Gujarat Coal Attracting Attention

This story features GREAT NORTHERN MINERALS LIMITED. For more info SHARE ANALYSIS: GNM

By Chris Shaw

Consolidation and higher prices have kept interest high in the Australian coal sector, so companies with potential to significantly lift production are of particular interest to investors. One such stock is Gujarat NRE Coking Coal ((GNM)), which has received two initiations of coverage in the past week.

The latest comes from JP Morgan, which on Friday last week commenced coverage on Gujarat with an Overweight rating. This follows a similarly positive initiation by UBS earlier last week, bringing coverage to three brokers all with Buy ratings on the stock. Macquarie initiated coverage early in September.

As JP Morgan points out, Gujarat has two coal mines in the Illawarra region of New South Wales. Plans are in place for production to grow from 1.1 million tonnes in FY10 to more than 6.0 million tonnes in FY15.

This expansion will come by replacing board and pillar mining with longwall mining at the NRE No. 1 mine and via an upgrade of the current longwall at the Wongawilli mine. Shipping the increased production should not be a problem according to JP Morgan, as it estimates Gujarat has sufficient export capacity through Port Kembla.

Selling the higher output is also unlikely to be an issue as Gujarat's Indian parent company, Gujarat NRE Coke, which holds a 77% stake, has indicated it will continue to purchase all of Guajarat's run of mine (ROM) coal on commercial terms.

Assuming the jump in production is achieved, JP Morgan expects this will lower cash costs for Gujarat which in turn should flow through to a material improvement in profitability. UBS is positive on such an outcome as it notes Gujarat already has a high cash margin relative to its sector peers.

An improvement in production and margins is reflected in JP Morgan's earnings estimates, as the broker is forecasting earnings per share (EPS) to increase from a modest loss in FY10 to 5.7c in FY11, 12.1c in FY12 and 14.8c in FY13.

On its FY12 numbers JP Morgan estimates Gujarat would be trading on an earnings multiple of just 5.0 times. This suggests value relative to the rest of the Australian coal sector.

Its forecasts mean JP Morgan is expecting stronger earnings than the rest of the market in FY12, as consensus EPS forecasts according to the FNArena database stand at 5.2c in FY11 and 10.6c in FY12. This reflects more conservative growth expectations from UBS, which is forecasting EPS of 3c in both FY11 and FY12 before a jump to EPS of 8c in FY13.

A key risk for Gujarat in the view of JP Morgan is the ability to source adequate funding for its growth plans. An equity raising appears unlikely because management sees the stock as undervalued at current levels, so the broker notes further debt is likely to be sourced via Indian banks.

Macquarie takes some issue with such an approach, suggesting any further debt would stretch Gujarat's balance sheet. In contrast, the broker suggests an equity raising would likely increase liquidity in the shares.

This is potentially significant, as JP Morgan also sees liquidity as an issue for Gujarat because given the parent's large stake average daily trading volume is only a little over 300,000 shares. This lack of liquidity leads the broker to suggest the stock is only suitable for investors with a long-term investment horizon.

There is still value in the stock according to both JP Morgan and UBS, the former valuing Gujarat at $0.74 per share and the latter at $0.82. Price targets reflect this, JP Morgan setting its target at $0.74 and UBS at $0.80. Macquarie's target for Gujarat is $0.72.

What supports UBS's positive view is Gujarat is 100% exposed to the metallurgical coal market. This is the preferred long-term coal exposure in the broker's view, as met coal has superior supply and demand dynamics and therefore better pricing potential going forward.

Another supportive element in the Gujarat story for UBS is the company's resource base and the potential for this to be expanded. Currently Gujarat has a resource of 573 million tonnes but UBS expects an upgrade to both resources and reserves before the end of this year.

Shares in Gujarat today are unchanged with a last sale price of $0.63. This compares to a range over the past year of $0.54 to $0.77 and implies upside of around 20% to the $0.75 average price target in the FNArena database.

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