The burning question for Thungela

Coal is a paradox for investors. Despite it being hugely damaging to the planet, the burning of thermal coal will continue in massive volumes for decades. 

That’s because it is a very significant source of power globally, and particularly in emerging markets and developing economies (EMDEs). There is no magic switch that can be flicked to change this overnight, even as cleaner energy options become cheaper and more reliable. 

As the International Energy Agency (IEA) has pointed out in recent reports, despite radically reduced reliance on coal in developed countries, it still accounts for 18 per cent of global energy supply. Without radical change, energy demand will climb a quarter in EMDE countries by 2030 where coal is most prevalent. And last year, there were 5 gigawatts (GW) of approvals for coal plants in Cambodia, Indonesia and Pakistan. 

Newly listed London company Thungela Resources (TGA) could benefit from this dynamic but presents its own paradox for shareholders due to the huge uncertainties associated with regulatory trends. 

The company is not a completely novel prospect for investors: it is the South African thermal coal division of London-listed Anglo American (AAL). Earlier this month, it was spun out to improve the diversified miner’s valuation in the coal-averse investing environment. 

A carbon conundrum  

There is a concerted global effort to choke off investment into coal power projects and the coal mines that supply them. Investors, banks and insurers as well as governments are all bringing their powers to bear and turning the screw on coal. 

For existing players and Thungela, these contradictory forces mean a significant reduction in competition could emerge some time before any actual fall in demand. Ironically, this could put thermal coal producers in a sweet spot in coming years before their operations finally succumb to the transfer to greener power, as appears inevitable. 

Broker Liberum is among those that think coal prices are likely to stay strong because of current investment trends. It points out: “A third of the world’s power-generating capacity is coal-fired: it will take decades to wean the world off this fuel option. Until the ‘Age of Coal’ passes, expect prices to remain buoyant, given how total supply is already shrinking on a lack of funding.”

While Thungela is a new company, many London investors will hold it as every Anglo shareholder was handed one share for every 10 they held in the diversified miner. This was not universally popular, given the shares immediately dropped in value by almost a quarter from 150p, although they have recovered since to sit a little way above the listing price. 

Some of the sellers will be large institutions with mandates that forbid them from investing in coal companies. The avoidance of coal is due not only to the environmental impact, but also the financial risk associated with stranded assets and rising regulation. 

Other sellers will be passive funds, which will need to get out of the stock when it is ejected from the FTSE 100 at the next reshuffle. It only has a spot in the blue-chip index on a technicality due to the nature of the spin-out.

So, the share price could remain under selling pressure for a while. This provides bold investors with a chance to bag a handsome potential dividend yield in the meantime. And cash is also expected to build up fast (see chart).

But there's more to consider than just exciting forecasts.

What's on offer

Thungela starts afresh without debt thanks to a $180m gift from Anglo and a pledge of additional financial support out to 2022 should thermal coal prices tumble. But given recent thermal coal price strength, and the prospect of rising demand from a post-pandemic recovery, the company should have an easy start to life. 

Thungela has not been a solid earner for Anglo. While Anglo’s historical reporting units are slightly different to the new company, they do give an indication of its profitability. FactSet has cash profits falling from $546m in 2018 to a loss of $65m in 2020, while the gross margin has fallen from 41 per cent to 16 per cent in the same period. 

At the same time, Thungela’s mines have increased production from 26m tonnes in 2016 to 29m tonnes last year. The mines also have existing infrastructure to process and distribute their output. 

The company has shifted towards exports in recent years, which provide 80 per cent of its revenue. It has sold off mines that supply coal to state energy company Eskom, which Anglo also relied on to power its mines.  

Anglo’s boss, Mark Cutifani, has even described the scandal-plagued organisation as the “single most-important risk” the company deals with. Domestic sales have tended to be based on cost-plus contracts, so the increased focus on exports makes the coal price more significant to long-term cash flows. 

Investors do not have to look way into the future to value Thungela. Its mines have relatively short lives. Without extensions, their productive lives will finish in five to 11 years. There is also good clarity on the company’s capital expenditure plans and it has made clear its intention to pay out 30 per cent of cash flows as dividends. 

Broker Liberum estimates that fair value for the shares lies somewhere between 230p and 490p. This is based on: expectations for the coal price; the net present value of Thungela’s mines as estimated by independent consultancy SRK; and comparisons with peers. 

In other words, Anglo’s desire to free itself of its dirty assets and many of Thungela’s new shareholders' desire to sell could have left a lot of value on the table for those willing to take a risk on the shares. But the risk is not to be underestimated.

Environmental enemy number one

Coal is rightly despised by climate change activists. It is estimated to produce about 30 per cent of the world’s carbon dioxide emissions. And not only is there mounting pressure on governments all around the world to remove it from the power mix, there also appears to be a growing appetite to seek redress for past environmental damage from the companies responsible. 

One aspect of this in South Africa is the requirement to pay rehabilitation costs when mines are closed. For many of Thungela’s mines this may not be far off. The company has put costs associated with mine closures at $480m. However, there are fears this estimate could prove way too low. 

Thungela has come into the sights of shorting specialist Boatman Capital. The firm may be familiar to UK investors for a short attack on outsourcer Babcock (BAB) ahead of significant writedowns by the company. Boatman believes Thungela’s shares are worthless because proposed changes to South African law could lift rehabilitation costs to almost $1.4bn.

Anglo has countered by saying the proposals have existed in draft form for more than half a decade without coming into force, and that the headline numbers are “artificial” and “arbitrarily inflated”. 

The tussle illustrates the fact that investors in this area have to expect nasty surprises and weigh exposure accordingly. One feather in Thungela's cap is that while its product may be filthy, it has been working to boost its own ESG credentials. This could be an advantage based on the world’s ongoing need for coal. Greener coal producers are likely to get favourable treatment and this could influence decisions on extending the life of Thungela’s mines. 

While a decision will not need to be made until 2023, mine life could be extended by about a decade. If such actions were economic and allowed, this would have the added bonus of pushing those rehabilitation costs further out while boosting the company’s cash coffers.

Stick or twist

Were current regulations set in stone, the combination of temporary selling pressure on the shares, limits on new supply and a recovery in demand would make a very attractive mix. However, the regulatory environment is getting tougher all the time. Yet the world still needs coal. 

The powers that be have to balance the reality of the global power mix with green ambitions. In the coming years, this could play to greener coal producers’ advantage. Nevertheless on balance we see the risk for Thungela’s newly minted shares to be to the downside.