Prophecy Coal (OTCQX:PRPCF)- May 2012
Prophecy Coal was conceived on June 14th of 2011. Originally Prophecy Resource Corp, the company divested its non-coal assets by creating a second company, Prophecy Platinum, that it retained approximately 43% ownership in. The company then changed its' name to Prophecy Coal highlighting its' primary operations. The company has two mines in the country of Mongolia and hopes to ultimately build mine mouth power plants and sell electricity to the Mongolian government and China. They have completed the permitting process on their first plant and are finalizing a Power Purchasing Agreement as well as debt financing.
Investment Thesis: Long
At current market valuations Prophecy's coal operations are being severely undervalued. The company's approximate 43% stake in Prophecy Platinum (PNIKF.PK) is currently worth about $46M; which, using their current market cap, values their coal operations at about $4.7M. With nearly 1.5 billion tons in reserve in Mongolia and a 600MW power plant already permitted, this company has significant upside when the market reduces the systematic risk inherent in Mongolia.
Market Cap: $50.73M
Enterprise Value: 53.44M
Shares Outstanding: 225M
I believe that given the company's lack of revenue recognition and long time horizon, it is nearly impossible to give an appropriate price target. Rather I think an analysis of the situation will shed light on how poorly the company is currently valued. They have significant coal assets in Mongolia that are valued at about $4.7M given their ownership in Prophecy Platinum. This means that either the market believes the coal assets and power plant plans are very risky given their location and time horizon, or that Prophecy Platinum is overvalued. The latter seems to be false because of the increasingly strong asset portfolio that Prophecy Platinum has assembled. The derisking that has occurred, and continues to be a point of emphasis, affirms that. Also the amount of platinum that the Wellgreen mine holds is staggering and rightly deserves the current valuation if not justifying a greater one, regardless of their other properties. The other possible valuation problem, the risk in Mongolia, also seems overblown. Even though there is some instability in the political sphere, the need for energy is undeniable and Prophecy Coal has taken all of the proper steps to put them in a position to generate significant revenues in the future, first from Mongolia and later from China. Given these two points, I would contend the company is significantly undervalued.
In the long-run I fully expect the markets to realize the opportunity that Prophecy Coal has to produce future revenue streams. I see this occurring as we near the completion date of the first generator in 2015. As things begin to become a reality the market will have no choice but to realize it in the stock price.
In the short-run the stock price could see significant run up around the announcement of the PPA and the finalization of project financing. Both of these would be predicated on positive outcomes of course, but the management team seems very confident that they can get the job done while keeping the shareholders' best interests first. There is the potential for another equity offering or private placement as part of the financing package, but I believe that as long as the company can get their targeted 85% in bank loans that the market will still react positively at the securing of financing.
Given the nature of this industry and the time horizon there are a lot of inherent risks
1). Mongolia economic growth
2). Mongolian government stability
3). World debt markets
The first three risks are very much intertwined. The most intriguing part of this investment is the apparent supply-demand gap that is emerging (and growing) in the power markets in Mongolia. The Mongolian economy is driven by its mining sector and it has significant potential given the current underdevelopment throughout the system. If this growth were to slow, or worse cease, then the demand for electricity (which Prophecy is planning to meet) will not be nearly as strong and there may not be room for multiple new plants as are being proposed. The major risks to an economic slowdown in Mongolia are world market conditions and the government. Regarding the latter, recently in the news the government has been attempting to block an acquisition of a SouthGobi Resource mine by Chalco (a state-owned Chinese miner). The fear is that Mongolia may try to nationalize their mines, however the government has said its' goal is to prevent state-owned entities from taking controlling interests in Mongolian mines. This would not bar private companies (including foreign) from developing the mineral properties. The Mongolian government wants to develop their economy and they do not have the resources to nationalize mines while still extracting the same economic value.
Regarding the world markets, I believe this to be much more uncertain. The ongoing instability in Europe coupled with the precarious position the US has put itself in requires us to proceed with caution. With these two major factors hanging in the balance the market has been very tentative, moving significantly on any semblance of news. This presents a systematic risk that forces investors to step back and ask whether or not they want to be involved in the markets at all. We believe that while we are on a dangerous path, the full breadth of the negative effects won't be seen for many years. We also believe that this presents an opportunity for diligent investors that can capitalize on fear and increased volatility. The Mongolian economy is being affected by market fear on both fronts and we believe this presents an exciting opportunity.
