Mongolian met recovery comes with key caveats

15 Oct 2017 Marian Hookham

Caveat emptor, the venerable Latin term denoting 'buyer beware,' apparently originates from ancient Roman real estate reports. It could be almost as applicable today for investment in the coal industry.

Caveats look singularly apt, for instance, in the Mongolian metallurgical (met) sector, where an early stage recovery is in danger of being over-hyped amid a surge in Chinese demand. Recent filings from the two most accessible proxies for the region's health - quoted Mongolian Mining (MM) and SouthGobi Resources - typify the trend, showing gutsy top-line rebounds this year.

But closer reading of reported results reveals continued corporate nasties, a natural culmination of more than half a decade spent in hand-to-mouth survival battles by both companies. Even so, the scale of recovery has been impressive, especially by MM. How else to categorize a corporate 'lazarus act' as the company this year achieved the rare feat of beating the liquidators? But the heavy restructuring that allowed MM's emergence from provisional liquidation has not come without repercussion, casting a long shadow over the company's recent June half results. Celebrating this emergence, MM reported June half net earnings topping $311m, a $370m-plus positive turnaround from a $61.7m loss previously, and its first profit for more than half a decade.

But accounts released late last month show that almost 85% of the latest result ($263.0m) came from what the company terms a gain from debt restructuring,' a one-off non-cash entry reflecting debt 'forgiveness' in the restructuring.

Without that, the company's bottom line would have reflected a more meagre $48.1m profit. The results also carried a working capital deficit of almost $91m.

Although a big reduction on a ruinous $921m a year earlier, the deficit, taken with more than $34m of negative cash generation in the latest period, still saw auditors issue an all too familiar 'going concern' warning on the company.

MM's reporting indicated its future remains closely tied to a company-defining expansion push - development of Mongolia's vast Tavan Tolgoi resource, long-delayed despite intervention from deep-pocketed internationals, China Shenhua and Japan's Sumitomo.

Should Tavan Tolgoi finally navigate through Mongolia's internecine politics and other prickly issues, MM would need to raise substantial further capital. With a still modest balance sheet, that funding conundrum threatens further shareholder dilution, with the only real remedy lying in acceleration of MM's earnings recovery. Given MM's half decade of severe adversary, it would scarcely surprise if this recovery proves faltering. Yet latest results yielded reasons for optimism.

This is best appreciated from the company's top-line which showed a gross profit of $110.6m for the June half against a $33.6m loss previously. The prime mover was a 690% jump in revenue to almost $246m from just $31.1m previously. Against this, MM's cost of revenue barely doubled to $135.3m, admirable restraint given that coal sales that almost quadrupled to 2.3mt in the half from 0.6mt previously.

That reflected total costs of ROM coal produced at $22.93/t, and although a jump on $8.94/t previously, this still comfortably justified the tonnage lift. MM's sales comprised 1.9mt (82%) hard coking coal, at an average price received of $127.7/t, a 144% increased on $52.20/t a year earlier.

The company's earlier-mentioned $263.0m debt restructure gain sprang from refinancing of $600m in senior debt after payment defaults sent the company into liquidation purgatory last year.

The refinancing involves a sizable debt-for-equity swap plus complex instruments relating repayments to ruling met coal pricing. Investors might see some irony that such financial engineering can now be accounted as the major contributor to MM's stated earnings.

At South Gobi, a late September disclosure served as a cue to corporate pressures. It referenced an adverse Canadian court decision on class action proceedings attacking the company's recent results reporting.

This is just one of many flash points threatening SouthGobi, including an $11.5m dispute in Hong Kong over a coal supply agreement which the company acknowledges could cause default to its major creditor, China Investment Corp (CIC), now owed a 'restructured' $500m. SouthGobi said CIC debt default is also threatened by continued sanctions from the Mongolian government following an adverse tax evasion ruling.

A filing shows various government actions have obliged SouthGobi to make payments and provisions of almost $7m, plus provide mining services valued at about $8m to state-controlled miner, Erdenes Tavan Tolgoi.

Then there are claims for about $8m as reimbursements for management services from the company's former major shareholder, Rio Tinto, since assigned to Canada-based Turquoise Hill.

These are large amounts in the context of SouthGobi's reported bottom line loss of $6.9m for the June quarter and it's no surprise the company was forced to repeat solvency warnings. But the loss was a 63% year on year reduction against an $18.6m deficit a year earlier and partially obscured a battling return to positive top-line territory, with a $9.4m gross profit before charges, a year on year turnaround of more than $19m on a previous loss of $9.9m.

As with MM, the SouthGobi result was primed by higher tonnage sales and prices, the best by the company in nearly half a decade.

SouthGobi's total coal sales approached an annualized rate of 6mt/yr for the latest June quarter and received prices for the company's crucial premium semi-soft product hit $45.67/t, more than double the 2015-2016 average.

But these recovery signs for both MM and SouthGobi remain at the infant stage and largely depend on a 'China captive' discounted version of broader met coal price markers. The latter have turned distinctly downwards in recent weeks. Perhaps just as tellingly, a year-on-year doubling so far in 2017 in total Mongolian coal exports to China - prompting many pundits to bellow the 'boom' word - is showing palpable plateau signs.

Learn more about our metallurgical coal market coverage.

Marian Hookham is Research and Analysis Associate Director at IHS Markit.
Posted 16 October 2017


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