Fat Prophets take profits

The planned improvements to port and rail infrastructure on Australia’s east coast are central to our investment case for Macarthur Coal (MCC). These improvements are expected to relieve the current supply constraints and provide a considerable earnings uplift in the years ahead. However, given the recent stock price strength, this week we consider whether the risk/reward profile remains as favourable as it once was.

For the six months to 31 December 2007, Macarthur’s net earnings fell to $13.5 million, down considerably from the $42.4 million earned in the 2006 first half. Although at the lower end of expectations, the result was within the $12 to $18 million previously advised by management.

The fall in earnings followed a 29% reduction in coal sales during the period, from 2.44 million tonnes in 2006 to 1.73 million tonnes. Reduced port allocations aimed at easing the queue of ships off the key Dalrymple Bay Coal Terminal (DBCT) were the primary culprit, although heavy rain also played a part.

Last year was the wettest on record for the company and bad weather has continued to hamper operations in 2008, with widespread flooding in the region of the Coppabella and Moorvale mines. As a result, the company called “force majure” in late January, releasing themselves from contractual obligations to deliver coal to their customers.

Production at the mines cannot proceed until large quantities of water are removed from both open cut pits. On this front though, the port bottlenecks offer a silver lining given that the miner has large stockpiles of unshipped coal available for delivery, in lieu of current production.

As a result, management remain confident of achieving their previously revised full year sales target of 4 million tonnes. However, due to uncertainties surrounding the port expansion and the potential for further adverse weather events, management have not provided full year earnings guidance.

Of course, the industry’s supply constraints are also impacting coal prices. Indeed, spot prices for thermal coal are reaching record highs on continued demand strength from Asia. The spot price is currently over US$130 per tonne, compared to last year’s contract prices of around US$56 per tonne.

Certainly, the current coal price strength has also been an important factor in support of the company’s buoyant stock price.

In terms of the valuation, the stock currently trades at around a whopping 60 times consensus 2008 earnings. However, the market is looking ahead to the DBCT expansion, which will see Macarthur’s port allocation more than double through to 2012. In addition, expectations of large coal price increases should result in a significant earnings pick up. Reflecting this, the consensus 2009 price to earnings ratio is around 9 times.

The company is certainly set to capitalise on the future easing of supply constraints and continued high demand for the black rock. Nevertheless, there remain factors outside management’s control that may hinder this process.

Primarily, potential delays to the DBCT expansion project could result in a revision of the market’s willingness to pay up for future earnings. And given that recent coal price strength has been partly driven by supply constraints, a rapid increase in supply could well negatively impact prices beyond 2009.

From a technical perspective, buoyant investor support over the past 16 months has seen Macarthur’s stock price triple and the pace of gains is continuing to accelerate. However, upward trends rarely proceed without interruption and as shown on the daily chart, there has been little in the way of corrective moves during the recent rally from $7.87 to $12.20.

In our opinion, this leaves Macarthur at increased risk of a substantial correction in the near-term. As marked on the chart, major support levels are considerably below the current share price, at $10.25 and $8.

Although the broad outlook remains positive, it is unlikely that the pace of gains achieved over the past 16 months is sustainable. We therefore believe it is prudent to lock in a portion of the healthy profits achieved to date. Accordingly, Fat Prophets recommend selling half of the position held in Macarthur Coal around $12.00.