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Searching for Investment Opportunities in the Micro Cap Coal Space

By Free Cash Flow 50 | Sat, 10 November 2012 00:00 | 0

A few months back, I wrote a piece about a company called CIC Energy (see here) which was acquired two months after publication. While the timing of the article and acquisition was sheer luck, the value was there given how much the stock had been beaten down. While the embers of the coal industry are still smoking, several very interesting speculations among all market capitalizations remain. Another such company is Cardero Resources (CDY.)

Investment thesis:

The days of $200 plus for a ton of coking coal are likely over for some time. That said, what would you pay to own a high quality coking deposit in a very friendly jurisdiction surrounded by the biggest players in the industry? What if I also told you that the proven and probable reserves were recently listed at 121 million tons and that in the last two years alone, there had been a consolidation wave in the area amounting to $5 billion? Well, if you are looking at Cardero Resources, the answer is a current enterprise value of only $66 million (adjusted for recent private placement and debt financing). The fact that the market is currently valuing Cardero Resources at such a low valuation highlights the state of the thermal and metallurgical coal markets.

The big questions remain, though: has the great commodities boom of the last ten years come to an end? Coal stocks have reflected much of the slowdown, but has it been enough? Will China's other shoe drop?

While many unknown variables remain, perhaps the best way to counteract these risks is simply by demanding a lower share price. As it stands today, I believe we are well protected on the downside as current market prices provide us with a considerable margin of safety.

Business

Cardero can best be summed up as a conglomerate of sorts, but rather than having businesses in several different industries, the company's focus has always been in the resource sector. While Cardero can be quite tough to break apart (they have 12 subsidiaries), their main asset is a 75% interest in the Carbon Creek Coal Deposit located in British Columbia's Peace River Coalfield. Carbon Creek remains one of the last remaining assets in the region not controlled by a major. It is quite likely that the many moving parts have played a role in dissuading a potential acquirer from taking them out despite the many operational successes the company has had over the past two years.

Up until just a few months ago, they also had an extensive equity portfolio, but have since sold it down to a current market value of close to $4 million.

Breakdown of assets:
•    Carbon Creek Coal Deposit 75% interest
•    Sheini Hills Iron Project (Ghana)
•    Longnose Iron/Titanium deposit (Minnesota)

As a side note, BHP Billiton (BHP) has stated Longnose is the largest known ilmenite resource in North America.

Peace River Coalfield and Cardero's Carbon Creek Deposit

British Columbia's Peace River Coalfield extends for about 250 miles along the northern part of the Rocky Mountains. The amount of coal in the ground there is estimated to be around 160 billion tons at a depth of about 2000 meters, according to the British Columbia Ministry of Energy and Mines. Coal was first discovered in the region over 200 hundred years ago, but before 1980, only about 100,000 tons was mined due to a lack of infrastructure. Today, several of the big players have a presence in the area, including Xstrata (XSRAY.PK), Anglo American (AAUKF.PK), and Walter Energy (WLT).

Within the Peace River Coalfield lies Cardero's Carbon Creek deposit. The deposit is in fact the oldest in British Columbia, and has been known about since 1909, but, like much of the rest of the Peace River Coalfield, it remained largely undeveloped until the 1970's.

A very important aspect about Peace River and Carbon Creek is that this is an area with ample infrastructure. The coalfield is about 750 miles from the coast, with the Canadian National rail passing by roughly 30 miles from the property giving them access to Vancouver's Ports and Ridley terminals for shipment to Asia. In May, the company did just that, signing a 15 year agreement with Ridley Terminals to export coal beginning in 2014.

It is also a mining-friendly jurisdiction with basically everything a mining company needs to be successful. This is not a region located a million miles from anything with no infrastructure, in a contentious area, with political instability, etc.

As shown in the graphic below, this is a good place to have a coal deposit.

