Peter Epstein's  Instablog

SouthGobi Resources, (SGQ.TO, 1878.HK, SGQRF.PK), the Canadian-listed Mongolian coal producer, announced that it is producing coal at an annual rate of 5.3mm metric tonnes and that production continues to ramp up.  In CY 2012, SGQ will mine and sell approximately 7mm tonnes of coal, most of it coking coal.  This level of production makes SGQ one of the 2 dominant coal producers in Mongolia. 

While much has been written about Mongolia's massive Tavan Tolgoi coking coal deposit, market participants appear largely unaware that SGQ's production profile will dwarf that of the recently announced winning mining groups.  For example, Tavan Tolgoi is expected to be operating at 15mm metirc tonnes of coal, about 2/3 of it coking coal, by 2016.  Of that amount, Peabody Energy will control 3.6mm tonnes with its respective 24% stake in the project. 

By 2016, SouthGobi will be producing 12-13mm tonnes of coking coal, including 3mm tonnes of premium hard coking coal.  As such, SGQ will remain 1 of the top 2 producers in Mongolia for many years to come.  As a dominant producer in a frontier country that many global miners and steel companies want to get access to, SGQ is a prime takeout candidate. 

I believe that within 6-12 months, SGQ will be taken out by a strategic player at a price at least 50% higher than today's closing price, (Sept 6, 2011).  The reason for my conviction is twofold.  First, like Mongolia, Mozambique is an emerging coking coal exporting country with 2 dominant coking coal companies.  There, Rio Tinto just acquired 1 of the 2 dominant players, Riversdale Mining, for an 8.5x 2014 EV/EBITDA multiple.  The other major player in Mozambique is global mining giant Vale.  Second, the company is known to be for sale.  Interested parties are already talking to 57% majority owner Ivanhoe Mines.

Just as many miners are interested in getting into Mozambique, many are also interested in getting a foothold in Mongolia.  In fact, Mongolia's coal exports are already running at greater than 20mm tonnes per year, while Mozambique is beginning to export coal in 2h 2011.  Mozambique is thousands of kms from China, while SGQ is just 45km from the Chinese boarder.  Coal from SouthGobi's mines arrives at Chinese steel mills faster and more reliably than coal from Canada, Australia or Africa. 

SGQ is in the early stages of substantial organic earnings and production volume growth.  Within 3 years, the company will be exporting at a run-rate of 10mm tonnes of coking coal and generating a run-rate of up to $600mm in EBITDA.   Compared to the 8.5x multiple that Rio Tinto just paid for Riversdale Mining, SGQ is trading at less than half that multiple.  Sooner or later, perhaps when the world sees how painfully slow the ramp up will be at Tavan Tolgoi, global miners and steel companies will recognize not only how cheap SGQ is, but also its importance as a major strategic coking coal producer serving China's every growing needs. 

SGQ is the perfect hedge for the global seaborne coking coal markets.  If (when) Australia's coking coal mines get inundated by massive flooding, as they have twice in the past 4 years, SouthGobi's proximity to China becomes even more valuable.  Strikes in Canada and Australia are another wildcard for global coking coal supply that is mitigated by SGQ's production on China's doorstep.  

As a frontier market, Mongolia has country risk, but this risk is diversified if any of the major players were to acquire the company.  The major coal producers have coal mines in countries like Indonesia, Mozambique, Botswana and Colombia.  Mongolia is not materially different from these other countries.  More important, the process that lead to the choosing of 3 mining groups to mine Tavan Tolgoi involved an initial list of 15-20 parties.  Each of the 12-17 mining groups that did not win a place at the table are possible suitors of SGQ as each has accepted Mongolia country risk.

Finally, SGQ's enterprise value of about $1.6 billion makes it digestible for dozens of strategic and financial buyers.  Given the proven ability of the global miners to issue debt with fixed coupons of 4%-5% these days, SGQ is a very cheap option on the continued tightness of the coking coal markets.  I think that any of the following companies could be interested in acquiring SGQ; BHP, VALE, Anglo American, Xstrata, Glencore, Noble Group, ArcelorMittal, New World Resources, Exxaro, Fortescue Metals, Teck Resources, BTU, Arch Coal or Consol Energy.