Geo Energy Resources Investing Thesis – Part I

This has been a frustrating company to research on. Deep value investing involves ascertaining a value based on the fundamentals and the macro factors of the company. But that’s only half the equation: the price you have to pay for the value is the other half.

The problem with Geo Energy Resources is that whilst I was researching halfway, the share price started shooting up very aggressively. It is very frustrating to see the price-value gap narrowing while I am still working on my investing thesis.

Eventually I committed a cardinal sin that deep value investors should never do: Invest without completing your research. Thus far, it has turned out well, and I am finally done with my work.

This company has been dominating my thoughts so much in the past couple of weeks that I actually had a ridiculous dream about coal one night!


Anyway, in response to my earlier post, I have received several requests to analyse companies. I will probably choose a few and work on them, but please be patient. It takes time.

Here’s my investing thesis for Geo Energy Resources. Some data regarding share price and the corresponding related valuation may not be updated. The prices are accurate at the point of writing, but it has risen rapidly since I wrote some of this.

229-geo-energy-resources

For Geo Energy, this is how it’s share price in the past few years, looks like:

230) Geo Energyy Resources share price 30092016.jpg

Not a pretty sight, although in recent weeks, there’s been an uptick in the share price. A bet at this stage would surely be considered contrarian, wouldn’t it? Question is, is it wise?

It’s not shown here, but my simple technical analysis is rather favorable: both 50 and 150 moving averages have been breached with strong volumes. My focus is on FA though, so we shan’t spend too much time on that.

Alright, so let’s see what’s been occupying me for the past couple of weeks:

Business Background

The company’s business is easy to understand. It owns coal mines in Indonesia, so obviously it’s in the commodities space. Just earlier this year, Geo Energy Resources divested it’s mining and haulage services division (All Win Holdings) for USD 10mil, recording a net gain of USD 3.7mil in the process.

This means that Geo Energy is now truly a pure mine owner; they sub-con out the mining operations to PT Bukit Makmur Mandiri Utama (BUMA)

I view this as a positive development. As you’d see later, the business has been bleeding $$$ for quite some time now, so being focused has many advantages. The most visible of which is an elimination of USD 1.7mil of operating costs every quarter with this divestment.

Coal Industry Characteristics

Since the company’s fortune is largely tagged to coal, my thoughts are that it’d be necessary to understand the characteristics of how the industry works.

231) geo-process-coal.jpg

Most of the coal is divided into thermal coal and coking coal. We’ll focus on thermal coal as this is what Geo Energy mines (mostly). It’s coal gets excavated (by BUMA), transported by dump trucks on dirt paths to the port where it gets crushed into smaller pieces, and eventually gets loaded onto barrages and transported by sea to the client, ending up in coal power stations where it’s used to generate electricity.

Geo Energy owns the machinery and equipment that’s used for the transport, and loading onto barrages. As opposed to leasing, this is good as they get more reliability. The maintenance and repair of the machinery is also done in-house.

However, as a result, there’ll always be relatively high PPE and correspondingly, depreciation.

Back to the raw product: There are different grades of coal. One of the ways to measure this is via the gross calorific value (GAR value). Generally, the higher the GAR value, the more energy is stored in each unit of the coal, so that means the coal is of a higher grade.

In addition, the moisture, ash and sulphur content of the coal all plays a role in determining the demand for the coal. Here, Geo Energy has an advantage as it’s coal has low levels of sulphur, and is thus sought after by power plants in China, where pollution is a concern.

In fact, China bans the import of coal with >40% ash and >3% sulphur, starting from 2015. This is great news for Geo Energy, whose coal falls well below these regulatory amounts.

This diagram given in one of the company’s presentations, describes the types of coal nicely:

240) types of coal 04102016.jpg

The Indonesian Coal Index (ICI) rates 5 grades of coal, with grade 1 being the one with the highest GAR value.

Geo Energy’s coal is of the ICI grade 4 thermal coal, with a GAR value of 4,200. This means there’s 4,200 kcal of energy in each kg of the coal. It’s not the highest grade, but this sort of coal is great for electricity generation and is used in power plants, as opposed to coking coal, which is used to make steel.

Earnings

There’s a reason for the ugly share price chart above.

