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Morningstar | Lower Coal Price and Share Price Sees New Hope Undervalued, AUD 3.50 FVE Retained

No-moat New Hope’s shares have sold off significantly. After reaching highs of AUD 4.50 in March, the shares are down nearly 40% to below AUD 2.80 per share. We attribute the sell-off to soft production and higher unit costs in the first half, as well as a decline in the thermal coal price. Thermal coal is down about 30% to USD 83 per metric ton from USD 120 in July 2018. New Hope has also not made much progress with the proposed new 1.5 million metric ton a year Burton/Lenton mine and the long-awaited approvals for the third stage of Acland Stage are still outstanding.

However, we think the risks are sufficiently reflected in the share price and the current discount of about 21% to our unchanged AUD 3.50 per share fair value estimate reflects an attractive entry point. Third-quarter fiscal 2019 production was in line with our expectations and we make no material changes to our fiscal 2019 forecasts. The traded thermal coal price aligns with our expectations for the second half of fiscal 2019, albeit that the current spot is now slightly below our USD 90 per metric ton realised price forecast. However, New Hope will sell some coal into the higher contract price, which settled at USD 95 per metric ton and runs until end of March 2019. We also don’t see much sustained downside in coal prices from current spot prices. Demand in China is seasonally weak and competing production from China is costly. High costs are likely to put a floor under the thermal coal price.

Meanwhile, we’re not particularly concerned about the recent increases in unit costs for Acland. The mine, in its current form, is near the end of its lifecycle and mining operations are constrained. These constraints should dissipate once the third-stage Acland expansion is approved and unit costs return to a better level, more in line with the past when Acland was a low-cost thermal coal mine. At Bengalla, we see the potential for increased production and lower unit costs through efficiencies.

We’ve not heard more about the development of the proposed Burton/Lenton mine. The key constraint remains securing port and rail capacity. There is some capacity which is not being used by third parties, so we believe a commercial deal to secure capacity is the most likely outcome. New Hope expects to produce about 1.5 million metric tons of coal a year from the Burton/Lenton development, approximately 50% thermal coal and 50% metallurgical coal. We still think the mine will go ahead, but expect it to open in late 2020 or early 2021. We’ve factored this start date into our model, but the delay is not material to the fair value estimate.

A few approvals are still are outstanding for Acland, but we’re confident the positive Land Court decision will pave the way for the ultimate approval of the mining lease. The question is timing. The federal election result in Queensland is encouraging for New Hope, with Labor losing primary votes to the right-wing One Nation and Australia United parties. The electorate appears to have given a mandate to pro-coal forces to develop the mine. At Acland, while there will be a modest increase in output during the second stage of Acland, the investment is largely to extend current operations.

Our valuation incorporates a 100% possibility that the third stage will go ahead. Approval from the environmental authority supports this view. New Hope needs final approvals for the third stage of Acland in 2019 to ensure continuity of production and employment at the mine. This seems to be the likely scenario. However, there is the risk of a delay. If we assume a two-year delay with first production in 2023, and an additional AUD 100 million in costs to shut and restart the mine, our fair value estimate would fall to AUD 3.00 per share. The primary driver of the reduced fair value estimate would be a delay to the start of mining and the consequent cash flows, rather than any additional costs to stop and start mining. At this stage the shares would still be modestly undervalued, hence we believe the risk is factored into the shares.

There’s also concern in the market that Australian thermal coal exports could be affected by a China-U.S. trade war. However, we believe the most likely downside scenario is that Australian coal would be redirected to other export markets and would receive a small discount relative to what it would otherwise get. While China’s coal import restrictions send a strong message, we think it’s unlikely the issue will have a material impact on New Hope’s cash flows. The headlines actually contribute to the undervalued opportunity we currently see.