In line with the market risk are the debt markets. Prophecy is attempting to raise north of $700M and further negativity in the capital markets could make this more difficult and more expensive. However, we believe that Prophecy is mitigating their project risk for banks by securing the PPA. This contract, coupled with the firm's coal assets, makes this a much more feasible lending opportunity for banks. Furthermore, given the project feasibility study we still see this as very profitable for Prophecy even if they must incur a higher cost of debt.
Prospect of Selling Power
The coal markets have been abysmal of late and while they will recover, given the economics of the commodity, a definite time line is not forthcoming. Furthermore, coal in Mongolia is extremely abundant making the local price much lower. This makes the prospects of mining and selling coal on the open market bleak to say the least. Acknowledging this, Prophecy has seen an alternate option driven by the country's growing energy deficit. While the country has enough energy assets to be net exporter, they have not been able to develop the necessary infrastructure and are required to import energy from their neighbors, Russia and China. The current contract with Russia is at a rate of $0.08 kWh. This problem is only going to become worse in the coming years as the Mongolian economy continues to grow and power demand increases. As can be seen below the deficit is expected to grow to over 700MW by the year 2015; this is attributable to the economic growth and the sharp increase in mining, a high power industry. This model assumes stable output from the 5 coal fired plants they currently have in operation, which produce 80% of the country's electricity. The problem with these plants is that they are aging quickly, 3 are over 30 years old, and 2 are expected to be shut down by 2016. This creates further demand for new power and the cheapest/most efficient route would seem to be the construction of new coal-fired plants. Renewables could provide some competition moving forward because of the government's pledge to reach 20% of total power generation by 2020 (currently they are under 5% even with the new Salkhit Project going online later this year). Even if the renewable growth subtracted directly from coal, over the next three years the demand for new coal power would still be nearly 500MW and that does not account for the plants going offline (which could mean a loss of around 150MW). So based on these estimates I think it is conservative to say there will be over 600MW of demand for new coal power in the next 3 years.
The country has a few plants in various stages of the process because these things take significant time to be completed. The Fifth Thermal Power Plant in Ulaanbaatar is set to be announced before June. This project will have a target capacity of 820MW with the entire plant coming online in 2020, but with smaller sections starting as soon as 2015. Another 600MW plant has been permitted by Prophecy Coal and, after financing is secured, is set to begin construction in 2013 with the first section targeted for completion in 2015 and the whole plant in 2017. Another that is still early in the discussion stage is the Tavan Tolgoi TPP with 600MW of output. While it would appear that three plants like this would actually far exceed the projected demand, this would provide Mongolia with the option to become a net energy exporter, particularly to China. China imported about 5700 million kWh last year alone and their electricity demand is only expected to grow overtime. This gives Mongolia an opportunity to capitalize on its natural proximity to China and export energy. This is a great opportunity for economic growth and a chance to capitalize on the value chain that is inherent in Mongolia. Electricity oversupply isn't a bad thing
1). Can sell excess to China and stimulate economy
2). Have yet to see if these plants will be completed as proposed and on time
3). Given GDP growth projections, I think there will still be a lot of volatility in the demand curve
Prophecy has two coal mines in Mongolia, Chandgana and Ulaan Ovoo. Chandgana has 1.2 billion tons of thermal coal reserves (split between Chandgana Tal and Khavtgai Uul) and has a 600MW mine mouth power plant permitted. The plant will be connected to the Mongolian grid 150km away and begin producing for the country. The next step in the finalizing the Power Purchasing Agreement (NYSEARCA:PPA), this is projected to come in at about $0.06 kWh and is anticipated to be done in Q2 2012. After that the company intends to secure financing. CEO John Lee believes they can get 85% of the necessary $744 million from banks with the question coming from the last 15%. Possibilities include private placement, sale of some Prophecy Platinum shares, equity offering to either the Mongolian government or project contractors. The reality of any of these options will become clearer when the PPA is finalized. Construction is scheduled to begin in Q1 2013 and the plant will be built as four 150MW units. The first unit is projected to be completed in Q4 of 2015 with an additional unit coming online every 6 months until the plant is at full capacity. Future plans include the addition of a 3600MW plant that would be connected directly to the Chinese grid, but that is very far off.
