Insufficient Capital June Update

A Change in Our Reporting
Going forward, we will only report performance when we deem it to be significant to the fund. We will report industry weightings quarterly. At the end of the June quarter, our portfolio was most heavily weighted to Australia’s energy industry (particularly towards coal and natural gas):

On a monthly basis, we will report net equities exposure, the largest contributor, the largest detractor, monthly ASX300 performance and any key changes to the portfolio. At June end, net equities exposure was 87%. The largest contributor was Stanmore Coal, while the largest detractor was Aurelia Metals. The ASX300 appreciated 3.41% over June. We generally like to hold a minimal cash position (See investing Ground Rule* #10) due to the long term powers of capitalism but believe current market and economic conditions present an extremely challenging environment to achieve our desired annual return target (See investing Ground Rule* #12) without taking on excessive risk. We believe that future opportunities will yield better risk/return profiles.

As a high conviction fund, Insufficient Capital has a more volatile return profile than the benchmark due to its larger position sizes. We stress that high volatility does not indicate that the fund is taking on excessive risk. Abstaining from monthly performance reporting will ensure that the fund’s long-term positioning is not misrepresented. We do not engage in proprietary trading or other short-term strategies.

Afterpay Touch Group (APT:ASX)
Our long-term position in buy now, pay later juggernaut, Afterpay (APT:ASX), recently corrected 25% over compliance fears after Austrac ordered the appointment of an external auditor to assess its AML/CTF compliance. We believe this was an overreaction since the mere appointment of an external auditor should not result in a more than $1.5B destruction of firm value. This significantly impacted our performance over the short term (the stock has since recovered around 20%).

More recently, Visa’s announcement of a set of tools and APIs for card issuers and merchants to establish instalment solutions sent the company down 15% in under two hours on the last day of the financial year. Bizarrely, the release from Visa surfaced before the ASX opened and Afterpay was up. We are glad to see such inefficiencies in the market! Visa’s unique position ‘upstream’ in the payment ecosystem from Afterpay puts it in a powerful position to grow quickly and fairly seamlessly. Our take on this development is that whilst Visa could dominate Afterpay on a global offering, Afterpay retains the first mover advantage in the way that these are merely a set of tools to create an instalment service. Visa’s business model has historically been to take on limited credit risk (much like that of Mastercard). Visa does not issue lending products, purely offering the back end for their partners. There has been nothing to indicate that this will change in the short term. Consequently, the risk would have to be taken on by the merchants (unlikely) or the card issuers, who presently make the majority of their money from interest and a smaller amount from interchange fees – while transaction/network fees are the largest revenue source for Afterpay/Visa. Nonetheless, we will be watching this development closely as widespread adoption does have the ability to jeopardise Afterpay’s offering. We believe Afterpay’s first mover advantage, as well as the necessity for card issuers to alter their business models, make it safe – for now.

Stanmore Coal (SMR:ASX)
We have continued to build a position in Stanmore Coal over the last year and it is now the fund’s largest holding. Stanmore owns the Isaac Plains mine, a metallurgical (also known as coking) coal mine with significant mine life (over 15 years) located in Queensland’s premier coal region, the Bowen Basin. In addition, a small amount of thermal coal is produced from the project. Mining is currently at a rate of 2.9Mtpa, with the product being exported to key customers in the steel manufacturing industry. Exposure to China’s slowing economic growth or political chess is a minimal threat to Stanmore’s earnings since around half of Stanmore’ customers are in Korea and Japan, while Europe and India represent most of the remaining bulk of the customer base:

As an aside, it should be noted that we believe China’s impact on the Australian coal market, whilst significant, is not as significant as commonly portrayed – Japan imported 50% more Australian coal (preferred for its relatively low ash content) than China in 2017.

Isaac Plains East Project
Stanmore acquired Isaac Plains East in 2015. There are significant synergies through the acquisition since the project can use Isaac Plains’ CHPP and rail network rather than engaging in capital expenditure. Operations commenced in June 2018.

Other Mining/Exploration Opportunities
Isaac Downs was acquired in 2018, with consenting and approvals underway. Isaac Plains South is in exploration phase. Stanmore also has a portfolio of over 2,000km2 of exploration tenements in the Bowen Basin and Surat Basin, as well as 2 JVs with coal junior, Bowen Coking Coal (ASX:BCB).

Coking Coal – The Evil(?) Elephant in the Room
Recently, some of our team attended an Australasian Institute of Mining and Metallurgy (AusIMM) panel event with the topic “Does coal have an image problem?” – The answer, supported by numerous Australian media houses, a resounding “Yes”. It is astounding to note that the majority of the Australian public relates coal solely to power generation. However, there are two types of coal:

  1. Steam/Thermal Coal (mostly used in power generation)
  2. Coking/Metallurgical Coal (higher grade coal, used in steel production)

While the great majority of Australians hope there will be cleaner power generation in future, most (Insufficient Capital’s management included) also see steel production as a future necessity in a continually developing world. Since steel production will remain crucial until there is a foreseeable replacement for the product, Insufficient Capital will continue to evaluate metallurgical coal opportunities.