Geo Energy’s financial results have been outright horrible in the past few years:

232) Geo Energy Income statement 10012016.jpg

As we can see here, Geo Energy has been running up massive losses in FY14 and FY15, in line with the collapse in coal prices. FY16 though, seems to be the start of a turn around:

233) Geo Energy FY16Q2 10012016.jpg

At 1st glance, the FY16Q2 results look immensely better than FY15Q2 results, having finally swung to profitability in the most recent Q2.

However, the USD 2.63mil in reported profit for the quarter includes a USD 5mil gain parked under “Other Income”, due to the divestment of their mining and haulage services division. (As mentioned above). This USD 5mil translate to a net gain of USD 3.7mil.

Without this extraordinary, one-off item, FY16Q2 would still be showing red ink. So based on earnings, the company is not exactly out of the woods yet.

As with most such turnaround situations though, I think the earnings, as well as the balance sheet, are not accurate barometers. IMO, particularly when assessing a recovery, the most important parameter lies within the cashflow statements. Even then, one has to try to make an educated guess how the cashflow picture would look like going forward, so a macro view cannot be avoided.

Acquisitions

To try to predict how the company’s cashflow is going to look like in the near future, we’d have to have an understanding of the numerous activities the company has been involved in of late.

I took some time to understand this as Geo Energy has definitely been busy on the M&A front.

Geo Energy has been embarking on a string of acquisitions. In 2011, Geo Energy acquired the PT Bumi Enggang Khatulistiwa (BEK) coal mine.

In 2014, the company acquired a 66% stake in the PT Sungai Danau Jaya (SDJ) mine.

The remaining 34% in SDJ was acquired in Dec 2015, and operations started that month. The contribution from SDJ accounted for the bulk of the revenue increase in 1H16.

SDJ has an estimated 42.4mil tonnes of coal, mostly of the GAR 4,200 grade.

This acquisition is done at a price of USD 25mil (for the 34% stake), of which USD 3.5mil is paid by issuing shares at SGD 0.18.

The acquisition spree didn’t stop. In 2016, Geo Energy bought a 79.9% stake in PT Parisma Jaya Abadi (PJA), giving the company access to coal with calorific values of 6,700 to 8,100 kcal/kg.

The company also bought a 99.5% stake in PT Cahaya Lembusuana (CLS), which owns a mining concession for coal with an estimated calorific value of 6,500 to 7,100 kcal/kg in March 2016.

In September 2016, the company bought  a 98.73% stake in PT Tanah Bumbu Resources (TBR) for US$90 million

This TBR mine would add 44.4 million tonnes and double the Group’s total mineable coal reserves, with an average calorific value of no less than 4,200 kcal/kg. On top of this, the TBR mine is just adjacent to the SDJ mine, hence significant cost savings can be derived from sharing resources between the 2 mines.

The TBR mine is bought for USD 90mil, of which USD 13mil will be paid by issuing 117mil shares at $0.15. The vendor has agreed not to dispose off any of the 117mil shares for the next 3 years, so this potential dilution above a share price of $0.15 has to be taken into consideration.

TBR  is due to start production in early 2017, and collectively, management expects total production for 2017 would reach 10 million tonnes.

To me,this seems to be a rather aggressive target, seeing that in the 1H2016, total production is just over 1.3 million tonnes. Management has guided though, that they expect a total production of 6 million tonnes for 2016, so we should be expecting production to ramp up significantly for 2H2016.

So just to summarize (cos I know it’s all very confusing at this point), currently Geo Energy owns BEK, SDJ, PJA, CLS and TBR mines. All these mines have been acquired in the last couple of years.

The most significant mines that’ll be leading the recovery for the company, are the SDJ and the TBR mines.

Offtake Agreements

Alright, so we have thus far established that Geo Energy has been accumulating assets, the bulk of which is in the form of GAR 4,200 thermal coal with low sulphur, which are in turn in high demand by Chinese power plants.

But it’s no good just having mines, what’s important is the client’s demand for your coal, as well as the price that you can sell it at.

This is what I like about Geo Energy’s situation right now. Having cleverly sub-con out the mining operations (supposedly at very competitive rates, although I cannot find data on this. I assume it’s confidential), Geo Energy proceeded to secure offtake agreements.

