IPO Watch: Coronado Global Resources

We are generally pretty sceptical about new IPOs (initial public offerings). Occasionally, however, a great IPO comes along, either for a long-term investment or one with a high probability of making a short-term gain on its opening day, so it is always worthwhile to run the ruler over companies about to list on the ASX.

In this week’s piece we are going to look at the seven key questions we ask when assessing an IPO and apply them to Coronado Global Resources (ASX: CRN). Coronado’s prospectus was one of the largest that I have ever seen – close to 700 pages – perhaps reflecting what is likely to be the biggest IPO in 2018 with an expected market capitalisation of between $3-4 billion.

When analyzing IPOs few have been more eloquent on this subject that Benjamin Graham, the father of Value Investing.

“Our recommendation is that all investors should be wary of new issues – which usually mean, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under ‘favorable market conditions’ – which means favorable for the sellers and consequently less favorable for the buyer” (The Intelligent Investor 1949 edition, p.80)

History

Coronado was founded in 2011 by private equity group EMG and since then they have spent US$1.2 billion acquiring 4 producing coal mines located in Queensland, and in Virginia and West Virginia in the US. This places Coronado as the 5th largest metallurgical coal producer globally with annual coal production of around 20 million tonnes (of which 75% is metallurgical coal and 25% thermal coal). In terms of profit, in 2017 60% came from the Curragh coal mine in Queensland and 34% from the Buchanan mine in Virginia.

Can the business be readily understood?

Yes, as a miner Coronado essentially digs coal out of the ground and sells the coal predominately to steel mills in Northern Asia and the US. The thermal coal produced by Coronado is sold to the Stanwell power station in Queensland under a long-term contract.

Whilst coal is a dirty word globally – mainly in conjunction with power generation – 75% of Coronado production is metallurgical or coking coal, which is used in the smelting of iron ore to make steel. This is high-quality coal (commanding a higher price) that low is in ash, sulphur and phosphorous and will burn at a very high temperature (1,300C in a blast furnace). Metallurgical coal is necessary for the production of steel, both as a source of carbon and as a means of heating the iron ore to around 1,300C. By contrast, thermal coal can’t be used in steel production, due to both its high ash content and because it cannot be coked (a process to concentrate the carbon and reduce impurities by heating or cooking the met coal in an airless environment). Globally metallurgical coal is much scarcer that thermal coal and currently trades at twice the price of thermal coal per tonne.

How does the company make money?

Coronado digs the coal out of the ground at a cash cost of ~US$80/t (after royalties) and then sells it to steel mills in the US and Asia. Current prices per tonne of met coal are a little over US$200/t which makes this a profitable exercise. However, in Australia, Coronado’s product is priced at a discount between 6-16% to the benchmark price due to higher imperfections. Additionally, Coronado is subject to two separate royalty payments from production out of its two biggest mines which will cap profits in the near future. This results in Coronado having weaker profit margins than competitors such as BHP Coal and Whitehaven.

The biggest factors determining the price for metallurgical coal have been spikes in Chinese demand fueled by the construction of new Chinese mills (2006-2010) and pollution controls in China (2016-2018). During these periods Coronado’s coal mines have been very profitable, however, the below chart showing the metallurgical coal price over the past 10 years demonstrates that prices have been quite volatile. Over the past few years, metallurgical coal has risen from US$80/t in early 2016 to around US$200/t, leading to perceptions that the price is vulnerable to a fall if demand for steel weakens. Arguably current high prices above US$200/t for metallurgical coal encouraged Wesfarmers to sell the Curragh mine to Coronado earlier this year for A$700M (or at a multiple of only 1.5 times current annual profit).

Why is the vendor selling?

The motivation behind the IPO is one of the first things to look at. Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business, or when the vendors are using the proceeds to expand their business. Coronado is a little bit different from most IPOs – which typically see the vendors seeking to exit as much of their investment as possible – in that post the IPO 80% of the company will be retained by the vendors. This is an unusually high proportion to hold onto, as prospective investor usually likes to see the private equity owners retain a stake in the business on listing between 20-30%.

