is sitting on a 330 mm MT JORC resource (80%) measured & indicated, with ~250mm MT less than about 250 meters deep. Aspire believes there's substantial upside to their 330mm MT resource.
Peter Epstein: Some look at the price you're receiving on your raw semi-soft coal of about $65 per MT and assume that SouthGobi will never grow into a highly profitable company.
Alex Molyneux: I hope prospective investors dig a bit deeper than that! Think of it this way, coal from the Bowen basin trades at $220 per MT. But that coal is from a very mature basin. Strip ratios there are 10 or 12 or even 15 to 1 and rising. At our Ovoot Tolgoi open-pit complex, we are mining a coal seam with an average thickness of 53 meters!! Our strip ratio is about 4 to 1. While some Australian mines have costs of $100 per MT, SouthGobi's costs average in the low $20's. I would argue that looking at our margins and where they are headed is a better starting point.
Peter Epstein: Which leads to a question of margins, how will SouthGobi increase margins to $60-$70 per MT in the next few years from roughly $30 today?
Alex Molyneux: I can't give forward guidance to a specific margin, but there are a number of things that when taken together will make a big difference. To be clear, our margins will grow substantially without the necessity of higher benchmark pricing. We expect an up-tick of about $7.50 per MT from the increased quality and enhanced blending opportunities of the fully processed coking coal. We will capture $25-$30 per MT in margin over the next 2-3 years from transportation & logistics efficiencies. These include the use of a new 45 km paved haul road, new rail options, eliminating intermediaries, further de-bottlenecking of the border, and greater acceptance of our coal.
Peter Epstein: Can you flesh out that, "$25-$30" per MT of savings? That sounds like a lot.
Alex Molyneux: Again, it's a number of things, but an easy example is transportation. Rail spurs currently under construction or planned will help immensely. Using new rail spurs will greatly reduce our customer's reliance on trucks. More importantly, it will reduce the trans-loading of coal back and forth between truck and train, i.e. double & triple handling. For example, to get coal to Wuhai, it's either trucked the entire distance or trucked to the Ceke-Linhe rail, sent to Linhe, trans-loaded back onto trucks, and then sent to Wuhai. Once the rail spur is complete, coal can be railed directly from the Ceke border to Wuhai, which will save a lot of time and cost.
The same applies to Yinchuan. To get our coal to the Hebei region, the Ceke rail spur will save a 70 km truck run plus 1trans-loading. And at Jining, coal is trans-loaded back onto trucks because it cannot be railed straight through to Datong. Once the rail east of Jining is open, coal will be able to be railed directly from Ceke to Hebei markets.
Peter Epstein: Has anything changed now that Rio owns 51% of SouthGobi's majority shareholder, Ivanhoe Mines?
Alex Molyneux: In our August interview, I indicated that Ivanhoe was receiving expressions of interest in our company. That continues to this day. We were not surprised to see Macarthur get taken out by Peabody and Xstrata by Glencore. These are key strategic assets. There's a finite number of well positioned, established mining companies that are located in highly desired geographies and are selling highly sought after commodities. We think we're one of them.
Honestly, I'm hard pressed to come up with a reason why Macarthur and Riversdale are accepted as key strategic assets and SouthGobi is not. All three companies have (or had) similar sales, EBITDA and margin expectations by street analysts. Both Macarthur and Riversdale were acquired for 8 to 9 times EV/EBITDA multiples... Not 8 or 9 times 2012 or 2013 EBITDA, but 8 or 9 times 2014 or 2015 numbers. Those aggressive multiples were paid on 3-yr forward earnings because the acquirers wanted those assets badly. Within 3 years we will be a 10mm MT pure-play low-cost coking coal producer, situated 45 km from the Chinese border.
Peter Epstein: Presumably then, you think that your stock is undervalued?
Alex Molyneux: Yes, I do, especially given the heightened interest in M&A in the mining space. I've received articles this week on how a merged Xstrata & Glencore will look to acquire more iron ore assets. Of course they will, and Vale, BHP, Anglo, or Peabody or Teck Resources will be going after coking coal, copper, manganese, potash, etc. Scale is vitally important. Those with scale can issue long-term debt at under 4%! I find it strange that there's no discernible takeout premium in our stock price.
Peter Epstein: Some would say it's because your stock is expensive based on 2012 and 2013 earnings estimates.
Alex Molyneux: We're not cheap on this year's numbers, although I would argue that we look a lot better on next year's numbers, but the point is that we're still in the 3rd or 4th inning in terms of ramping up production. Within 3 years, we will be a 10 mm MT company. That will make us perhaps a top 15 producer globally.
Peter Epstein: Thank you, Alex.
Disclosure: I am long ACI, CNX, PCX, BTU, ANR. I am a consultant for SouthGobi Resources.