A key takeaway from the AusIMM panel event was the difficulty in financing new coal projects. Australian banks and other lenders are shying away from lending to coal firms (pressured by the public spotlight on coal). Future projects are much more likely to be financed through retained earnings and private/offshore capital rather than through debt financing. Stanmore is in an enviable position, well-prepared to fund future projects through its retained earnings. Net cash increased to $58.4M (market capitalisation $353M, no debt) through the March quarter. The firm also recently instigated an on-market share buy-back of up to 10% of stock.

Coal Price Risk?
Many funds choose to shy away from any exposure to commodity price risk. We do not pretend to be experts in commodity price movements (or more specifically, the individual factors which affect a commodity’s demand and supply). We also acknowledge that the largest lever for Stanmore’s performance is completely out of our control. However, there are three key factors which alleviate the vicissitudes of metallurgical coal prices:

  1. High Margin: Stanmore has low FOB costs of $88/tonne and a high margin, translating to expected underlying EBITDA of $140-$155M for FY2019. Stanmore’s FOB cost has also fallen around 10% since Q1 FY2019 as the company achieved further synergies through the Isaac Plains East project. We are confident that there is enough margin in Stanmore’s production to weather a significant drop in metallurgical coal prices.
  2. Valuation: We will discuss Stanmore’s valuation later on in the newsletter. We are content to have metallurgical coal price risk mitigated by a valuation 40% below industry peers similarly exposed to the commodity’s price risk.
  3. Strong Balance Sheet: At the end of Q3 FY2019, Stanmore had $58.4M net cash. This cash will likely be deployed when coal prices are lower as greater opportunities prevail. The firm’s fiscal conservatism reflects the views of the experienced management team. We have entrusted our capital to a proven team who have expertly negotiated coal price movements throughout the business cycle in their prior roles.

Management
Insufficient Capital strongly backs operationally focussed management, particularly in the resources sector where it can be make or break for the firm’s longevity. As a result, it is no secret that we are huge fans of Stanmore’s management and board, awash with former Glencore Coal, Rio Tinto and Wesfarmers Resources leadership. In particular, it is very reassuring to see three ex-Glencore employees on Stanmore’s four-person leadership team:
Dan Clifford (Managing Director) – Former GM of Glencore’s Ulan Coal, Bernie O’Neill (General Manager Operations) – Former GM of Glencore’s Newlands/Collinsville Coal, Jon Romcke (General Manager Development) – Former Head of Iron Ore assets for Glencore International.

Dividend Reinvestment Plan (DRIP)
In April, Stanmore paid a 3c/share interim dividend, reflecting an annualised yield at the time of around 5%. We believe that the firm’s dividend yield will increase over time through greater future cashflows coupled with 10% fewer shares on the registry (if the 10% buy-back is completed). Stanmore offers a dividend reinvestment plan at a very attractive 5% discount to the VWAP over the short period following the ex-dividend date. We took part in the last DRIP according to our investment ground rules (See investing Ground Rule* #9), a lucrative decision for the fund. Shares received in the DRIP have since appreciated over 30%.

Valuation
Stanmore Coal has experienced management, low production cost and superb future opportunities. However, the firm trades at 2.3X EBITDA, a 40% discount to some of its larger peers. We believe Stanmore should be trading at 4X EV/EBITDA due to its strong cashflow generation, operational expertise and consistent upgrades to mine development.

Quip of the Month
Liam Twigger, PCF Capital Group MD, said of M&A activity:
“Too many companies are looking for a Brad Pitt when in the right circumstances, they might be able to settle for a Bart Simpson.”

At Insufficient Capital, we do not strive to relate pop culture to investment theory. However, Liam’s argument rings extraordinarily true, particularly in relation to the energy industry. Stanmore bought Isaac Plains (then a mothballed, unwanted mine) for all of $1 from Vale and Sumitomo. Rather than searching for an expensive acquisition with a lower risk profile (Brad Pitt), Stanmore took on the challenge of an unloved asset (Bart Simpson), striving to make it work by applying experienced management. If we were to take this metaphor further, we’d say that Stanmore’s management are comparable to Steven Spielberg, a director who could generate great results from Bart. In time, we will see what Spielberg has in store for Stanmore.

Liam’s remark relates to a core dilemma of value investing – Should we pay a fair price for a great opportunity or a great price for a fair opportunity? Warren Buffet argues the former. However, Stanmore clearly observed the latter. Insufficient Capital has a rather unhelpful, on the fence belief, that each opportunity requires case by case analysis. We are happy to follow either school of thought.

If subscribers would like further details on our activities, we are always happy to discuss portfolio positions.

Kind Regards,
Insufficient Capital

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