Six months ago I was pretty down on Yanzhou Coal (NYSE:YZC), as I didn't like the company's asset mix or cost structure relative to other Chinese coal companies like China Shenhua Energy (OTCPK:CSUAY) or Indonesia's PT Bukit Asam (OTCPK:TBNGY). Since mid-December, Yanzhou's ADRs have fallen more than 13%, while Shenhua's shares have fallen about 7% and Bukit Asam's have risen about 5%. In that time, coal markets really haven't improved much as supply continues to stay well ahead of demand and producers are loath to close capacity.
Not all coal companies are the same, though, and this could be a reasonable time to consider China Shenhua. The company has large thermal coal reserves, but also highly integrated coal-fired power generation and railway assets. Though I'm not expecting a fast turnaround in Chinese coal prices, Yanzhou has one of the best cost structures in the business and its parent company could inject addition value-creating assets into the business. At a somewhat distressed multiple of 6x EBITDA these shares offer a decent total return, while a more normalized 7x multiple would offer a good return.
Differences That Matter
China Shenhua isn't a run of the mill Chinese coal company, and its differences are largely to the benefit of shareholders. The company produces over 300Mt of coal each year and boasts about 8.7Bt of marketable reserves - making the company the holder of the second-largest coal reserves in the world. Unlike Yanzhou or global producers like Peabody (NYSE:BTU), China Shenhua has relatively little in the way of met coal assets.
China Shenhua stands apart with its low-cost asset base. While the company's per-tonne costs have increased nearly 60% since 2008, at RMB 127/tonne, Shenhua's cost of production is among the lowest in China. Yitai (OTC:IMYBY) is quite competitive with costs in the neighborhood of RMB 100/t, Yanzhou and China Coal (OTCPK:CCOZY) are both over RMB 300/tonne. By virtue of this production cost advantage, China Shenhua can absorb the discount to spot prices often worked into long-term contracts - trading off the opportunity to "top-tick" coal prices for greater revenue certainty.
The bigger differences are the non-coal assets that make up around 40% of the company's revenue base. China Shenhua operates 23 thermal plants with over 40GW installed capacity. More than 80% of the coal burned at these plants comes from China Shenhua and these power operations generate gross margins in the high 20%'s (about 10 points higher than coal). Keep in mind, though, that power tariffs are regulated in China and the company can't completely control its profits here.
I'm also quite bullish on the company's rail assets. These generated about 20% of company EBIT in 2013 and earn gross margins in the neighborhood of 50%. Shenhua has over 260 billion ton-kms of capacity and is building new lines (including the 180km Zhunchi line). China Shenhua is also getting traction with higher tariffs - including a boost to RMB 0.20/ton/km on its Baoshen line (versus an all-system average of RMB 0.114/ton/km in 2013 and about 0.15 for the Baoshen line). The company also operates quality shipping assets, allowing it to hold about one-third share of the domestic seaborne market in China.
Last and not is a relatively new coal chemicals business. Through an asset injection in December, China Shenhua gained a coal-to-olefins project (the world's first commercial plant). This plant can produce up to 300kt of polyethylene and polypropylene with operating margins reportedly around 25% and EBITDA margins close to 40%. Not only is that a very profitable business opportunity (if accurate), it's a good use of low-priced coal in a market where olefin demand is growing faster than the global rate.
Waiting For The Recovery
Coal producers like Peabody, Rio Tinto (NYSE:RIO), and BHP Billiton (NYSE:BHP) have opened a lot of capacity in Australia to take advantage of the large Chinese market, and Indonesian producers have likewise looked at China as a sizable export market. Coupled with slower than expected economic growth (reducing power demand), coal prices have fallen close to 10% for the year (down 12% for the first quarter before a slight rebound).
Prices may have bottomed in April when they hit RMB 510/t (a prior bottom was set in 2008 at RMB 520/t), helped in part by state governments pushing for the closure of sub-scale mines. Larger producers like Yanzhou, China Coal, and Yitai have also behaved relatively responsibly in terms of cutting back capital expansions (though the extent to which that is a savvy business decision versus a need to conserve capital is up for debate). It's also important to note that while China has been aggressively supporting wind, solar, and nuclear power installation, coal fires around 70% of China's electricity generation and is likely to stay above 65% for at least the next three years (if not longer).
China Shenhua can afford to wait. While the company's contracts lead to lower realized prices (RMB 370/t in the first quarter), that's still a more profitable spread than most other Chinese producers, spiked by the higher profits of the power and rail operations. Should prices improve, China Shenhua will benefit (a 5% improvement in coal prices would lead to nearly double that in EBITDA). Add in a strong balance sheet (the strongest in the sector) and the potential for more asset injections (including coal-to-olefin), and I think this company is not only going to survive but do well when the recovery comes.
Estimating The Value
I'm going to declare straight-up that coal stock valuation involves guesswork and a lot of imprecision; cash flow modeling doesn't work well and China Shenhua is too strong to trade much below its tangible book. With that, I use an EV/EBITDA approach. Many of China's coal companies are trading at forward multiples around 5x, but I believe Shenhua's balance sheet, cost structure, and higher-margin non-coal assets argue for a multiple more on the order of 6x or 6.5x, supporting a fair value of close to $12/ADR.
The Bottom Line
China Shenhua is a state-owned company, with the Shenhua Group owning 73% of the A-shares. Unlike most state-owned enterprises, China Shenhua has been well-run with good consideration for common shareholders. Add in those potential asset injections and I believe Shenhua Group is a quality parent.
If or when it becomes more clear that thermal coal prices have indeed bottomed, I think China Shenhua could trade back at a 7x multiple, or a fair value of almost $14. Add in a yield of around 5% and I think investors are getting decent compensation to wait for a recovery.
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