Chinese demand for coal remains scorching hot, despite a relative cooling among global growth expectations. But small-cap coal companies with operations in China have suffered a glacial freeze in investor sentiment toward their stocks. Puda Coal's
Interested in assessing whether L&L Energy's sell-off may have gone too far with the recent pile-on effect of multiple, high-profile cases of fraud like that involving Longtop Financial Technologies, I took a closer look at L&L Energy recently, and submitted a set of questions in search of greater insight. The results are discussed in Part 1 of this inquiry, and I strongly encourage Fools to review them along with L&L Energy's responses to these questions:
Christopher Barker: L&L Energy's intention to blend very high-quality coal from the Bowie mine in Colorado with L&L-mined product in China strikes me as an enticing means of enhancing per-ton revenue in a cost-effective manner, as well as a productive fit with L&L's coal washing and wholesale operations in China. Does L&L Energy intend to actively pursue additional export capacity in North America as part of its near-term growth strategy, or will further consolidation of mining operations in China remain the primary focus?
L&L Energy: With the appetite for coal in China expected to continue to grow into the foreseeable future, L&L Energy will evaluate growth opportunities in both geographies. We continue to see attractive consolidation opportunities in Southwest China driven by government mandates and growing industrial development. In North America, we will likely take a more opportunistic approach.
Barker: Given that opportunities to consolidate small-scale coal mining operations in a highly fractured Chinese coal industry appear extensive, do you consider your principal competition for acquisitions coming from a well-capitalized state-owned enterprise like Shenhua Group, a mid-tier cash-flow standout like Yanzhou Coal Mining
L&L Energy: L&L Energy has operated coal mining and other coal-related operations in Southern China since 2004, and we have developed deep relationships with the entire coal value chain, including customers, service providers, and also current owners of mines that could become acquisition targets. Additionally, as we have consistently served our coal customers with their required amounts of coal at the designated specifications, we have developed a reputation as a trusted provider. These relationships and our reputation are quite valuable as we survey the landscape for incremental acquisitions and position L&L favorably as we continue to evaluate new opportunities. We believe it will be difficult for companies that have not had a comparable operating history in this region to quickly replicate our success. And in regards to much larger companies, they have yet to show an inclination to pursue properties of the scale that fall within our target parameters.
[Author's note: According to L&L Energy's most recent corporate presentation and other sources, the company acquired its first coal-related operations in 2006.]
Barker: L&L Energy points to the application of U.S. coal mining practices and management techniques to operations in China as a key strategic advantage of the company. In reviewing biographical information for the company's senior-level management and its board of directors, however, one encounters very little indication of experience specific to the coal mining industry. Could you help investors to understand how direct experience in the coal mining industry may not be required to harness your stated strategic advantage?
L&L Energy: First, we would like to point out that we do indeed have many executives with deep experience in the coal industry. Tony Li, the CEO of our KMC subsidiary, is a trained geologist and has been working in the coal for several decades. We are also fortunate to have Dr. Syd Peng on our board of advisors, as Dr. Peng is one of the foremost experts in longwall mining and has personally been involved with our due diligence efforts. Additionally, our chairman and CEO, Dickson Lee, has been involved in the coal industry in various capacities for several years and has built up substantial knowledge and expertise in that period. While certain members of L&L Energy's executive team come from sectors other than coal, they do hold substantial public and private sector experience and also networks that allow them to have an immediate and positive impact both on our ongoing operations and also our growth strategy. Our senior staff and board are particularly well versed in international trade, human capital management and logistics, and we have found that these skills are very well applied to running a global coal operation.
Barker: As a corollary to the above question, could you provide a couple of specific examples of post-acquisition improvements made to mining operations that typify the strategy in action, along with your characterization of the results of those efforts?
L&L Energy: Typically, the mines we acquire have not been run for maximum output or efficiency, as the current owners do not have a typical U.S. business mind-set. Most often, the biggest improvement we can make is to increase the number of shifts per day from one to two and to implement employee compensation plans that incentivize workers to maximize production. Additional techniques we employ include shoring up the shafts, adding conveyor belts and also above ground machinery such as bulldozers.
Barker: With reported coal reserves of 53 million tons at the Tian-Ri development project alone, it would appear that advancing the project toward production could spur a powerful organic growth surge for a small-cap miner like L&L Energy. What are the next few steps in the development process for the Tian-Ri project, and do you have a targeted timeline in place for achieving commercial production?