Surrounded by giants

Cardero Resources
Source: Cardero Resources

Cardero's interest in Carbon Creek goes back to 2010, when the then CEO of Coalhunter Mining and current Cardero CEO Michael Hunter was contemplating taking Coalhunter public. Cardero had purchased a 49.5% stake in Coalhunter, which in turn had its 75% ownership in Carbon Creek. In 2011, the two companies were able to come to the table and work out a deal which saw Coalhunter folded into Cardero, and Michael Hunter being named CEO of the combined entity replacing then CEO Henk van Alphen who now serves as managing director. While management only owns about 3% of the company, they are very experienced coalmen and have proven to be highly capable operators.

2012 - A year of several accomplishments

This year has proven to be a year of several key operational successes as the company accomplished four large goals:

•    Signed 15 year agreement with Ridley Terminals
•    Hiring of industry heavy-weight Angus Christie as COO (recent experience in the Peace River Coalfield)
•    Acceptance of the Environmental baseline for the project
•    Received mining license from British Columbia
•    Recent release of Prefeasibility Study

Next will be a bankable feasibility study slated for June 2013. Shortly following this, a mine application will be submitted with the likelihood of receiving an operating license by the end of the year. The mine's first coal production is targeted for the second half of 2014.

Most recently, the company announced a private placement of 22.5 million shares and a bridge loan credit facility with Sprott Resource lending for $11 million. While a private placement at the lowest price the stock has been in nine years certainly hurts, this will give them the capital they need to tackle the bankable feasibility study as well as working capital.

121 million tons of proven and probable reserves and an explosion in the measured and indicated resources provides a powerful free option

The company recently released their Prefeasibility Study which showed a tremendous expansion of measured and indicated resources from 166 million tons to 468 million. The pre-production capital also was reduced to around $217 million from $301 million as stated in their PEA. The base case NPV of the project (using an 8% discount rate) is listed as $633 million although this is down from $752 million as listed in their PEA. The decrease in the NPV can be attributed to the drop in met coal prices as well as a decline in mineable coal from 137 million tons (as listed in their PEA) to 121 million. An important distinction must be made in that the NPV of the project is based on the 121 million tons of proven and probable coal reserves and excludes any new mineable tons as a result of the 182% increase in measured and indicated. While the initial drop might seem worrisome, it should be of no concern as the large increase in the measured and indicated category will no doubt raise the amount of mineable coal (perhaps substantially) over time. While we don't know the amount that the increase will yield yet, it serves as a powerful option that a potential acquirer will have to take into account.

NPV for Carbon Creek

 NPV for Carbon Creek
Source: Cardero Resources

On top of this, there is an additional 232 million tons in the inferred category. The mean plant recovery for underground and surface coal was 64%. If this same recovery percentage holds true for the increase in measured and indicated tons and eventually increasing the proven and probable reserves, the value could go up materially. While there is no guarantee of course that they will be able to greatly increase their proven and probable reserves based on the latest increase, I'd say the probability is quite high that they will.

High quality coking coal makes it a prized asset

While the market for coking coal might currently be taking it on the chin (and no doubt could continue to do so), it truly is rare stuff. Around 88 percent of global coal resources are thermal leaving only 12 percent coking coal to fuel the steel plants of the world. The best quality premium coking coal is only known to be accessible in abundance in Canada, Australia, China, Mongolia, the U.S., Russia, and Mozambique. Anglo American has further noted that only three countries (Canada, the U.S., and Australia) together make up 90 percent of the seaborne metallurgical coal market.

If this were another thermal coal mine the investment thesis wouldn't be nearly as interesting. The estimated coal quality breakdown held at Carbon Creek is the following:

coal quality breakdown

Middle volatile hard coking coal makes up the lower seams of the deposit while a combination of (less valuable but still good quality) high volatile semi-soft and PCI coal is found at the upper seams. The remaining 6% consists of lower quality thermal coal close to the surface. While low volatile hard coking coal is the most valuable and fetches the highest price, Carbon Creek's middle volatile hard coking coal is still very high quality stuff coupled with their remaining valuable semi-soft and PCI coal. PCI coal is generally not considered to be coking coal and is used mainly for its heat value by injecting it into a blast furnace to replace expensive coke. Semi-soft and PCI coal normally fetch lower prices on the open market relative to hard coking.