Offtake agreements are contracts whereby the company secures certain guarantees/orders from clients before the coal is actually mined and transported.

This is obviously great for the company as you’d be certain that the coal you mine has a place to go to. You’d only get it out of the ground if you’re sure someone’s going to pay up for it.

To view it another way, the client is now making the long term commitment and providing the cashflow for the operations, kinda like how Amazon’s clients pay up before the goods they have ordered is delivered to them.

This is very different from having clients pay on delivery, as now, your clients are the ones funding the entire operations, indirectly. You’d also get much more stability and take on less risk. Essentially, no $$$, no coal.

Here, let me divert a bit and talk about the concept of cash conversion cycle (CCC), since I mentioned Amazon. Here’s a simple diagram I made regarding CCC sometime back, to remind myself of the concept:

236) cash conversion cycle 03102016.jpg

This concept applies more to retailers, but let me try to adapt it to Geo Energy to explain why I think offtake agreements are great for the company.

Essentially, the CCC measures how long it takes for a company to convert a dollar that it has paid to buy inventory, into revenue that’s collected as cold hard cash (not receivables)

Obviously the shorter the CCC, the better. If the retailer only buys the inventory AFTER the client has ordered and paid up, essentially the client is paying for the inventory indirectly and the CCC is actually zero or -ve!

The retailer becomes merely a middleman, which is a great thing because you don’t have to stock inventory and deal with storage costs and space issues, you don’t have to commit to capital so you’d potentially save on funding costs and your cashflow is practically protected cos you only send the goods after clients pay up.

Similarly, for Geo Energy, with the offtake agreement, the “CCC” essentially becomes zero. or at least very minimal. They’d have to invest to buy machinery, get the manpower, transport the coal etc (the inventory), but all this is done with the knowledge that the client would’ve committed to paying up.

234) contract-1229857__180.jpg

Let’s try to understand the terms of this offtake agreement.

On the 4th July 2016, Geo Energy Resources entered into an offtake agreement with Engelhart Commodities Trading Partners (ECTP) for the SDJ mine.

Essentially, ECTP agreed to commit to buy a minimum of:

4 million tonnes from now till 31st Jan 2017

6 million tonnes from 1st Feb 2017 to 31st Dec 2017

4 million tonnes annually after that for the remainder of the life of the mine

Now, SDJ has 42.2mil tonnes of coal (Estimated).

This means that if the minimum amounts are taken up in each period, the coal would last till 2024. But Geo Energy’s mining license expires in May 2022.

Management though, is projecting 6mil tonnes will be produced annually though, and that’d bring the life of the mine till around 2022, roughly the same period that the license expires.

I think investors would have to watch the coal production closely. Based on these figures, if the production drops below the projected 6mil tonnes / annum, that’d be a real concern. For sure, the license could possibly be extended, but I’d rather not have such uncertainty when it comes to Indonesian authorities.

Again, I’d emphasize that the figures given above are the minimum amounts. In all likelihood, ECTP may take up more coal, increasing the cashflow for Geo Energy annually. If coal prices continue to show an uptrend, and if coal demand holds up, ECTP would more likely “front load” their uptake. If demand drops, ECTP would then just take the minimum amounts and wait for demand to recover.

Still, there’s no denying the dynamics of the deal is great for Geo Energy.

But that’s not all. The agreement also takes care of the immediate cashflow of Geo Energy:

As part of the agreement, ECTP will pay an upfront fee of $20mil for the development of SDJ mine (this amount is already received by Geo Energy), and a USD 4/tonne advance for the future supply of coal that they’d be taking up.

Again, this is great for Geo Energy, as I mentioned earlier. The funding for the operations of the mine is taken care of, at least partially, by the client. The USD 4/tonne advance for a long term contract is fantastic too. The remainder of the fee will be paid, presumably, upon delivery of the coal.

The company is touting this as a $1.2 billion contract, based on 40mil tonnes and an average selling price of $30/tonne. I’m treating this as just a sound bite though, the size of the contract really doesn’t mean anything. $1.2bil over a year is very different from $1.2bil over a decade. Also, the costs involved to get this $1.2bil is equally as important.

Anyway, management is forecasting that ECTP will take up 10mil tonnes of coal annually, thus giving the company an advance of USD 40mil. This is only the advance, not the actual $$$ for the coal. The actual sum will depend on the spot rates for coal at the point of ordering.

