One way to sum up the general sentiment towards Yanzhou Coal (NYSE:YZC) is to observe that the shares are down more than 15% over the past month while coal prices in China have increased by around 20%. There are reasons for more optimism about coal prices going into 2014, but Yanzhou's high production costs and high leverage make this a risky and volatile play on higher prices relative to peers like China Shenhua (OTCPK:CSUAY) or China Coal (OTCPK:CCOZY).
I can understand if Yanzhou jumps out as a contrarian play on coal given that generally negative sentiment on the stock. While I won't rule out the possibility that a rising tide of coal prices will lift this boat, I don't see enough undervaluation to compensate for the risks, nor the company's history of taking not-so-shareholder friendly actions.
Assets In The Right Places
Yanzhou counts about 3.5 billion tonnes of coal in its reserve base, and more than half of that is located in Shandong in eastern China. As transportation costs are an increasingly relevant factor in the economics of coal in China, the location of Yanzhou's reserves relatively close to coal ports and major coal-consuming urban centers is a positive in the company's favor. I'm also positive on the company's asset base in Australia. Almost 40% of the company's reserves (more than 1 billion tonnes) are located in Australia, and these reserves include high-quality coal deposits.
Coal is still far and away the primary fuel source for power generation in the PRC. About 72% of rated Chinese power capacity is coal-fired and utilized capacity is even higher. Even with a concerted effort to develop renewable power (wind and solar) and build nuclear power plants, most industry analysts still expect coal to make more than 60% of China's power generation in 2020.
Thermal coal isn't the sole driver for Yanzhou. Like most coal companies, this one also mines met coal for use in steelmaking. Met coal has always traded at a significant premium to thermal coal, and though international met coal prices have fallen steadily over the last three years, met coal still makes up more than 40% of Yanzhou's revenue base.
But It's Not Cheap Coal
One of my primary concerns about Yanzhou is the company's cost structure. Of the four largest Chinese coal companies (Yanzhou, Shenhua, China Coal, and Yitai Coal), Yanzhou has far and away the highest production costs at around RMB 300/tonne. China Coal trails at distant second with costs around RMB 225/tonne, while Shenhua and Yitai produce their coal at around RMB 125/tonne and RB 90/tonne respectively.
Management isn't pretending that there's no problem here, and there has been a greater focus on improved efficiency and a better cost structure going forward. Unit production costs were down more than 15% in the third quarter of this year, and management believes there is room for further improvement, but my concern is that this company has a fundamentally inferior cost structure. The company can offset some of this by virtue of its higher-quality coal commanding better prices, but the company's gross margin is still not very compelling relative to its peer group.
Debt is also a real concern. Net debt to equity is around 85%, well ahead of China Coal (around 45%), Yitai (around 40%) and Shenhua (around 10%), and interest payments consume around one-quarter of the company's EBITDA. It's also worth noting that about two-thirds of the company's debt is dollar-denominated, which could create problems if the Chinese government changes its approach to the exchange rate.
Have Prices Bottomed Out?
It doesn't really matter if you're looking at an American coal mining company, a Russian company, or a Chinese company - the big worry for every player in the sector is the weak price of coal. In the third quarter, Yanzhou saw a double-digit decline in domestic coal ASPs and there are still concerns in the market that any improvements in price will be whittled away quickly by production increases.
Yanzhou management is more bullish about the prospects for a coal price recovery, and prices have definitely been strong to close out 2013. Slower domestic production has been a help, as industry-wide production growth was only up 2% in the first half of the year. What's more, the Chinese government's efforts to improve air quality and worker safety fall more heavily on the smaller sub-scale miners. Stockpiles and inventory through the supply chain look pretty healthy (as in there are no obvious large surpluses), and rising freight costs have made imported coal less attractive, so it may be possible for prices to exceed and hold above RMB 600/tonne in the coming year.
The Bottom Line
One of the counterintuitive things about investing in resource stocks is that it's often the worst operators that benefit the most when industry conditions improve. Yitai and Shenhua will make money at almost any reasonable price for thermal coal, but should prices move to RMB 600 or higher, Yanzhou's profitability improves a great deal more. With that, I will say that Yanzhou may be the stock to pick if you really have a bullish view on the Chinese coal market.
All in all, though, I'm not particularly excited about this stock. This is still a state-owned enterprise and it has not always conducted itself in particularly shareholder-friendly ways. Moreover, I just don't like owning high-cost, highly-leveraged producers unless I'm dead certain that prices are going to rise meaningfully. At 8x 2014 EBITDA these shares would be worth around $10 to $11, and while higher coal prices could definitely lead to higher EBITDA estimates as 2014 develops, I don't see enough return relative to the risk to prefer Yanzhou to Shenhua, Yitai, or China Coal right now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.