huntley's article - 16% below his buy rec. Huntly has a buy at...

huntley's article - 16% below his buy rec.
Huntly has a buy at $5. It is $4.17...16% below the buy recommendation. Huntley incorporates a margin of safety in his buy recommendations so what about 16% below.
Market Overreaction


Last week CEY said approximately 450,000t of coal production had been lost at its Newstan mine on the Central Coast of NSW. Newstan is one of the company's most productive and profitable underground mines. It contributes approximately 15% of FY06 group production, which we now forecast at approximately 18Mt. It's profitability is a function of productivity and product mix. Newstan's sales include export semi soft coking coal which currently attracts a strong premium over export thermal coal. CEY doubts the lost production can be made up in the remainder of the year.


The recent production loss does not change any of CEY's competitive advantages and it does not change what the company will look like in a few years. It is important that CEY capitalises on the strong market to generate sufficient cashflow for the development of Anvil Hill. Anvil Hill should allow the group to deliver maintainable earnings of 70 - 80c per share. Our view is that increasing volumes from the start of Anvil Hill in 2008 should offset the impact of prices falling from their peaks towards our long term forecasts. Our upgraded Buy recommendation is with this time frame in mind. There could be further short term share price weakness with risks including further production losses and persistent softness in the export thermal and coking coal markets. On coal markets, our view is that coal buyers are playing games by running down inventory prior to annual contract price negotiations. We think management can deliver and the China/India story will underpin long term coking and thermal coal prices.


We have recommended CEY for some time now. Incidents like last week's lost production do not change our view. We have recommended the stock on the basis of a few key themes. Firstly, group cashflows are supported by a very solid domestic thermal coal business. The domestic business is as close to an annuity revenue stream as possible in mining. It will continue to account for approximately 50% of revenue for the foreseeable future, in line with CEY's strategy of having a balance between the domestic and export markets. Secondly, CEY has a track record for buying second tier mines and reaping productivity gains. The ex-NSW Government Powercoal mines, like many other privatised government assets, provide scope for continual cost improvement. Thirdly, strong near term output, revenue and profit growth will come from the acquisition of Tahmoor and the first full year of production from Mandalong. Tahmoor and Mandalong will be the two most profitable mines in the stable. Tahmoor also adds diversification into export coking coal. Fourthly, Anvil Hill will be a company changing flagship operation and one of the lowest cost mines in the Hunter Valley. It will add approximately 10Mtpa or 50% to group output via a large open cut mine. The open cut will lower the operational risk and provide flexibility to quickly ramp up or ramp down production as required, a luxury generally not afforded underground mines. Lastly, CEY is about the only Australian coal producer not constrained by port capacity. Roughly 80% of its export coal goes through Port Kembla which has significant excess capacity. This gives the group leverage to upside should export coking and thermal prices remain stronger for longer.


As a result of the lost production we reduce our FY06 NPAT forecast by 15.5% to $132.2m. We have chosen to be conservative and assumed Newstan will continue to produce at below capacity in 2Q05. Our FY07 forecast is virtually unchanged at $215.1m. Our Net Present Value (NPV) of $1.62bn of $5.50 per share is based on a 10% discount rate, long term US$60/t for coking coal, US$40/t for export thermal coal and an A$/US$ exchange rate of 0.76.


Domestic thermal coal makes up approximately 70% of sales volumes and 50% of revenue. Domestic coal is set under long term fixed price A$ contracts. We expect this year's price to be A$40/t. The base $40/t price is subject to escalation every quarter based on inflation, typically the headline CPI. The inflation escalator should be sufficient to offset average annual operating cost increases. CEY could expand margins by controlling costs through better productivity. The company has a history of success in continuous productivity improvement. To be conservative, our model assumes additional revenue from indexing will be offset by production cost increases. The kicker is that approximately 10% of CEY's contracted coal is subject to a price review every year. The reviews are based on the export thermal market and can result in the price moving up or down by a maximum of 10%. With the recent strength in the export market, the price of the coal under review can be expected to increase by the maximum of 10%. This should add approximately 0.5% a year to EBITDA margins. The average life of the contracts is approximately 12 years.