Geo Energy Resources Ltd - Phillip Securities 2017-02-23: More offtakes to take off

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GEO ENERGY RESOURCES LIMITED RE4.SI

Geo Energy Resources Ltd - More offtakes to take off

• We initiate coverage on Geo Energy Resources Ltd (Geo) with a Buy rating and a target price of 45 SG cents based on 11.0x annualised 3Q16 P/E ratio and 3 US cents FY17e EPS, as well as 1.3x USD/SGD exchange rate (5 year average), which implies an upside of 66.7%.

Investment Thesis 

1. Global energy consumption pattern remains similar over past three decades.

• Transformation of energy consumption patterns towards renewable sources is a long process with slow progress.
• Even though renewable energy displayed high growth in recent years, it lags far behind the consumption of fossil fuels.

2. Global coal consumption has been trending up, peaking in 2013 but remains elevated.

• Contribution from coal to total world energy consumption will be reduced from 30% in 2015 to 27% by 2021.
• Demand from Europe and North America continues to shrink, while Asia remains the major market for coal.

3. China will remain the largest coal consumption country.

• Coal, as the primary energy source, continues to prevail in the near term in China where substitutes for coal hardly replace coal in such a large scale and scope.
• Domestic coal production will continue to fall, shifting the dependence to imports amid the mild reduction of total consumption in China.

4. Indonesia coal market is on the run and expected to have strong growth.

• We see bright prospects for the domestic coal market in Indonesia driven by strong growth in energy demand and large scale expansion in infrastructure development.

Company Background 

• Established in 2008, Geo was listed in SGX in 2012.
• Prior to 2016, the group is engaged in coal trading, mining and haulage services, and production business. In 2016, it divested the service segment and focused on coal production.
• Currently, the group is operating on BEK and SDJ coal mine. As of Dec 2016, the Group owned 6 coal mines with total over 17,000 hectares of area and 100mn tonnes of coal reserves.
• Geo subcontracts mining work to BUMA, the the second largest mining services company in Indonesia. It also signs offtake agreements with ECTP, a global merchant of commodity products, to secure upcoming sales volume. 70% to 80% of the output will be shipped to China, while the rest is consumed domestically in Indonesia.
• In Dec-16, Geo secured 7mn tonnes of coal sales via offtake agreement with ECTP.

Investment Merits 

1. Geo has strong competent in low cash cost 

• 2016 is the year of change for Geo, since it optimised the business when coal price had not soared. In June 2016, the group has completed the divestment of mining and haulage services business, which eliminated US$ 1.7mn of fixed cost and US$1mn of working capital thereafter. Henceforth, Geo is capable to focus on the simplified business model shown below. The group owns coal mines through acquisitions, and it subcontracts the mining, overburden removal, and coal haulage services to PT Bukit Makmur Mandiri Utama (BUMA), the second largest mining services company in Indonesia. Accordingly, Geo does not bear any fixed cost and capital expenditure.
• Next, it signs sales and purchase (offtake) agreement to Engelhart Commodities Trading Partners (Singapore) (ECTP) to secure certain tonnages of coal sales in the coming financial year. At the same time, Geo will receive prepayments from ECTP which then it will use to ramp up coal capacity or reserve for future mine acquisitions. Throughout this, it will gradually expand the business via duplicating the model.
• Geo has a competitive advantage in terms of low cash cost. Based on the guidance from company, Geo’s cash cost was aligned with coal output and averaged at US$22.2/tonne in 2H16, during which sales of coal started to increase phenomenally. Since all the coal mines of Geo are open pit with average 3:1 of stripping ratio, excavation cost has been low so far. It is expected that the average cash cost of targeting 10mn tonnes of coal extraction in 2017 remains no more than US$26/tonne, which buffer against a drawdown in coal price. 
• Moreover, the current three major coal mines under PT Bumi Enggang Khatulistiwa (BEK), PT Sungai Danau Jaua (SDJ), and PT Tanah Bumbu Resources (TBR) are strategically located close to seacoast where there are transportation costs advantages due to good accessibility to ports.

