Whitehaven: Trading on a 20% free cash flow yield

Tim Hannon

Conrad Capital Group

Whitehaven Coal (WHC) is an Australian coal production company that produces approximately 20 million tonnes per annum of high-energy thermal coal.  This production compares to global coal consumption of approximately six billion tonnes.  Thermal coal is used to run coal fired power stations.

WHC sells its thermal coal to Japan, South Korea and Taiwan. WHC sells high quality coal with an energy value of 6000 calories per kilogram.  To provide context, Victoria in Australia burns low energy lignite coal with a calorific value of just 2000 calories per kilogram.  Victorian coal is some of the worst quality in the world, generating the highest carbon emissions.  WHC coal in relative terms is a low carbon emission product that is in high demand by developed economies.

Whitehaven (WHC) delivered a mildly disappointing first half result due to production issues at one of their coal mines.  These production issues have persisted for some time, and the market has become impatient and overreacted, translating into a significant 10% share price fall on the day of its result.  This share price fall is completely unwarranted given the significant free cashflow the company is generating.  We think the market is too focused on short term production problems and missing the bigger picture.

Fundamentals supportive for thermal coal

We generally expect production problems from resource companies, it is the reality of dealing with the inconsistency of geology and the host of mechanical and process issues that comes with the extraction and logistics of physical material.  We are surprised that the market is surprised when problems arise.

If production issues are transitory, as they often are, it provides an excellent opportunity to make an investment with a medium-term view.  To illustrate the opportunity, we will describe the current industry backdrop for thermal coal and why WHC is extremely well positioned.

The price of thermal coal is elevated because of a lack of investment in new coal production capacity. This is primarily because of the global providers of capital are unwilling to support economic activity they deem harmful to the environment.   It is extremely difficult to get funding for coal mine investment.

Demand for coal is still increasing.  Independent forecasts vary in the range of 100 to 200 million tonnes of thermal coal will be required over the next 15 years to meet demand from the Asian region.  Coal driven power will allow millions of people access to electricity to lift them out of poverty.  

This increased demand will require several coal basins to open, a very difficult scenario to envisage given severe community résistance and lack of funding availability

The industry structure for the high-quality thermal coal is almost an unregulated monopoly. The supply of high-quality thermal coal that produce the lowest emissions comes from the Hunter Valley in New South Wales.

There are three major suppliers in this market, representing 75% of supply.  They are Glencore, Yancoal and Whitehaven.  We expect these players to act rationally and supply the market in a disciplined fashion.

Most analysts expect a decline in the thermal coal price from $US95 per tonne to $US70 per tonne.  We think these estimations are incorrect. 

The market is incorrect because of the combination of naturally growing demand, constrained supply and a tightly controlled market.  We expect high quality thermal coal prices to maintain at historically high levels of $US90-$US100 per tonne.

At current coal prices, WHC trades on a double-digit free cash flow yield and will be debt free over the coming 12 months. 

WHC has little capital expenditure requirements over the next few years.  We expect the company will be able to use its free cashflow to fund several profitable coal mine developments, increase dividends and potentially implement a share buyback.  All these features will be extremely supportive for WHC’s share price.

High-level economics for WHC

WHC sell 20 million tonnes of coal at $AUD130 per tonne: $2.6 billion revenue

Costs per tonne at AUD$70 per tonne, about $1.4 billion of costs

Less capital expenditure:  $100 million capex

Less tax: $250 million tax

Free cashflow: $850 million

On these very basic numbers, WHC is generating $850 million of free cashflow on a market capitalisation of $4.4 billion. This represents a free cashflow yield of 20%.  We can debate how long thermal coal prices stay elevated for, but as we have highlighted there are some structural factors that are likely to support it at much higher levels than we have seen in history.

Lucern Investment Partners 

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Tim Hannon
Managing Director
Conrad Capital Group

Tim has 25 years’ experience in the investment and securities markets. Tim was a partner of Goldman Sachs and during his 16-year tenure at the firm had senior experience across all areas of equities investing.

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