Opportunity in adversity

In June (FAT19) we issued a traffic light recommendation on Fording Canadian Coal Trust (NYSE, FDG). Our view was that the trust offered solid leverage to long term strength in coking coal prices. However at the time, the charting outlook was negative, and we refrained from making a buy recommendation. Our caution proved well founded as the stock price continued to deteriorate.

Six months on, FDG appears far more attractive from a contrarian viewpoint. We believe that the recent lack of investor enthusiasm towards metallurgical coal companies, along with the fallout with Canadian income trust debacle, are now firmly in the price.

Fording holds a 60 percent stake in the Elk Valley Coal Partnership, the world's second largest exporter of metallurgical coal. Teck Cominco owns the other 40 percent and manages the 6 mining operations based in British Columbia and Alberta.

Affecting investor sentiment in recent times has been a fall in coal prices, which followed the August/September decline in steel prices. However, we are encouraged by industry reports that prices are likely to stabilize pending the latest round of contract negotiations.

We estimate that prices will likely be set at around the $110 per tonne mark. Fording realised average prices of around $99 per tonne last year.

Ultimately, we believe long-term supply and demand fundamentals will support robust metallurgical coal prices. Supplies are tightening with material quantities of new hard coking coal supply not expected any time soon due to the long lead-time to develop mines. Meanwhile, ongoing growth in China and India should ensure the support of the industry's primary customers, the steel makers.

A steel glut in 2005, of course, forced many steelmakers to cut back output quickly, however demand is now catching up to supply. Steel prices in many regions are now rising, which will inevitably lead to production increases and higher metallurgical coal demand.

A lacklustre operating performance has also hampered investor appetite for Fording stock over the past few months, although the tide now appears set to turn.

Income from operations in the three months to 30 September decreased by C$120 million on the prior year to C$144 million. An 8 percent tail off in coal prices to $109 per tonne, lower volumes, and higher costs shared the blame. However, respite is on the horizon, with coal prices set to stabilize, capacity on the increase, and unit costs consequently in check.

Volumes at Elk Valley weakened 8 percent to 3.5 million tonnes due to plant shutdowns and planned maintenance. In addition, some customers reduced their requirements for hard coking coal, instead opting for lower quality, cheaper coals. Encouragingly, the plant will be at full capacity in the fourth quarter. As a result management are sticking to earlier sales guidance of 22 million to 23 million tonnes in 2006.

Meanwhile, longer term demand is not an issue. Last year's strategic deal saw Japan's Nippon Steel take a stake of 2.5 percent in Elk Valley. Nippon has contracted to purchase 29 million tonnes in total from 2005-2015. This effectively underwrites the expansion of coal production at Elk Valley by 6 to 7 million tonnes per annum by next year.

Elk Valley, like most of the industry, is facing rising costs. Having said that, weak volumes also contributed to the 17 percent blow out in unit costs over the year to C$42.60 per tonne. We expect significant improvement on the cost front going forward, with the plant now restored to normal capacity. Management expects unit costs for 2006 to be between C$38 and C$39 per tonne.

Fording also owns industrial minerals business NYCO, the globe's largest producer of wollastonite (a mineral used in the automotive and construction industries amongst others). The earnings result here was negligible at C$300,000, on volumes which rose 8 percent to 24,000 tonnes. The Trust is however assessing options for NYCO and we would suspect the business may be up for sale next year. We would welcome the move as it will allow management to focus fully on the core coal operations.

From a balance sheet and liquidity perspective, Fording is in solid shape. Cash and equivalents are C$128 million. With long-term debt of C$306 million gearing is relatively high at 82 percent. However, the serviceability of debt is not in question. EBITDA (earnings before interest, tax, depreciation and amortisation) covers interest expense to the tune of 30 times.

Fundamentally, Fording is attractive in our opinion. The shares trade on a trailing EV/EBITDA (enterprise value to earnings before interest, tax, and depreciation) of 7 times. A high payout ratio translates into a current year yield of 15 percent.

Supporting the healthy fundamental outlook, there are already signs that the fourth quarter earnings pickup is eventuating. Last week the company declared a cash payout of C$0.95 per unit for the fourth quarter, breaking a string of five successive distribution reductions.

In addition to concerns over coal prices and operating performance, sentiment towards Fording's received an additional blow in November. The Canadian government announced changes to the tax treatment of Income Trusts, which resulted in panic selling across the sector.

However we note that the changes are still 'proposals', and would not actually come into effect until 2011. From that point onward, however, the Trust will pay tax similar to a standard company. This of course impacts the potential net distribution investors will receive. However, given a healthy current yield, along with prospects for further growth, the market sell-off seems overdone.

Recent price action indicates that the market is coming around to this viewpoint. Fording has staged a notable recovery, climbing 30 percent since the November low of $18.90.

While an extension above this week's high of $24.49 would signal a clear improvement in investor sentiment, from a technical perspective we need to see further gains to confirm a sustainable restoration of upward momentum. A clear break above the $25.45 to $25.95 area will signal that the $18.90 level is indeed a long term, enduring low.

Nevertheless, the fundamental picture surrounding Fording Coal is overtly positive. With capacity expanding, and costs in check, the company is highly leveraged to a recovery in metallurgical coal prices. As such, we recommend Fording Canadian Coal as a Buy to all Members around $23.71.