UNIVERSAL COAL: RESEARCH TIP – MAY 2017

We think that there is money to be made as the South African coal producer ramps up its second mine which delivers the potential for a capital return. This stock is not for the faint of heart.


WHY WE LIKE IT

We think UNV shares are way undervalued, but with output ramping up in the 2017-18 year this situation won’t last for long. The South African coal producer recently started production at its second mine, the New Clydesdale Colliery and the operation is running smoothly. Output from the company’s first mine, Kangala, is underpinned by a ‘take or pay’ agreement with the state-owned utility Eskom. On current trends, UNV should be in a position to start paying dividends and/or return capital to shareholders.

WHAT’S NEW?

After a poor December quarter, UNV reported total March quarter sales of 729,000 tonnes, 7% higher. This resulted in revenue of $43.5m and operating cash flow of $9.2m; its cash on hand is $7.9m. Kangala is humming along, producing an annualised 2.4mt but has room for improvement; while its NCC underground operation are doing a ‘steady state’ 900,000 tonnes a year. But with the open pit expansion the company is targeting an annualised rate of over 3m tonnes a year. UNV expects to be a substantive miner with annual output of 4-4.5m tonnes in 2017-18.


THE END OF THE AFRICAN DISCOUNT IN SIGHT

We believe that the “Africa discount” or an investor aversion to ASX companies operating in the Dark Continent has weighed on the company’s share price, and that this discount could reduce as the lure of a big capital return entices investors into Universal Coal.

In particular, the South African political environment is considered shaky post the unifying force of the great Nelson Mandela. A delayed start to the company’s second mine, the New Clydesdale Colliery (NCC) didn’t help, either.

UNV shares have traded well below the value ascribed to the stock by two parties who launched takeover offers in 2015. In a hostile move UNV’s biggest shareholder, South Africa’s biggest coal miner Ichor Coal offered 16c a share. In an agreed offer Coal of Africa (ASX code CZA) bid 25c a share, 20c in cash. A mystery party also presented an indicative cash offer of 20c a share. In the event, the Ichor bid lapsed and the NCC delay plus the bidder’s deficient working capital led to the CoA offer being stymied at the last moment, leading to UNV shares collapsing from 20c to the current levels in July 2016.

EXPANDING ITS OPERATIONS

Since then, UNV has commissioned the underground phase of NCC. The company owns 70.5% of Kangala, a greenfields development that started producing in April 2014. UNV also owns 49% of NCC, acquired from Exxaro Resources in 2015 for $17m. UNV is the operator, with Black Empowerment Enterprises (BEEs) owning the remainder. By law, BEEs must have a minimum 26% stake in such projects.

As well as the domestic output, UNV is contracted for 650,000 tonnes of export output from NCC, with an additional ad hoc 50-100,000 tonnes a year from Kangala.

While the company is cash flow positive, UNV should need to draw down roughly half of a $20m debt facility to fund the open cut phase, although this also includes upgrading the existing processing plant. This will take debt to $35-40m, with no more capital requirements.

The state-owned utility Eskom purchases most of UNV’s output on a ‘take or pay’ basis. The company also sells on the export market via traders and has benefited from the depreciating rand and firmer prices for both thermal and metallurgical coal.

CAPITAL RETURN?

Under the Radar is conscious of the tendency of miners to expend free cash on the next project at the top of the cycle, which can have disastrous results. Look no further than BHP Billiton with US shale gas and the Ravensthorpe nickel disaster, or Rio Tinto’s near fatal purchase of Alcan.

The company says that UNV is eyeing other existing operations and looking at acquiring in Australia or South Africa. Such brownfields opportunities are cheaper and faster to generate returns than doing it from scratch in greenfields developments.

Alternatively, a maiden dividend might not be too far off, judging from the company’s comments in its recent quarterly report about sustainable cash flows paving the way for “continued growth and initiating shareholder returns.”

CORPORATE & BALANCE SHEET INTRIGUE

UNV’s appeal is complicated by management fees received from the operating entity as compensation for managing the mines. These fees, as well as loan repayments from UNV’s BEE partners are an asset but are not apparent in the accounts.

Meanwhile, Ichor continues to sit on UNV’s register with a 30% stake. It’s possible Ichor could mount another takeover attempt, but it is cash constrained. A more likely prospect is that another predator acquires the stake as a beachhead for a full takeover.