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  Contrary coal

BENJ GALLANDER and BEN STADELMANN

Friday, December 20, 2013

Dirty old coal is once again deep in contrarian territory. Such was the case back in December 2000, when we bought Luscar Coal at a deep discount price near the peak of the internet bubble. That worked out wonderfully as burgeoning electricity demand led to higher coal prices, and we made nearly a triple in less than six months on a takeover by Sherritt International.

This time around, it is the shale gas revolution that has coal in retreat. Power generation using natural gas produces fewer CO2 emissions and far less pollution than coal.

While fuel substitution is well established in North America, the option is less available in other parts of the world, particularly in China, which burns more of the fossil fuel than the rest of the world put together.

Yanzhou Coal Mining, whose ADRs trade on the NYSE under the symbol YZC, is a behemoth in the industry. Production was 94.1 million tonnes in 2012, way up from 64.3 million tonnes in 2011. The company has been aggressively buying up assets in Australia over the past several years, but its mines are mainly in China's Shandong province and Mongolia.

Chinese companies frequently have complex corporate structures, which keeps control firmly in national hands. In the case of Yanzhou, the government-controlled Yankuang Group holds 52.9 percent of the outstanding shares.

Yanzhou has an enviable track record of profitability and has rewarded shareholders with a robust stream of dividends. Unlike North American companies that strive for consistent quarterly payouts, Yanzhou's policy has the feel of a true profit-sharing plan. The dividend is paid once a year and is pegged at approximately 35 percent of the net income of the previous year. The distribution peaked in 2006, when shareholders collected $1.37 (U.S.) for each ADR held.

In 2012, the miner started to feel the squeeze between higher labour costs and lower coal prices; the dividend paid this past July was only 50 cents. The retreat turned into a full-fledged rout in the first half of this year.

Operating cash flow dwindled to a trickle, and the net loss was 2.1 billion yuan, equivalent to about $345 million (U.S.). The ADRs were shafted to a low of $6.68 in July, miles from the high-water mark of $41.89 set a couple of years earlier.

The teeming metropolises of China are notoriously polluted, and its citizens are not happy about it. Intuitively, one might think that government initiatives to reduce smog would be a negative for Yanzhou, but they are actually helping.

Coal quality varies widely; it is the cheap, high-sulphur stuff that burns with low heat and lots of ash that is the prime culprit. Much of this low-grade coal is imported, chiefly from Indonesia.

Tariffs and other measures have been introduced to block these imports, though it is unclear yet how far the government is willing to go. One of the reasons why Yanzhou has invested so heavily in Australia is that much of that country's output is of very high quality.

Aside from a few major producers, China also has thousands of small coal operations. These excavations are often dangerous, with hundreds of workers losing their lives every year. The government is using the downturn as an impetus to shut these mines, consolidate the industry, ensure safer practices and control production quality. With inefficient capacity removed, coal prices have firmed and Yanzhou's stock price advanced.

Is Yanzhou's current trading price of $9.70 a good buy? None of the 22 analysts tracked by CNN think so; 12 have it as a sell or underperform, another eight a hold and two outliers score it an outperform.

This is the kind of negative sentiment that grabs a contrarian's attention. No purchase has been made here, but it is tempting.

One yellow flag is increasing liabilities: the debt/equity ratio of 1.2 is not awful, but it has deteriorated significantly. A larger question is to what extent Yanzhou overpaid for those Australian mines when coal's outlook was rosy. More contemplation will be needed before deciding whether a lump of coal will be placed in the Christmas stocking.


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