The actual layout of the deposit makes for another positive factor in that the coalfield is basically flat and even as opposed to heavily fractured as many deposits are. This enables both surface and underground mining to take place. The company plans on initially using trucks/shovels for the first few years before transitioning to high-wall mining. About 60% of the resource lies below the surface although the plan is not to mine this until around year seven.

Heavy consolidation in the Peace River Coalfield

It is difficult of course to know if management is 100% set on bringing the mine to production, or if they are going through all the motions in the hopes of being bought out. They have had great operational success the past year, but I suppose if the price were right, anybody could be convinced that selling out to the highest bidder would be the best course of action. There has been over $5 billion in acquisitions the past two years in the area alone as shown in the chart below:

Cardero Resources 1
Source: Cardero Resources

Xstrata was leading the charge during this time, acquiring three deposits for roughly $670 million in 2011. Given that met coal was peaking over this time frame, it could also be that the buyout binge has come to an end.

An interesting note as of late is that in their last two investor presentations they have excluded any mention of their other assets. The market would no doubt assign a higher valuation to the company as well as possibly spark interest from a major if they spun off or sold their other assets and became a pure play.

China's worsening cold is giving Australia a non-Foster's fueled headache

In August, iron ore and coking coal prices fell to their lowest levels since 2009, as China's slowdown puts its steel sector under severe pressure. The China Iron & Steel Association (CISA) has stated that the country's steel prices are likely to remain weak over the next few months due to a supply glut. The Association further noted that the nation's steel industry's profits collapsed by 96 percent in the first half of 2012 compared to a year ago. CISA also stated that roughly 40 percent of the country's iron mines have shut because of low prices. Macquarie estimated that 40m tons of annual capacity in the seaborne iron ore market was losing money at current prices.

Despite iron ore and coking coal prices dropping heavily since July (although recovering somewhat), imports of metallurgical coal into China for the June quarter still were around 26 per cent higher than those in the quarter ending in March.

For what it's worth (likely not much), the 2013 forecast for China's coking imports are to increase by 15 percent while India's are estimated to increase by 9 percent to 23 million tons. At this point, it's very hard to imagine that there will be any material increase coming out of China.

Hard Coking Coal Prices

Recent activity by the largest players in the industry speaks volumes as to what is happening as well as what they view on the horizon. In September, BHP shelved $6 billion in development in two of their largest Queensland coking coal plants. Further, the company and Xstrata cut some 900 coal mining jobs in the State. BHP will also close its 33 year old Gregory coking mine, stating that it was no longer profitable. Rio Tinto (RIO) has plans to close their Blair Athol coal mine in Queensland by the end of the year.

In the U.S., Consol Energy (CNX) stated in September that it was idling its Buchanan coking coal deposit which accounts for 5 million tons a year for 30-60 days due to the depressed market.

BHP's CEO warned last month that a large amount of thermal and coking coal production on the Eastern seaboard of Australia is unprofitable at today's production costs and prices. It has to be taken into account, though, that the commodities boom experienced in Australia the last ten years has seen expenses skyrocket coupled with the strong Oz dollar (though this may change soon) making some mines simply uneconomical.

Peace River Coalfield - A Lower Cost Alternative

Given the tremendous boom Australia has experienced, Canada's deposits could begin to take a much greater share of the coking coal market away from Australia due to the high operating costs in Queensland.

In June of this year, Anglo American released a coking coal presentation basically laying out the case for coking coal in Peace River:

Rising Cost Pressures
Source: Anglo American Metallurgical Coal Investor and Analyst Briefing

Valuation

The current enterprise value is only 14% of the estimated NPV of $633 million, while similar comparable sales transactions on the company's mineable coal reveals a similar discrepancy between price and value. As it stands today, Cardero's stock price is the lowest it has been in 9 years, while the prospects have never been better. We have a company with basically no debt, good management, and presence in a prolific mining region that has undergone heavy consolidation by the big boys in the area.

Valuation was looked at using three methodologies: Proven and Probable Reserves, NPV, and Measured and Indicated resources.

Proven and Probable Reserves

In October of last year, Xstrata bought Cline's Lossan property. The deposit itself contained 186 million tons in the measured and indicated category but of that amount, only 14 million was estimated to be mineable. The Lossan deposit consists of about 41% PCI coal and 59% coking coal. Although there is a mixture of PCI coal at Carbon Creek, it is a mix with higher quality semi-soft coal as opposed to Lossan, of which 41% was classified as PCI.

