Macarthur Coal Limited 25 Nov 09

A dramatic fall in earnings was expected.

The fall in forecast profit for 2H09 was largely anticipated by the market. The announcement was made on 18 November. On that day the stock opened at $10.24 and closed at $9.70 after hitting a low of $9.41. The market took the news in its stride, looking more to future prospects for the company.

Macarthur earns its bread and butter from PCI and coking coal. Strong growth in the production of pig iron in China has ensured that the market for coking and PCI coal is tight.

The last price spike of the benchmark price of steel in China was US$886/t in July 2008. The price of steel in China subsequently fell to US$500/t in November 2008. Steel prices have been volatile this year but the trend in China is upwards and the Chinese benchmark has risen to US$600/t. This is good news for suppliers of coking and PCI coals, because if steel prices fell further and showed little or no sign of recovery, coal prices would have come under attack.

Fat Prophets has bought the company twice, the first time at $1.25, and the second time at $5.27. Macarthur Coal has done well, but now is a good time to take some profits and switch into diversified miner RIO Tinto.

Fat Prophets initially recommended buying Macarthur Coal at $1.25 in September 2002 in the Australasian report (FAT98). Our last review of this stock for the Mining and Resources report was in July (Fat Mining 185).

In our last coverage, MCC was trading at $7.80, since then prices have stormed higher to reach a high of $10.62 last week, representing a gain of 36% in just over three months of trading. As such, we would expect prices to retreat slightly to around the $9.10 - $9.00 support level. The series of higher highs and higher lows represents the strength of the uptrend and the fact that buyers are willing to push prices higher.

Looking at the broader picture, a bullish ascending triangle is currently forming, should prices break above the current resistance level at $10.62, we potentially will be in for another upward leg of the price rise.

The company has however attained a market capitalisation of $2.4bn. On a comparative basis Macarthur is expensive compared with RIO. Consensus forecast PERs for Macarthur for 2010 and 2011 are 24X and 15X respectively. The comparable ratios for RIO are 18X and 15X. The price to cash flow multiples are high for Macarthur, 24X for 2010, and 14X for 2011. RIO on the other hand is trading on cash flow multiples of 11X and 10X.

The risk-reward profile for RIO is more attractive than for Macarthur. For this reason we are recommending a HALF SELL on Macarthur and recommend switching into RIO.

Macarthur has got back to full production after scaling back for the global financial crisis. The company has reported that the outlook for 2HFY10 is uncertain because the coal supply train is choked to capacity, and the wet season the 1Q10 is expected to further constrain production.

FY09 was a pretty good year for the company with sales of 4.6mt which includes coal purchases from other suppliers. This was well above initial guidance of 3.9mt. Despite the global financial crisis the company reported a FY09 profit of $168.6m.

The company has returned to its policy of a 50% payout ratio, and declared a final dividend of 13 cents per share.

Strong AUD coal prices in FY09 contributed $184.2m to net profit, whereas higher costs deducted $58.7m. In FY08 the company only reported a net profit after tax of $72.2m.

FOB cash costs in 2HFY09 were $77.28/t, which was 16.8% lower than 1H. Costs were overall higher in FY09 because of higher mining costs, port and rail charges.

JORC reserves have been increased by 53% to 183Mt. An increase in reserves and the granting of a mining lease for Olive Downs North provide a path for growth. The rail contract has increased by 3.7mtpa to match increased capacity at the Dalrymple Bay Coal Terminal.

The company plans to double production in 5 years. The priorities for 2010 are safety performance, people focus, cost management, operational excellence and sustainable growth. The sales target for FY10 is 4.6mt.

Macarthur is the dominant JV partner in over 10 projects capable of ensuring a sustainable growth profile. However, the coal industry is constrained by availability of infrastructure and there are always many players seeking additional port allocations.

The next cab off the rank is the Middlemount Development. A mining lease was granted in September 2009 and construction of the coal handling and processing plant (CHPP) is underway. Macarthur Coal owns 70% of Middlemount and has an option to buy another 20% from Noble for $100m. The option is exercisable after the CHPP has been completed.

Middlemount has an initial proved and probable reserve of 57Mt of around 70% semi-hard coking coal, and 30% low volatile PCI coal. First production at 1.8mtpa is scheduled for 2011. This is the limit for Stage-1 production until an EIS has been accepted for Stage-2, which would take production to 5.0Mtpa, thus doubling the current production.

In the short-to medium-term the company is beholden to coal price and the AUD/USD exchange rate, rather than being volume driven. This is another reason that we like the large diversified miners with multiple divisions for volume growth as well as higher prices. However, most companies are of course adversely affected by the strong AUD.

We recommend a HALF SELL on Macarthur Coal and recommend a switch into RIO Tinto.


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