Whilst the owners floating a company may want to sell out completely, an effect of the 2009 Myer IPO – which saw the department store’s private equity owners sell their entire holding – is that new investors are unlikely to accept a full exit without a substantially lower price (in terms of profit multiples). However, seeing private equity owners retaining an ownership stake after the float is no guarantee that the IPO will be a sure-fire winner; the vendors of Dick Smith retained a 20% stake on the listing which was sold down 9 months later. Within three years of the float, Dick Smith went into administration.

The issue with an 80% stake being held by EMG is that the market will perceive this to be an overhang that may depress the CRN share price following listing. This 80% stake is subject to voluntary escrow. Coronado’s owners expect to raise around A$774 million. Of this around $600M will be used to repay debt and pay the costs of the IPO with the sellers banking around $110 million.

Is the business profitable?

Yes: rising coal prices in 2017 saw Coronado’s net profit after tax move from -US$9 million loss to US$282 million profit in 2017 with a similar amount expected in 2018, before a big jump to US$400 million in 2019. However, this is very dependent on the coal price; for instance, a 10% change in the coal price would move 2019 EBITDA by either plus or minus US$200 million. The coal price is highly volatile, despite current very high prices, driven by expansion in the Chinese steel-making industry and demands for high-quality Australian coal over lower quality domestic Chinese coal to reduce pollution. During 2011-2016 the coal price fell dramatically, which saw Coronado’s US mines move to break-even at the EBITDA line (Earnings before interest tax depreciation and amortisation) and the glitzy Curragh mine’s EBITDA decline to US$61 million (2018 EBITDA $360 Million).

Financial stability?

Coronado is expected to have net debt of only around 0.5x EBITDA in 2019, which will equate to an interesting cover of around 14x – two very strong debt metrics. This reflects a $500M reduction in debt as part of the IPO. However, we see that this is a business that cannot handle too much debt, due to the volatility in pricing of its product, of which Coronado is a price taker.

How attractive is the price?

A decision to invest in Coronado should be based on your outlook for met coal prices. If current prices are maintained Coronado will trade on an EV/EBITDA multiple of around 4x, and based on the company’s stated pay-out ratio of 100% free cash flow this results in a dividend yield between 10-12%! Whilst this looks sensational, there are questions about its sustainability. Comparable coal stock Whitehaven Coal is currently trading on 5x EV/EBITDA multiple and a 6% yield with no debt. Globally coal companies are trading on an EV/EBITDA multiple of 4.5x, a very cheap multiple that indicates that the market does not believe that current high prices for coal will be sustained.

Our take

Using a conservative coal price of around US$150/t, our modelling indicates that Coronado’s free cash flow will drop from around $400M today to around $180M, which would place Coronado on a yield of 5%, i.e. solid but unspectacular.

Whilst we are comforted by vendor EMG retaining an 80% holding, we are concerned about buying into a recently put together company trading at peak earnings, especially when the previous owners of major assets that make up Coronado’s portfolio were happy to sell at lower prices.

We will be passing up Coronado due to this concern and our inability to predict the metallurgical coal price in the near future. Additionally, with the last line of Ben Graham’s quote from above on IPO’s in mind, given the movement in the coal price over the past few years, it is hard not to take the view that October 2018 may represent a very favourable time for Coronado’s owners to be selling shares to Australian investors.

Lendlease: Experts ask if falling property market will end company’s stellar run

An office tower in Brisbane under construction by Lendlease. Lendlease is similar to Goodman Group in that it has experienced internal development capability and strong capital partner relationships which help it build its other arm: funds management, where it earns fees on performance and management of billions of dollars worth of property. Growth in funds under management was 15 per cent to $30.1 billion in fiscal 2018. But how sustainable is that growth? And will all this be enough when the commercial property cycle changes? When interest rates rise and when property valuations and volume transactions fall away?

Atlas fund manager Hugh Dive admits that Lendlease is a cyclical business but that it is shifting away from that.

“It’s a cyclical stock, but not as cyclical as it has been in the past,” he says. “If it had 40 per cent gearing you wouldn’t touch it!”

Lendlease’s net debt to total tangible assets, less cash is 8.2 per cent which will help the company wade through the cycles.

Dive also reminds investors that 40 per cent of Lendlease’s earnings come from offshore, giving it plenty of upside in the coming year from the depreciated Australia dollar.

