Is Whitehaven still undervalued after its excellent result? -Emmanuel Datt

Whitehaven Coal reported record profit of $2 billion (NPAT) for fiscal year 2022. EBITDA (earnings before interest, tax and D&A) increased 15 times over the prior year to $3.1 billion. Free cash flow from operations was exceptional at $2.6 billion.

This fantastic result was mainly driven by a series of factors, including:

  • A significantly improved realized coal price of AU$325/t from AU$95/t from FY21;
  • Consistent production within targeted 20 million ton guidelines, despite labor challenges and inclement weather;
  • the best cost control on a per ton basis, significantly better than its peer group;
  • and, an improvement in its performance in terms of workforce safety.

Unequivocally, this was the most notable result among the ASX100, with a total shareholder return (TSR) of 154% achieved for FY22.

Importantly, in FY22, the company took advantage of favorable market conditions to significantly strengthen its balance sheet and reward its shareholders.

Specifically, Whitehaven was able to pay off $775 million in debt, canceling all long-term debt; fund its capital expenditures entirely from its operating cash flow and finally return $1 billion of cash to shareholders via fully franked dividends and market buybacks (a small portion ongoing).

Whitehaven continues to experience exceptionally strong market and activity conditions, with spot thermal coal prices (Newcastle Specification) around AU$600/t compared to the FY22 price of AU$325/t.

Whitehaven continues to face demand in excess of its supply capabilities due to the high quality and highly sought-after nature of its coal products as well as its enduring relationships with primarily East Asian customers located in Japan and Korea.

A supply response to meet demand is unlikely to occur for at least 2-3 years, even Whitehaven itself has not been able to increase production given the constraints of permit, labor and outright inability to finance new thermal coal developments.

As a result, existing high-quality producers benefit from a significant and likely lasting competitive gap to any potential new entrants; and this is reflected in the gap between lower and higher quality coal products.

We see the outlook for the future as exceptionally strong, with the ongoing global energy crisis and the peak demand season of winter in the Northern Hemisphere just months away; offering a strong upside risk both at the level of company prices and at the level of commodity prices.

Whitehaven has underscored its commitment to returning capital to shareholders through dividends and share buybacks, and we believe these initiatives will be highly accretive to shareholders.

We consider WHC’s current market valuation of just $7.3 billion, at a (retrospective) price earnings multiple of only 3.5x, to be materially undervalued given the strong outlook for the market. industry, the quality of corporate assets and a commitment to aggressively returning excess capital to shareholders.

The form in which this excess capital is returned to shareholders is likely to be the key decision at this stage. The company disclosed a capital allocation framework in its latest presentation.

The most convincing for us is the method of return of capital to shareholders. Whitehaven pointed out that excess capital can be repaid via dividends as well as redemptions (both on and Off-market). This is structured so that the 20-50% of NPAT is returned through dividends and redemptions; with excess capital above that deployed in other buyouts if returns are more attractive than growth investments such as shovel-ready development projects and acquisition prospects.

What does this really mean for shareholders?

The first exercise we undertake is to try to forecast 5 years into the future; we chose this arbitrary number of years because we have transparent price discovery via the futures market. This is despite the fact that Whitehaven has a production-weighted asset life of over 23 years for assets currently in production (i.e. not including development assets).

Using monthly futures prices for the next 5 years ahead, we were able to deduce the following high level numbers.

What this tells us is that in one scenario, using the assumptions listed, we get cumulative, undiscounted excess capital of $14.3 billion, along with about $6.1 billion in credits. postage at the end of the 5 year term. Note that this is purely on the projected financial statements and assumes zero terminal value for the remaining life of mine, which would be approximately 18 years on a weighted basis.

The next question that could be asked is: what are the main risk factors associated with the hypothesis?

  1. A significant drop in thermal coal prices. This should be supported by either a) a significant increase in supply or b) a significant reduction in demand. We consider a) unlikely over a 5 year period due to the permitting process and the life cycle of development in regions where high quality thermal coals can be found and mined. b) is also an unlikely event as alternative energy sources remain elevated due to nearly a decade of underinvestment and given the current geopolitical turmoil.
  2. Government royalty rates. As investors have recently discovered in the case of assets located in Queensland, government royalty rates can change. Whitehaven’s generation assets are located in New South Wales; which is ostensibly considered a rather business-friendly state. The current state government has indicated in its budget that no change in royalties has been assumed. There is a risk that an impending change of government will attempt to adopt higher royalty rates than currently exist. This is a somewhat uncertain situation given that the next NSW state election will take place at the start of CY23. However, even if a QLD-like royalty increase occurs (effectively double the assumed royalty); this would only marginally affect the value proposition over the 5 year period.
  3. Costs and inadequate allocation of capital. Cost risk is a factor, however, we are reassured that Whitehaven has the best controlled production costs among its ASX-listed peer group, demonstrating strong operational management quality. We are also reassured by the clarity of the capital allocation guidelines and the structure articulated to investors, and we hope that the Board will undertake the initiatives most beneficial to the long-term interests of shareholders. For example, it makes no sense to invest in development projects and expose yourself to delivery and capital risk until the business as a whole is trading at a much higher earnings multiple. .

The final question is: what is the most efficient way to return capital to shareholders in the most value-creating way?

In my mind, it really boils down to an opinion on what terminal business *could* be like at the end of the 5-year period, as well as operational performance over that period.

At the current market value of approximately $7.5 billion, Whitehaven is valued at approximately 1.5 times projected EBIT in FY23 alone – an unprecedented valuation for a high-quality, multi-mine, listed and liquid.

Using our 5-year projection, the current market value is effectively about half of the projected cumulative after-tax amount of excess capital; or only 36% if you include accrued postage credits (taxes).

As a result, we believe Whitehaven should undertake a huge aggressive buyback program instead of paying dividends. If the market is unwilling to place a fair value on the company’s shares, then the company may recognize and attempt to capture the value differential itself for the benefit of its long-term shareholders.

Much of the attraction of dividends in Australia stems from the potential distribution of franking (or tax) credits which can be passed on and used by the shareholder. With dividends come other issues such as reinvestment risk that are usually considered by professional investors.

However, postage credits can be returned in other ways, such as via off-market redemption. If no postage credit has been accumulated, then a market buyout would be the preferred outcome. However, a buyout can be expressed using both methodologies assuming shareholder approval has been obtained.

There has been a lot of confusion around the off-market buyback methodology, and we thought it would be useful to demonstrate how it might work in practice. The ATO allows a maximum market discount of 14% for off-market redemptions, so we have used this figure in our assumptions.

Scenario of selling shares on the market

Purchase Price – $5
On sale in the market – $7.80
capital gain – $2.80
Net profit for the shareholder: sale price only

Off-market buyout scenario

off-market redemption price – $6.71 (14% off market)
capital component – $0.50
dividend – $6.21
postage credits – $2.61
Total Selling Shareholder Profit – $9.32 – ~19.5% premium to market price, including tax credits, despite discount to market.

The off-market buyback methodology is well known in the Australian markets, with many precedents. For example, BHP undertook a $7.3 billion off-market buyout in 2018. Additionally, this allows investors to choose whether they want to participate based on their own tax circumstances. For example, a foreign investor is unable to claim franking credits, so they are unlikely to participate; however, a retiree may receive tax benefits and may benefit from the franking credits distributed.

In summary, we believe Whitehaven continues to look undervalued and the company should aggressively attempt to return capital to shareholders through a combination of on and off market buybacks if circumstances allow.

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