L&L Energy: Tian-Ri does indeed hold substantial reserves, and we are very pleased to have it in our portfolio. However, development of this property is on hold at present as we are able to receive a better return on capital and management energies by focusing on acquiring mines that are already permitted and producing, than by focusing on a greenfield mine such as Tian-Ri.
Barker: To what do you attribute L&L Energy's ability to purchase a 60% stake in the Da Ping mine for just over 1.6 times your projected attributable net income from the operation during your next fiscal year alone? Do you consider that seemingly bargain-basement purchase price roughly indicative of prevailing market values for small-scale coal mining operations in China?
L&L Energy: The biggest driver of our ability to purchase mining properties for attractive valuations is the government-mandated consolidation policy, which calls for mines that are producing below 300,000 tons per year to either raise production to that level or shut down. Owners of mines in this situation typically lack the capital, management capability, or, often, desire to reinvest to ramp up production and find our offers an appeal alternative to being shut down. Additionally, we usually partner with the current owners by acquiring a stake in the operation and allowing the legacy team the opportunity to remain on board as we improve the mine. In the case of the Da Ping, we acquired a 60% stake and plan on doubling the production of the mine. So the original owner of the mine will eventually own 40% of a much larger property as compared with the potential with owning nothing at all.
In these situations, the network and reputation that we have built up over the years is a tremendous asset. When we approach a new mine owner, such as the Da Ping team as an example, we generally find that our reputation and past success in acquiring and improving mines make the conversations proceed smoothly from the outset.
Barker: L&L Energy has logged multiple noteworthy achievements of late. In your fiscal third quarter of 2011, net income attributable to shareholders rose 15.7% to $12.6 million, while revenue surged 74% to nearly $66 million. During the past 12 months, L&L Energy has secured an exclusive supply agreement from (and an option to acquire a 9% interest in) the Bowie coal mine in Colorado, and recently added a fourth mine in China with the attractively priced acquisition of the Da Ping mine. What do you perceive as the principal risks or limiting factors to L&L Energy's capacity to sustain this sort of explosive growth rate going forward?
L&L Energy: Clearly, as any small company progresses, the law of large numbers begins to apply, and growth rates must inevitably slow. Despite this, we still feel that L&L Energy is in the early innings of what we hope will continue to be an attractive growth story, driven by China's burgeoning demand for energy and our solid track record in acquiring and improving mine properties. In terms of risks and limiting factors, we would probably point to continued access to the capital markets and other financing resources that are vital to maintaining growth. We are also subject to the continued favorable stance of the Chinese government to independent mine operators like L&L Energy. However, as you look to our track record with improving our mining properties, the government can see that we are putting resources back into the mine and we feel has the potential to mitigate this risk. We are also exposed to fluctuations in coal prices in China, driven both by market price fluctuations and also government intervention, but as demand appears poised to continue and China to become a net coal importer, we are optimistic that current pricing should sustain.
Barker: To assist investors in their process of assessing shareholder value, could you kindly provide a clear breakdown of the company's attributable share of coal reserves; both by property and by product (thermal coal vs. metallurgical coal)?
- Ping Yi reserve = 14m tons
- DaPuAn reserve = 8m tons
- Su Tsong reserve = 2m tons
- DaPing = 14.75m tons
- [Tian-Ri = 53m tons]
Currently we are running at roughly 50/50 met to thermal coal, although with the addition of DaPing, which is a met coal operation, we expect our mix to adjust accordingly.
Barker: Although L&L Energy was founded in 1995 (several name changes notwithstanding) and uplisted to the Nasdaq in February of 2010, I notice that press releases available on the company's website go back only to November of 2010. How would you allay the concerns of investors who may interpret a lack of transparency in the scant archival record available on the company's website?
L&L Energy: We are committed to providing the utmost transparency to investors. Our SEC filings are available back to 2001 when our founder Dickson Lee commenced directly filing with the SEC. At this point in time, our policy with regard to press releases on our website is that we go back about 18 months. All material events are covered under 8-k filings and easily accessed by investors at sec.gov.
I (Barker) encourage Fools looking to target China's incredible growth momentum through stocks to consider timely advice from money manager Arthur Salzer: "Before you buy a company operating in China, due diligence above and beyond what you would perform on a Western company is needed." Personally, I have opted to invest in the global supercycle for coal through a combination of large-cap leaders like Peabody Energy
In order to differentiate between a true disaster stock like Sino-Forest, which has plunged more than 85% over the past several weeks, and a potential head-fake like Yongye International