Monthly Newsletter September 2018

September was a tough month for investors in Listed Property and whilst the Fund is designed to navigate market turbulence, the unit price did decline by -0.5%. In weak markets such as we saw this month; the Fund’s risk management strategies acted as expected and reduced volatility.
Over the month the Australian Listed Property sector declined by -1.8%, the sector’s first decline since March. We note that Trusts with earnings backed by development profits, rather than recurring rents, saw greater price falls in September.
The Fund paid a distribution of 4.84 cents per unit at the end of September, roughly in-line with the June quarterly distribution.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2019.

Politics and Rising Energy Prices

Over the past few months, rising energy prices have dominated newspaper headlines, treating readers to the sight of politicians wringing their hands, promising to get to the bottom of this issue and find out who is responsible. Large power generators, energy retailers and transmission companies are accused of being behind the rising cost of lighting, heating and cooling our nation’s homes.

Whilst the profits that companies such as AGL Energy, Spark Infrastructure and to a lesser extent Origin Energy have increased over the past decade, we see that a significant proportion of the increase can be attributed to energy decisions made by various governments. As an economist, these price increases were predictable based on changes in the supply and demand curves of energy in Australia. There is scant evidence that they are the result of a long-term insidious plan by energy companies to capture a greater share of the nation ’s pay packets. In this week’s piece, we are going to look at energy prices impacting Australia’s consumers and industrial users alike.

Energy prices this century

The above chart shows household gas and electricity prices in Australia and compares them to inflation. Using June 2000 as the baseline year, the CPI [Consumer price index which measures the prices paid by consumers for a basket of goods and services including energy] has risen by 61%. Over this same period, electricity has risen by +226% and natural gas by +207%. As you will note from the above chart, energy price rises roughly matched inflation up until 2008, however energy prices have accelerated in relation to CPI particularly since 2012. It is worth noting that electricity prices are influenced by natural gas prices in that gas is used in gas-fired power peaker plants that can be fired up in response to peak periods of electricity demand.

Gas Prices Up – a new source of demand

Due to the size of the Australian continent and the absence of pipelines linking the major fields off the coast of WA with Eastern Australia, gas prices are greatly influenced by geography. As you can observe from the below table, due to the lack of physical infrastructure WA’s gas from the giant offshore LNG fields is sold to consumers in Seoul and Tokyo rather than Sydney and Melbourne.

Until the construction of the construction of three liquefied natural gas (LNG where natural gas is cooled to -161 C to allow transportation) in the last five years, producers of natural gas on the East Coast of Australia could only sell their gas into the East Coast domestic market. This resulted in gas being priced below world prices for East Coast consumers. For example, in 2008 the wholesale price of 1 gigajoule of natural gas was $15 in WA versus $5 in NSW. The opening of these three export LNG plants in Gladstone in Queensland by Origin Energy, Santos and BG in 2015 and 2015 allowed the export of natural gas from Eastern Australia to Northern Asian customers that were willing to pay over $10 per gigajoule.

Additionally, unlike in WA which mandates that 15% of gas produced in the state is reserved for domestic consumers, no such gas reservation scheme was enacted on the East Coast of Australia. AGL’s plan to construct an LNG import terminal by 2020 to serve the Victorian gas market will further link the prices that Australian consumers pay for natural gas to the world market, with gas expected to be imported from the USA and Qatar.

Consequently, with a new source of demand for natural gas being introduced and East Coast gas markets opened up to world prices, domestic prices naturally gravitated towards the higher export price. The construction of these three LNG export terminals has not only had negative consequences for consumers but due to the elevated construction costs of around $71 billion have also been a burden for shareholders with returns below expectations.

Gas Prices Up – new sources of supply halted

At the same time that demand for natural gas was increasing, a range of decisions were made by governments in NSW and Victoria to restrict new supply. Arguing about the benefits and harms of coal seam gas is beyond the scope of this piece, but economics dictates that if demand is going up and supply is unchanged, prices will naturally rise. In 2012 Victoria imposed a moratorium on coal seam gas exploration and in 2015 the NSW government banned new gas exploration. This saw AGL announce that it would not proceed with their projects in NSW and that they would be relinquishing their exploration licences. This action contributed to the energy company recording an impairment charge of $640 million in 2016. We note that in April 2018 the Northern Territory reversed its ban on gas exploration outside towns and conservation areas in a move designed to put downward pressure on power bills.