2. More offtakes propelled sales 

• As of Dec 16, after a series of acquisitions, the Group now has coal reserves estimated to be over 100mn tonnes. As we mentioned above, BEK, SDJ, and TBR are Geo’s major coal assets, which make up 95.9% of total reserves. The 10mn tonnes of coal sales target per year that the management aims to achieve dwarfs the current reserves, since 10 years from now Geo will deplete the whole reserve.
• However, management will strategise to pursue more acquisitions to replenish coal reserve as well as to develop other energy business moving forward. Therefore, we believe it is more important to focus on the company’s ability to ramp up capacity.
• Geo’s coal sales volume started to take off in 1Q16, and it coincided with coal price’s rise in the subsequent quarters in FY16. According to the management, FY16’s sales volume will peak in 4Q16, estimated to be 2.7mn tonnes.
• Coal price, for instance that for ICI 4200GAR, the main type of coal sold, has been on an uptrend in FY16 and hit its highest level for the year in 4Q16 as well. Thereby, we expect Geo to deliver its best performance for FY16 in 4Q16. 
• Being forward-looking, the Group targets to generate sales volume of 10mn tonnes in FY17, compared to an estimated 5.8mn tonnes in FY16, a 72% Y-o-Y growth. To-date, the Group has secured a total 7mn tonnes of coal sale with ECTP for FY17. With this offtake agreement, the secured sales volume will be lifted by 20% Y-o-Y.
• Nonetheless, notwithstanding an expected higher sales volume for Geo in FY17, we expect to see coal price will average at c.US$37/tonne in FY17. Firstly, at the National Coal Trade Fair 2017, National Development and Reform Commission (NDRC) of PRC pushed the execution of medium- and long-term contracts between coal producers and buyers in order to avoid violent price fluctuations. 
• In Nov-16, Shenhua Energy Co and China Coal Enery Co, the two leading state-owned coal mining companies, signed long-term supply contracts with China Huadian Co and State Power Investment Co, the two advanced state-owned power companies, at c.25% below the spot rate at that time. Secondly, Perusahaan Listrik Negara (PLN), the Indonesian government-owner electricity corporation, has its coal power purchase agreements (PPAs) in Indonesia.
• Likewise, PPAs will fix the coal selling price in the coming year. Thus, in Indonesia domestic market, coal price is expected to be stabilised by the government.

How Do We View Geo? 

Catch the tailwind amid business expansion 

• After simplification of its coal mining business, Geo ramped up production capacity starting in FY16. At the same time, coal price has bottomed out since 2Q16 after 5 years of bearish trend. Both favourable conditions pulled up the financial performance of Geo. 
• Moving forward into FY17, Geo will encounter both relative certainty and uncertainty. Because of the updated offtake agreement, Geo has secured 7mn tonnes of coal sales, and we think it is capable to accomplish the order based on the approximated 6mn tonnes of sales in FY16.
• In terms of the estimated annual sales volume for FY17, it is reasonable to expect the Group to achieve sales of between 7mn tonnes and the targeted 10mn tonnes.
• As for the uncertainties, it will be the coal price level, which heavily depends on how China regulates the coal market and the price level China aims to reach. When coal price was as high as it was in 4Q16, China’s coal-fuelled power plants suffered the high cost pressure; on the contrary, lower price will weaken coal miners’ profitability. Therefore, we believe China’s central government will make efforts to balance the interest between both parties, and as a result, coal price is expected to stabilise. However, market is dynamic so price uncertainty remains.

Catalyst: more coal mine acquisitions and offtake agreements 

• As we mentioned above, the current 100mn tonnes of coal reserves are only enough for Geo to operate the business for 10 years on the assumption of 10mn tonnes per annum coal production. To maintain the ongoing growth as well as to possibly tap into other energy sectors, Geo has to generate inorganic growth through M&A activities. In the foreseeable future, we can expect the Group to seek such opportunities.
• By end of 2016, Geo has received US$40mn in total from the offtake agreement. Since Geo has affirmed its expansion through duplicating the business model mentioned previously, we expect Geo to secure further offtake agreements in FY17 and FY18.

Investment Actions 

• We initiate coverage on Geo with a “Buy” rating and a target price of 45 SG cents based on 11.0x annualised 3Q16 P/E ratio and 3 US cents FY17e EPS, as well as 1.3x USD/SGD exchange rate (5 year average), which implies an upside of 66.7%.

Valuation Methodology 

• We think discounted cash flow model, which is normally used in valuing mining companies, is inappropriate for Geo, for it has no track record of positive cash flow nor dividend paid.
• Moreover, Geo in under the expansionary stage, from which we expect potential M&As that incur cash inflows and outflows. Thus, the group’s cash flows will be fluctuated. Our primary valuation method is using the simple average of P/E ratio of comparable peers.
• Since Geo operates coal mining business in Indonesia, we use the average of P/E ratio of those companies that have similar operations there.
• Due to lack of reference data in forward P/E ratio for FY17, and being prudent, we use the average 3QFY16 annualised P/E ratio of BSSR, MBAP, TOBA, and KKGI (Bloomberg ticker), which is 11x, as the reference valuation P/E for FY17 forecast. These 4 companies have market capitalization values that are close to Geo’s. If we use 11x P/E ratio together with 1.6 US cents of FY16e ESP, we can derive 17.6 US cents, which are equivalent to 25 SG cents (using spot USD/SGD 1.43), as FY16e target price. Therefore, we think the growth in FY16 has been factored in the current price level, and 11x P/E ratio is justified.
• Based on FY17e EPS of US$0.03, we derive our target price of US$0.035. We use the 5 year average USD/SGD exchange rate of 1.3x as the FX rate. Eventually, we derive our target price of 45 SG cents, which implies an upside of 66.7% from the last closing price.

Chen Guangzhi Phillip Securities | Jeremy Ng Phillip Securities | http://www.poems.com.sg/ 2017-02-23

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