This is as good a comparable sales transaction as any, considering the coal is of similar quality and both are located in the Peace River Coalfield. When the Lossan deposit was taken out, coking coal prices were around $280 or so, which worked out to roughly $2.86 per mineable ton in the ground for Lossan. Since then, met coal prices have come down close to 40%, making it far from reality as a starting point. Factoring in that the great commodities run of the past 10 years or so could be coming to an end (or at least stalling out), using the current met coal price of around $170 seems like a good place to begin.

Under this scenario, the recent $170 a ton price gives us a per mineable ton value of around $1.70 ($2.80x0.60). If we multiply this figure by Cardero's 75% interest of 121 million proven and probable reserve tons, we end up with a value of about $155 million. Divide this by the company's 131 million shares (after private placement) and we end up with $1.20 per share versus the current share price of $0.53 cents.

Let us make an assumption that demand from China and others really falls off a cliff and the price drops a further 30% before settling at around $1.15 per ton of proven and probable reserves. At this price, we get a valuation of around $105 million or $0.80 per share. Assuming this case, we still have a potential upside of over 50%. As it stands today, Cardero's coal in the ground is being priced at only $0.73 per ton of proven and probable reserves given its enterprise value after adjusting for the soon to be increased share count.

Net present value

If we use Cardero's base case NPV of the project which assumes long-term met coal pricing of $174 a ton and uses a discount rate of 8%, we get $633 million. How much would a potential acquirer offer to take Cardero out? What is an acceptable discount to NPV? 25 percent? 50 percent? If we use a 25 percent discount, this would give us an acquisition price of $356 million (Cardero's 75% interest and the 25% discount) or about $2.70 per share.

If we use the low case NPV for the project, which assumes long-term met coal pricing of $143 a ton and uses a discount rate of 8%, we get $191 million. If we take a 25 percent discount from this, we end up with an acquisition price of $107 million or close to $0.82 a share. Not nearly as attractive but still a potential upside of close to 55%.

Are the discount rates used too low? Are the long-term coal prices too optimistic? You can play around with these numbers until the cows come home but under this method and these assumptions (which I believe are quite conservative) an adequate margin of safety exists considering the enterprise value right now is just 14% of the NPV.

Measured and Indicated Resources

When Xstrata purchased Talisman Energy's Sukunka deposit in March of 2011, it did so at a price of $500 million or $2.12 for each of the project's 236 million tons in measured and indicated resource. If we apply the 40% or so haircut that coking prices have taken since then and multiply it towards Cardero's 75% interest in Carbon Creek's 468 million measured and indicated tons, we get a figure of around $445 million for the deposit or around $3.40 a share.

The simple chart below reveals several of the acquisitions in the Peace River Coal field and the prices paid.

Anglo American Metallurgical Coal Investor and Analyst Briefing

Cardero's current enterprise value is around $66 million, based on their recent private placement of 22.5 million shares and reflecting the recent $11 million in debt financing. The Price/M&I and Price/Reserve are based on the adjusted market capitalization as well as the 75% interest in the coal reserves.

We have to take the figures above with a grain of salt as when these deposits/companies were acquired, coking coal prices were much higher as well as the outlook was much more favourable. Even with these factors taken into account, Cardero's measured and indicated tons are being valued at only $0.19 cents (75% ownership) and its proven and probable reserves at only $0.73.

All told, we end up with a very wide valuation range with these techniques, but if the assumptions used are in the ballpark of reality, an estimated intrinsic value is perhaps between $0.82 on the very low end to $3.40 or so on the high end. I've always liked the Buffett quote that if you actually have to sit down and calculate the value it's just too close. The value should jump up at you.

While market sentiment cannot be ignored entirely, I'm prepared to wait for price and value to come into some sort of equilibrium from the heavily discounted price the shares are currently fetching.

By. Free Cash Flow 50

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Sat 10 November 2012
Searching for Investment Opportunities in the Micro Cap Coal Space

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