Generation Costs Up – changing the mix and reducing supply

In the electricity market prices have been driven higher by the Federal Government’s Renewable Energy Target. This will require electricity retailers to acquire a fixed proportion of their electricity from renewable sources and is likely to result in 33,000 GWh of Australia’s electricity coming from renewable sources by 2020. Politicians seem surprised that regulations have added to electricity costs, following the closure of coal-fired base-load power stations in favour of more expensive renewables. For example, in 2017 Energie closed the Hazelwood power station that had previously supplied up to a quarter of Victoria’s electricity and AGL have announced that they will be closing the 1,680-megawatt Liddell coal-fired plant in 2022. Whilst we recognise that burning coal to generate electricity releases carbon into the atmosphere contributing to global warming, it is also a very cheap and consistent method of generating electricity. Additionally, coal-fired power plants are well-placed to provide a base-load of consistent generation, as these plans can generate electricity continuously, without requiring the wind to blow or the sun to shine.

Until the battery storage technology catches up to allow generators to store significant amounts of electricity, relying on solar and wind power generation requires natural gas-fired generation to step in to maintain consistent supply. As discussed above, this source of electricity generation is more expensive today that it was 10 years ago. Switching power generation to renewables – whilst socially desirable – comes at a cost, and this is reflected in higher energy bills. Further, in any market when supply is removed and demand remains relatively constant, prices tend to rise. This effect has proven profitable for incumbents who have generators, such as AGL Energy.

Our Take

Rising energy costs have impacted consumers and industrial users alike, but they have not arisen in a policy vacuum nor as part of a conspiracy. We see that they are the logical outcome of decisions that have changed the supply and demand for energy and that various companies have predicably acted to generate profit from these shifts. In the Atlas equity portfolio, we own positions in AGL Energy and Spark Infrastructure, both of which have benefited from changes in the energy markets in Australia over the past ten years. Neither of these companies is involved in the LNG export terminals that at this stage look to be a poor investment for shareholders.

What we have learned from reporting season

During the months of February and August every year, the majority of Australian listed companies reveal their profit results and most provide guidance as to how they expect their businesses to perform in the upcoming year. For fund managers, this is somewhat like Christmas, in that opening company results are like gift-wrapped presents: tearing the wrapping off starts to prove or disprove your reasons for owning a company.

In this piece, we will run through the key themes that have emerged over the August reporting season, the winners and the losers amongst Australia’s listed companies, and how our companies have performed.

Volatile price action on the day of the results

On the day of the result over the last month, we observed more over-reactions to profit results (both positive and negative) than usual. We see that this occurs as the market price on the day of a company’s result is generally set by the short-term holders (i.e. hedge funds) and very short-term holders (i.e. machines) of equities, rather than the more measured long-term investors. Often the short-term investors trade with reference to whether a company misses or exceeds their expected earnings, rather than the drivers behind a company’s profits. For example, global packaging company Amcor fell -3.5% on the day of their result, which was weaker than expected due to higher resin prices. Whilst the market priced Amcor as if these headwinds were permanent, the nature of Amcor’s contracts with their customers means that rising raw material costs are passed on, albeit with a lag of several months. Conversely, construction company CIMIC (which we also own in the portfolio) had a good result that was above expectations, but probably not deserving of the +17% gain on the day of the result.When thinking about the noise that we face as investors, a great quote from Ben Graham, one of the titans of investing, comes to mind: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Short-term prices are dominated by sentiment and short-term holders, but in the long term, share price growth is delivered by those companies that can constantly grow dividends flowing into their shareholder’s bank accounts.

Comparison to 2017 and a look ahead

The August 2018 results season was in aggregate better than expected for Australian listed companies, which reported on average earnings growth of 8% for the 2018 financial year. However, there was a large degree of variation amongst the different companies, with earnings growth in the miners (courtesy of higher commodity prices and a falling AUD) offsetting stagnant earnings growth in the financials. Having listened to close to eighty management presentations over the past four weeks, the general tone feels more cautious than it was in February or August last year. Companies with global exposure were concerned about inflation and the impact of a trade war between the US and China, whereas companies that are exposed to the domestic economy spoke about increasing political uncertainty and the potential for radical policy changes that may result from a change in government in mid-2019.