Their other mine is Ulaan Ovoo which has about 200 million tons and had production of 370k tons in 2011 (300-500k target for 2012). The company uses an accounting method that does not recognize these sales as revenues because the mine is still in a "pre-commercial" production phase; at this stage any proceeds are charged against mineral properties. This mine plans to sell most of its coal to Russia in 2012, though some is used in local Mongolian power plants. It will be reclassified as commercial when it reaches a sustained/stable level of sales.
One disturbing thing hanging over Prophecy is the instability of the government they are dealing with. They are still in a relatively young democracy and one that is ripe with corruption. Given that the company is now in the midst of the crucial stage of securing the PPA with the government, this instability could hinder their progress. However, given the country's need for electricity I think they have no option but to get a deal done and help encourage speedy construction. A strong-handed play on the pricing of the PPA would be ill-advised because without the plant the will be forced to purchase from Russia at $0.08 kWh, a 33% mark-up from the anticipated price with Prophecy. The one true problem that I could foresee would be delays, especially given the upcoming election in the end of June. I think that Prophecy realizes this and because of that they started the negotiations early; they are targeting a completion before the end of the quarter, thus beating Election Day. This would be big and would remove some of the uncertainty from the stock.
Prophecy Coal owns approximately a 43% stake in Prophecy Platinum . In June of 2011 Prophecy Resource Corp spun off some of its assets into a new company (Prophecy Platinum) and retained about 43% of the shares. Prophecy Resource Corp then proceeded to change its name to Prophecy Coal. Given the market cap of Prophecy Platinum, Prophecy Coal's stake is valued at about $46 million.
Wellgreen Property: This property is 100% owned and is located in the southern Yukon. Its most valued asset is platinum (NYSEARCA:PGM) of which they have 1.04 Moz indicated and 10.97 Moz inferred. This metal trades at around $1600 per oz currently and is considered one of the rarest on earth. The challenge will be in converting the inferred assets to measured and indicated. This will be done through further core sampling and excavation. The mine also has over 200 Mlbs each of indicated nickel and copper as well as over 2200 Mlbs each of nickel and copper. While not nearly as valuable as platinum, these are still important when evaluating the entire operation. The next steps include underground definition drilling, an engineering study, and metallurgical work. The plan for this year is to begin drilling 9000 meters underground as well as a separate 10000 meter surface drilling project.
Lynn Lake Property: This property is also 100% owned and operated in Canada. Though much smaller, it has 260 Mlbs of measured and indicated nickel reserves and 138 Mlbs of copper. The next step involves an environmental study so that the company can obtain mining permits.
With further drilling at both of these sites it is hoped that the underlying assets will continue to be derisked and increase the value to shareholders.
On May 10th, 2012 the company released a statement that they had not previously completed a Preliminary Economic Assessment (PEA) on their Chandgana mine. In January of this year the company released a feasibility study regarding the permitted power plant, but that study did not refer to the underlying mineral assets themselves. In order to satisfy Canadian security laws regarding mineral projects, the company must complete a NI 43-101 economic assessment. The company has secured the services of the John T. Boyd Company to complete the assessment. The company expects the report to be released by the end of July. The updated report will include both the mine and power plant economics at Chandgana Tal.
The company has already run studies on this mine and has stated that there are 141 mt of measured coal reserves (2007 study). This new study is intended to look more closely at the capital cost associated with the mine and the extraction of the coal. The now retracted power plant feasibility study incorporated a cost of $15.50/tonne. The company anticipates that the PEA will produce the same number, but it will be interesting to see how much it could fluctuate. Below I have attached a part of the now retracted feasibility study, obviously since this has been retracted by the company it must be taken with a grain of salt, but assuming the economics of the power plant stay the same the coal price input is the only thing that could fundamentally change the study at this point in time. The company accounted for this in a sensitivity analysis anchored at the 0.0 being $15.50/tonne. So you can see in this sensitivity that even if the coal price was increased to $20.50/tonne the project would still have an IRR of 19.1%.
Finally, the company still expects to announce the PPA before the end of Q2, though the final date will depend on how quickly the government reviews the proposal.
Disclosure: I am long OTCQX:PRPCF.