Contango Holdings PLC (LSE:CGO)

19th August 2020

Near-term coking coal producer with large resource offering significant expansion. Contango should become a cash generative company in 2020 and aim to introduce an early dividend policy.

Market Cap: £9.6M / 4.75p @ 19th August 2020

Key Highlights 

• Near-term producer targeting first production 2021
• 2bn+ tonne resource offering significant expansion scope
• 1mtpa initial coking coal production
• 20 year mining lease secured
• High value high grade 28CV metallurgical/coking coal
• Fully funded to first cashflow
• Near-term dividend payer
• Experienced Board

Why it should be a ‘Steel’

My previous dabble in the world of coal was in Prairie Mining who had two coking coal projects on Poland. Given its critical use in steel making and the lack of quality projects it seemed a good bet. Unfortunately, it didn’t pan out due to various political issues that have now left Prairie involved in litigation against Poland

Since then I’ve not really dabbled in coal but its a sector I have remained interested in. Many will brush it off with a limited understanding of what coal is used for, determining its just dirty business!

Well if you are talking about burning thermal coal in power stations then yes, it’s not going to tick the Eco-friendly boxes.

But if you are talking about Coking/Metallurgical coal then their uses have few if any substitutes for the production of industrial materials and specifically steel.

So if your investment thesis is to stay away from fossil fuels fair enough but the likes of Oil and Coal will be around for longer than our investment lifetimes and you certainly for now need to differentiate between coking/metallurgical coal vs thermal/domestic coal.

With Contango’s focus very much on the former and the healthy margins that can be achieved at scale, Contango looks very interesting at this juncture.

So lets talk about Contango then...

About Contango Holdings PLC

Contango was a main market listed cash shell seeking near-term producing assets. The company acquired a 70% interest in the Lubu coal project in Zimbabwe from CGH (the largest shareholder) for an implied £6.4m via the issue of consideration shares at 5p. The remaining 30% of shares sit with supportive local partners. CGH shares in Contango are locked in for one year so until May 2021 meaning free float is c.35% although Directors hold around 10% of that.

Since re-admission which took a long-time due to the board requiring the mining lease to be in place to complete the acquisition, the company have raised a further £1.4m at 5p per share to fully fund the mining development to production.

The board comprises an interesting mix of natural resources/mining and finance experience with the CEO being Carl Esprey, ex BHP Billiton. Another key shareholder and board member is Philip Richards who heads up RAB Capital, a prolific and successful mining investor.

I’ve spoken to both Carl and Philip and like the plans they have for Contango. The board are very much aligned with a material equity stake and exceptionally tight, total combined remuneration of just £96k pa

The strategy is clear, to develop/progress near-term producing assets to bring in cash flow as early as possible to underpin the companies financial position and introduce a dividend policy. If executed successfully, this will have the effect of limiting dilution and providing exceptional returns to shareholders via a dividend considering the number of shares in issue (c.240m fully diluted) and projected cash flows. The board are actually aiming to return c.50% of profits back to shareholders via a dividend, extremely attractive.

So a little more on the projects…

LUBU COAL PROJECT (70%)

The project covers 19,236 hectares of the highly prospective Karroo Mid Zambezi coal basin in established Hwange mining district in north-western Zimbabwe. Historically c.US$20M has been spent on the Lubu Coal Project by previous and current owners.

This has included extensive drilling, geophysics, test work on the washability characteristics of the coal (washed coal attracts a premium) and an N1343-101 JORC resource (Indicated 702Mt) and (510Mt inferred) Since heads of agreement in 2017, CGH the largest shareholder has spent a further $740k on the project.

Notably, recent drilling in 2019 identified high grade 28CV coking and semi-soft coking coal, two coal types that attract premium pricing and will certainly be the initial focus for Contango.

The company plan to initially produce 1mtpa of saleable coking/met coal c.70-80Mt per month and have signed their first LOI with a local Zimbwean coke producer for a minimum of 30kMt per month.

Pricing will be subject to final contract which is anticipated ahead of the commencement of mining in Q4 2020 but based on market assumptions the company believe they can achieve a sale price of between US$45-55 for un-washed coal and between US$70 and US$80 per metric tonne of washed coal. With respective mining costs of c.US$15-25Mt this offers nice margins.