Market favourites did well

One of the key themes coming out of this reporting season was that, unlike in the February 2018 reporting season, high price to earnings (PE) stocks that are well-regarded by the market mostly lived up or exceeded high expectations and their shareholders were rewarded. Polarising pizza company Domino’s Pizza (+9%) and JB Hi-Fi (+12%) both saw the short interest in their companies increase in the lead up to reporting their results, which ended up being better than expected. Similarly, a2Milk (+20%), Xero (+19%), ResMed (+10%) and CSL (+16%) all were expected to deliver very strong profit growth and did not disappoint. The exception to this group was Flight Centre (-14%) which was sold off despite growing profits by +17%.

Give me my money back

Capital management was again a prevalent factor in the recent reporting season and was understandably of interest to investors. A number of companies increased their dividends above expectations, including AGL Energy, Qantas, Magellan and Fortescue. Additionally, we saw a few companies announce special dividends; Suncorp, Woolworths and IAG which was well received by investors with the exception of IAG due to concerns about the outlook for 2019.Rio Tinto, BlueScope Steel, Janus Henderson, Qantas and Crown all announced buy-backs, which should support their share prices over the coming months. Bucking this trend of returning capital to shareholders, Transurban announced a $4.8 billion capital raising to help fund their share of Sydney’s WestConnex motorway, and Harvey Norman raised $164 million to reduce debt on their balance sheet.
Whilst buy-backs boost share prices in the short term, in the longer-term companies do need to retain cash to reinvest in their operations in order to grow earnings in the future without adding to debt.

Cost inflation

Rising costs was a common thread through this reporting season, with most companies mentioning rising costs in their results commentary. Higher labour costs were cited by resource companies Rio Tinto and Alumina, which took some of the shine off otherwise solid results as investors extrapolated the impact of rising costs and falling commodity prices over the near term. Unsurprisingly packaging companies Amcor, Pact and Orora all felt the impact of higher resin prices, though these additional costs are expected to be recovered via pass-through contracts to their customers in 2019. Qantas saw an additional $690 million in costs from rising jet fuel prices, so travellers can expect the company to recover this via higher fares over the next year.Rising energy prices delivered AGL Energy a record annual profit of over $1 billion which allowed the company to increase its dividend by 29%. Whilst this was positive for AGL shareholders, large electricity users such as the office and shopping centre owners GPT and SCA Property faced higher energy bills.

Best and worst results

Over the month the best results were delivered by A2Milk (+20%), Magellan (+17%) and CSL (+16%) The key theme amongst this diverse group of companies all in different industries was a strong profit result and expanding profit margins combined with a positive outlook for 2019. QBE Insurance’s (+11%) shareholders were rewarded when the insurance company produced a result absent of negative surprises the market has come to expect from this stock.On the negative side of the ledger Origin Energy (-19%), Iluka (-18%), Ansell (-12%) and Challenger (-12%) all reported disappointing results compared with other companies. The common themes amongst this group were the profit results coming in below expectations combined with bearish management commentary for the coming year, mainly due to higher costs.

How we fared

Overall, we were reasonably pleased with the results from this reporting season for the Atlas Concentrated Australian Equity Portfolio. As the Atlas High Income Property Fund focuses on owning conservative Trusts that are rent-collectors, reporting season offers few surprises especially as most of the Trusts we own pre-announced the distributions several months ago in June. Positions in Amcor, Pact and Flight Centre were offset by strong results from CSL, Wesfarmers, JB Hi-Fi and QBE Insurance.

As a long-term investor that is interested in delivering income in the portfolio to investors, something we look closely at is the dividends paid out by the companies that we own and whether or not they are growing. Following the great quote from Ben Graham mentioned above, we look to “weigh” the dividends that our investors will receive, as we view that talk and guidance from management is often cheap, but physically paying out higher dividends is a far better indicator that a business is performing well. Using a weighted average, the dividends that our investors will receive will be +11% greater than for the previous period in 2017. Using this measure, we are pretty happy with how the recent reporting season went.