Gloucester Coal Significantly Undervalued, Says RBS

This story features WHITEHAVEN COAL LIMITED. For more info SHARE ANALYSIS: WHC

By Greg Peel

It is hard to get excited about the coal space right now given annual contract prices are being settled 50-60% lower than last year and a weakening demand for steel is seeing the emphasis switch away from metallurgical coal to thermal coal. The collapse in commodity demand has seen Gloucester Coal’s ((GCL)) share price also collapse – from the dizzy heights of nearly $14 a year ago to $2.50 late last year. A bit more interest in commodities since that time have helped to revive the share price, but it’s takeover activity which has taken the trading price to $5.30 today.

Gloucester is 21.7% owned by Hong Kong-based trader Noble Group. With Gloucester’s share price wallowing Noble made what now looks like an opportunistic offer for the remainder of GCL at $4.85, and effectively that offer still stands. However, in the meantime, GCL has announced a proposed merger with Whitehaven Coal ((WHC)) on a ratio of 2.45 shares of WHC to one GCL. At yesterday’s closing prices, that implies a value of $4.90 for GCL.

This seems like a smallish premium over the Noble bid but this is a scrip-based merger, not a cash takeover, and for GCL it’s a case of expanding its business rather than selling out.

RBS analysts consider the benefits to GCL of the merger to include: more flexibility in operating, marketing and financing; relief on port access constraints; more growth options given WHC’s Narrabri project; and increased investor interest in a larger and more powerful merged entity. But the deal would also improve the takeover attraction for both component entities if they were one. And that is also the stumbling block.

Noble’s stake of 21.7% in GCL – a stake it used to block a 2007 GCL takeover bid from Xstrata at $4.75 – would be diluted down to 7.1% on the scrip-swap. On that basis, Noble would be unable to seriously block an offer for the merged entity, and whatever premium is derived leaves Noble with only 7.1% participation. GCL has been understandably keen to seal the deal with WHC, even though there are a few disadvantages, as RBS also points out:

Whitehaven directors will have the majority on the board yet GCL is giving this up for little implied premium; GCL’s free cashflow will be crimped in the near term, reducing its capacity to pay dividends, and the proportion of “non-insider” shareholders in the entity will fall from 63% to 40%. GCL has nevertheless been pushing to take a vote.

But Noble is not going down without a fight. It has approached the Takeovers Panel, and that panel yesterday withdrew its initial support for the merger, thus preventing a vote from GCL shareholders, but at the same time allowing GCL to entertain any superior offers. One presumes this puts the ball in Noble’s court.

GCL could thus wait to see what Noble does, but instead it is still pushing for a merger with WHC. Not only is the ball in Noble’s court, it must act if it is going to prevent the merger. RBS does not believe Noble can pursue any further legal channels, so it could either make the $4.85 bid unconditional – although that is destined to fail with GCL’s share price up over $5.00 – or it could up its bid.

RBS suggests Noble would have to increase its bid significantly given an independent expert would value GCL at substantially higher than $4.85.

RBA notes that a GCL-WHC merger would be value accretive to GCL shareholders, with a large proportion of longer term value kicking in when WHC’s Narrabri longwall project has been fully commissioned in FY12. The analysts value the merged entity at $9.58. Applying an appropriate discount for risk still leaves a value of $8.40, as far as the analysts are concerned.

It is possible that Noble might just throw up its hands and walk away from any bid, given the price it might see necessary to secure GCL. Were this to happen, RBS notes, there would probably be a short term drop in the GCL share price while the takeover arbitrage players exit. But thereafter GCL should re-rate to represent closer to the value of the merged GCL-WHC entity.

In other words, RBS can only see upside for GCL in the longer term, if not very quickly. GCL is now “in play”, although the broker notes that until any merger is completed, Noble still holds a blocking stake and would probably use against any third party aspirant.

RBS has today upgraded its recommedation on Gloucester from Hold to Buy and lifted its 12-month price target from $4.85 (the Noble bid) to $6.26 as a result of the Takeover Panel ruling.

There are only four brokers in the FNArena database who have updated their views on GCL this year. Two of those are restricted as they are advising on the merger. This leaves only Macquarie with a Hold rating and a $4.23 target, however Macquarie had advised last week to sell into takeover speculation. The analysts have not responded post the Takeover Panel ruling.

Only two brokers cover WHC, and one is similarly restricted. GSJB Were has a Hold rating with a $1.60 target but was awaiting the Takeover Panel decision.

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