Fording Canadian Coal Trust: Rising Costs Mean Ongoing Pressure on the Stock

| About: Fording Canadian (FDG)
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Investopedia Advisor submits: Over the last couple of years, U.S. investors have managed to get a "double whammy" return on shares of Canadian companies inter-listed on U.S. exchanges. Due to rising commodity and energy prices, both the Canadian dollar and Canadian resource stocks have soared, producing double- and triple-digit annual returns for U.S. dollar home currency investors. As well, minimal withholding tax treatment on interest and dividends under Canada-US bilateral tax treaties was an added incentive for U.S. investors to load up on ultra-high yielding Canadian income and royalty trust units.

While on balance, investors have and continue to make healthy returns on these investments, there are some notable exceptions which offer a good lesson as to what can happen in the resource-sensitive Canadian income and royalty trust investment class. Such an example is Fording Canadian Coal Trust (FDG).

Since hitting an all-time high (intra-day) of almost US $44 last March, FDG units have taken an almost un-interrupted path to the basement, losing more than one-third of their value in just four short months.

The steepness of the descent must have come as quite a surprise to income-oriented investors who may have been lured by the company’s impressive record of paying out hefty quarterly cash distributions to shareholders that have totalled US $4.75 over the last 12 months.

Even based on last March’s high of US $44, that still works out to a cash-on-cash distribution yield of over 10%.

Lately however, the company’s reputation as a prime cash-cow has taken a bit of hit. Over the last four quarters, cash distributions have been nearly halved, falling from C$1.80 to C$1.00. Looking ahead, analysts covering the company now concede that further distribution reductions are likely as the consensus view expects a cash payout of only C$3.25( US $2.86) per unit in 2007.

Since this still equates to an expected cash yield of 10% based on the current price, the question needs to be asked: has the market now fully discounted the drop in income, and should investors now consider going long Fording units at current levels?

While the prospect of a 10% income yield may be tempting, there’s still plenty of reasons to be cautious about Fording. Import demand of high quality metallurgical coal by Chinese steel producers, which resulted in a doubling of the met coal price between 2004 and 2005, has dropped off dramatically this year.

Also, cost pressures resulting from rising prices for other steel-making inputs such as nickel and iron ore have led Chinese producers to pursue a cost-cutting strategy of more aggressively sourcing lower grade domestic supplies of met coal as well as bringing on-line cheaper imports from neighboring Mongolia.

While the price of high quality met coal, which Fording sells, has so far managed to hold up surprisingly well in the face of these moves by the Chinese, the basic economic law of substitution should eventually exert itself and push the high quality met coal price lower in coming quarters.

However, an even bigger issue is whether the Chinese steel industry, which has experienced capacity growth of 170% over the past five years, is now on the verge of a Beijing-inspired restructuring that would see much of its capacity closed down.

In addition to the glaring resource allocation inefficiencies that now characterize the industry, external pressures could also force Beijing to act. U.S. domestic steel producers have recently begun aggressively lobbying Washington to impose countervailing duties on Chinese steel imports which they allege are heavily subsidized by the Chinese government, contrary to World Trade Organization [WTO] rules.

In addition to these macro issues, Fording is now facing production difficulties due to such operational problems as a shortage of tires for its super-size dump trucks and rising operating costs for labor and energy. Rising costs for most inputs are now starting to be felt on many Canadian resource mega-projects. Recently Shell Canada (C.SHC) stunned the markets when it announced that the estimated project costs for its proposed oil sands plant expansion would be 50% higher than originally planned.

The weight of all the fundamental evidence convinces me that it’s unlikely we’ll witness a sustained rally in the company’s traded units any time soon. Moreover, the prospect of more downside surprises in the company’s quarterly cash distributions should give income investors ample reason to steer clear of the units for the time being.

FDG 1-year chart:

By Eugene Bukoveczky, Contributor - Investopedia Advisor
At the time of release Eugene Bukoveczky did not own any shares in any of the companies mentioned in this article.