It’s also somewhat comforting to note that Mr Dhamma Surya, one of the executive directors of Geo Energy, is providing a personal guaranty with regard to the terms of the agreement. I don’t think the company will screw this up if one of the executive directors is personally liable. Now, that, is a great example of leadership by example.

As of 1H2016, the total coal production is just over 1.3mil tonnes. Management is guiding 6mil tonnes for FY2016, and a further ramp up to 10mil tonnes in 2017.

10mil is quite far from the guaranteed min of 4mil though, and many things can happen in a tiny period of time. In my calculations, I prefer to use a 6mil tonnes figure to be conservative.

ECTP is also not a new client for Geo Energy. Previously, ECTP took up 1.5mil tonnes of coal from the BEK mine, but that contract ended in June 2016. Having the same client work with the company is definitely favorable for the company, as it means there’s long term business for the company.

Debts

235-stock-photo-financial-recovery-and-getting-out-of-poverty-with-the-word-debt-as-a-sinking-hole-in-the-ground-98788745

Now, thus far, I have written about all the fantastic assets and deals that Geo Energy has gotten itself. But the asset acquisitions did come with a price, and a hefty one too.

To fund it’s acquisitions in the past few years, Geo Energy got laden with a ton of debt. This is also why I said that I’m more interested in the cashflows now, rather than the income statement or the balance sheet.

With debt laden companies, the cashflow is key as it determines whether the company can pay it’s debt and survive. You won’t have a chance to thrive and enjoy all the great deals you’ve made, if you don’t have the cash to sustain through the so called “Valley of Death” that many debt laden companies died in.

This is how the liabilities segment for Geo Energy looks like:

237) Geo Energy liabilities 03102016.jpg

Although the total borrowings has dropped somewhat, the current portion of the liabilities has literally doubled from USD 23.5mil to USD 46.2mil.

On top of that, the non-current portion includes USD 69mil worth of notes that are currently non-current, but are due in Jan 2018.

That means that by the end of FY16, this debt will be shifted up to the current portion (due in a year’s time)

In fact, the notes due are now actually worth USD 73.2mil as of FY16Q2, instead of the USD 69mil as of FY15Q4. The increase is due to forex between USD and SGD.

I suspect management also understands that potential investors like myself would be concerned about the company’s CF. It is glaringly obvious to me and a major stumbling block to those wanting to invest in the company.

Thus, in the most recent investor briefing by the CEO, there’s a couple of slides addressing this issue:

238) Geo Energy Capital Funding slide 03102016.jpg

239) Geo Energy Capital Funding Slide II.jpg

Basically the A, B, C, D & E in slide 1 adds up to USD 310m, while the company thinks it needs to cover only USD 155m worth of liability in 2017.

All that looks pretty good, but peering into the details, I get a bit more concerned as I feel the projections are a bit rosy, with little room for error.

They’re not erroneous, it’s just that I’d prefer to be aggressive on the conservative side. Not just aggressive.

Let’s break it down item by item:

A – Based on a projected 10mil tonnes, management is expecting $100mil of operating cashflows in 2017. As mentioned earlier, I’d prefer to take it as 6mil tonnes for FY17 instead of 10mil. As of 1H2016, the total coal production is just over 1.3mil tonnes, although I do expect it to be ramped up significantly in 2H.

Let’s use 2Q2016 figures to have a rough gauge regarding the aggressiveness of this projection. I’m using 2Q and not 1H figures as in the 1Q, the production has not been ramped up yet.

In 2Q2016, the net cash generated from operations is $6.38mil. That’s generated from 850,000 tonnes of coal produced in 2Q. Extrapolating these figures to 10mil tonnes, we get a cash figure of $75.1mil.

Of course, in reality we can’t just extrapolate as there’d be significant cost savings from ramping up production at the same site. For eg. you need an excavator and an operator to excavate 100 tonnes of coal. To excavate 1mil tonnes of coal, you can prob still have the same excavator and the same operator, except that the excavator would be running continuously for a longer time, and the operator wouldn’t have as long a tea break as before.

So to factor in a cash of $100mil from 10mil tonnes is reasonable. But, like I mentioned earlier, I’d prefer to consider 6mil tonnes, so let’s just assume the cash derived here is $60mil.