Simple calculations on my part as follows:

At a margin of around US$30Mt (assuming no shipping cost) and 70kMt per month this at a 70% interest equates to approximately US$1.47m EBITDA pm or US$17.6m EBITDA pa

This excludes 30% Government Tax but the company have an initial US$6m tax credit so roughly a years worth run rate before tax kicks in. Post tax in year two still a healthy US$12.3m EBITDA pa!

You don’t need to be a brain box to work out that the current Market Cap of £9.6m is comfortably below first years earnings!

The beauty of the project is it’s scale and the company could well expand production in year two if they so wish to off-set the introduction of tax and maintain a dividend policy assuming the demand is there for the off-take.

The company have signalled more off-takes are on the way and that they will look at other sales options beyond the initial coking coal sales.

Why Coal or shall we say Coking Coal?

The Coal market is something I’m not too familiar with but as at the beginning of the year coking and high grade coking coal was trading in the region of US$90-$130Mt with thermal coal used for power generation trading around US$30-40Mt

It’s no surprise that thermal coal prices have and could continue to be under pressure given the move away from ‘dirty’ power generation however in local markets where there are no other options such as Africa who desperately need more power local prices could be at a premium when factoring in transport costs.

Coking coal prices will largely be driven by the steel an industrial sectors. Coking coal is the key ingredient to create the coke used to make steel so a strong market for steel will support coking-coal prices.

Premium coking coals, are in particular high demand within China primarily due to the low ratio of these coals in China’s own coal reserves but also due to the growing requirement for higher quality coking coals in the coke industry. The premium coals are increasing in demand faster than lower quality coals as China increases its use of larger blast furnaces to increase productivity.

The World Steel Association consider that global steel demand growth in 2020 will amount to 1.7%

Steel prices are cyclical and the peak of the next steel price cycle is predicted for 2022. This should bode well for coking coal prices which have come off in recent years along with steel.

Should we see increased stimulus following the impact of COVID-19 then steel and coking coal prices may stage a more significant up-turn as evidenced by recent Iron-Ore price increases

An Eye on Risk

As with any investment we need to be aware of the risks particularly with small cap pre-revenue companies. The two key risks I see are as follows:

The company are operating in Zimbabwe, Africa and these are considered higher risk countries in general. Zimbabwe is ranked 140th out of 190 countries listed in the World Banks 2020 doing business report which is a move up from where it was so a good sign and a similar rating to Zambia where other large copper mines operate

Notably, Caledonia Mining has been operating successfully in Zimbabwe generating strong cash-flow and has seen a huge uplift in its market cap in the last year

Secondly the macro risk needs to be considered, should demand for steel drop off, this could have an impact on coking coal prices and of course Contango.

Conclusion

So before I highlight all the fluffy bits and why those invested could be sitting on significant returns we need to be aware that investing in small cap companies in general carries high risk so don’t be throwing the kitchen sink in, manage your risk !

Now back to Contango…

So hopefully in this brief research note I have given you a flavour of who Contango are and the plans for the company since re-list after a long period of suspension.

The usual factors I look for have attracted me to Contango, a strong management team, a quality scaleable project with supporting market back-drop but perhaps more significantly in this case the projected near-term cash flow that should translate into an early and continuous dividend that when factoring in the current market cap and shares in issue would provide for a significant return.

Near-term cash flow which is significant should also protect against further dilution which is also very appealing.

The current market cap of c.£9.6m doesn’t reflect in my opinion the historic spend on the acquisition, de-risking of the project through further drilling and award of mining lease all whilst suspended and of course the economics of the project which should see annual EBITDA well in excess of current market cap.

The company have said that they will also look to acquire additional interests from cash flow generation so quite possible the company could diversify and investors see fast growth with the company utilising existing cash flow.

At the current market cap with a ramp up in news flow to come it could be a ‘steel’ !

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Disclaimer

Research materials prepared based upon my own analysis and research. Accuracy cannot be guaranteed and research notes should not be taken as investment advice. Please always do your own research.