B – An upfront fee of $20mil has been paid in July. This has been received by the company, after the Q2 results, so I’ll be expecting a nice fat $20mil appearing in the cashflow in Q3 results. This $20mil is not shown in the slide above as the slide above is referring to 2017, whereas this $20mil should be seen in the next quarter results.

The management is expecting 10mil tonnes of coal to be delivered, with a resulting prepayment of $40mil.

I’m guiding for a very conservative 6mil, so the cashflow would be $24mil.

In any case, this is prepayment, so this figure will be nett off as part of the funding requirements (seen in the 2nd slide above)

The difference is that management has included another $40mil based on an offtake agreement for the other mine, the TBR mine.

This offtake agreement as yet, does not exist!

Management just thinks that it’s highly likely they’d be able to secure another offtake agreement for the other mine, with the same terms.

While this is optimistic, as it shows that management must have some basis for such confidence, I’m ultra conservative and I’m assuming nothing exists until it does.

When they do announce such an offtake agreement though, it’d be a massive catalyst for sure. But until then, I think being conservative works better. You may end up missing out on some great deals, but you’d also avoid some land mines (pun intended, of course) as well.

C – Working capital loans / Trade financing loans of $30mil. Nothing to comment here, it depends on the deal they get from the banks. $30mil of financing loans seem reasonable to me, it depends on how much confidence the bankers have in the company.

D – Equity & convertible financing. I’m expecting future acquisitions, if any, to utilize the shares as currency to an extent. Already, Geo Energy is issuing 117mil shares @ $0.15 as part payment for the TBR mine.

While issuing shares is generally not good for existing shareholders, in this case, it’s actually good. This is because the shares are issued at a price that’s ABOVE the current share price.

So instead of diluting the existing shareholders, it improves the NAV for existing shareholders. The share price, as of the time of writing this though, is awfully close to $0.15 and I’m expecting yet more appreciation in the immediate term. (doesn’t help that many analysts seem to catch on and there are more and more reports coming out)

In most reports that I’ve read, it’s been mentioned that this 117mil shares to be issued is non dilutive at current share prices. I’ll like to point out that as long as the issue price is > the current share price, it does not dilute the NAV, but it does dilute the earnings per share in future, simply because there’re more issued shares.

E – I have no way of assessing this. I’m not sure how they came up with a magical $100mil figure. Sale of a minority stake can generate $100mil just like that?! OK I’ll have to be highly skeptical of this. It really looks like a figure plucked out of nowhere. I’m assuming zero for this.

So if we add up A to E, based on my ultra conservative reasoning, we get a 2017 CF of $114mil.

The capital requirements, based on my 6mil tonnes of coal, would be:

MTN – $73.2mil

TBR acquisition – $30mil (this is separate from the 117mil shares to be issued)

Offtake agreement liabilities – $24mil

General expenses – $7mil

Total – $134.2mil

So basically, if things stay exactly the same, and if management fails to meet its lofty target of 10mil tonnes of coal in 2017, we’ll be seeing a capital shortfall of about $20mil.

That’s……. actually not too bad, considering my ultra conservative assumptions. Also, by showing improvement in their CF, I do believe the company would be able to get further funding to meet this $20mil if it’s really necessary.

On top of that, let’s not forget the coal prices have been rising rapidly. The effect of this takes time to flow down to the cashflow and earnings, and in a rising coal price environment, the earnings that we see in each quarterly statement is lagging.

At this point, I’m not sure how many investors are jumping in Geo Energy Resources based on the above 2 slides.

Their balance sheet is NOT as strong as the figures in the slide project. It’s prob not as weak as my assumptions too. The reality is likely to be somewhere in between.

This does mean though, that the company is not exactly out of the woods. I’m not sure the share price should be shooting up so rapidly if investors really stopped to think and work out these figures.


Alright, I’ll stop Part I here as this post is getting to be too long. In Part II, I’ll analyze the macro situation for Geo Energy and the coal industry in general, as well as describe both the pros and the cons of investing in Geo Energy.

In the meantime, I’d really love to hear arguments/counter arguments and views of all sorts regarding this. Please post in the comments section, or drop me a mail.

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