Yanzhou Coal (NYSE:YZC,HKEX:1171,SSE:600188) is a China-based coal mining and production company. The company's business is mainly focused on the domestic market, but also has some operations overseas (Australia). The company's core business is coal mining and production (over 95% of FY 2010 revenue), but it also sells chemicals used in the production of coal and generates electricity and heat.
As of FY 2010, the company had 1.8 billion tons of in-place proven and probable reserves in its six mines in Eastern China (mostly Shandong Province).
The company's reports performance across five segments (Coal Business, Railway Transportation Business, Coal Chemical Business, Electric Power Business, and Heat Supply Business), but the main pillar of the company is the Coal Business.
The steps in the Coal Business are the mining, processing, and sale of coal. Because the coal deposits in the company's coalfields are underground, underground mining is the primary method of extraction (vs. open-pit mining for deposits closer to the surface). In underground mining, the company tunnels beneath the earth's surface to the coal deposit (using specialized digging machines called headers, or explosives), extracts the coal from the mine, and transports the coal back to the surface for processing.
The company sells some raw coal, but the majority of extracted coal undergoes further processing before sale. Processing coal involves separating coal from other rocks or minerals, washing, and processing the coal. Yanzhou claims to use all automated equipment, which allows the company to control ash (a term for unburnable material) content and overall coal quality.
All of the company's coal mines have processing facilities on site. The mines are connected to major transportation hubs by either rail (the majority) or roadway. The company's recovery rate (a measure of processing efficiency) was 69.5% in FY 2010.
The company's largest customer as of December 31, 2010 was China Huadian International, owner/operator of the Zouxian Power plant located in Shandong Province.. As of December 31, 2010, the Zouxian plant was the largest fossil fuel-powered plant in China, with a total capacity of 4,400 MW. The proportion of sales to Huadian have been declining, from 23.3% in 2008 to 18.5% in 2010.
The company's major shareholder as of December 31, 2010 was the Yankuang Group, a state owned enterprise (SOE), which held 52.9% of Yanzhou Coal's stock.
One obvious avenue for the business to grow is increased domestic production. The company owns six mines, however some of the mines haven't started meaningfully contributing to sales (specifically mines located in Inner Mongolia, Anyuan and Zhuan Longwan). As these fields are developed, total volume should increase which could have a positive impact on sales and profitability.
Domestic demand should follow the overall direction of the economy. Assuming that the Chinese economy continues to grow, it seems reasonable to conclude that there will be a demand for coal, particularly by power generation companies.
Other businesses (transportation, methanol production, electricity generation, etc.) could also be a source of growth, but the relative size of these businesses compared to the core coal business seems to suggest that any meaningful contributions could take time to develop.
Another possibility for the company's future growth is through development of its overseas business. The company has been expanding its operations in Australia through the purchases of Felix Resources in 2009 and the Ashton coal mine in 2010.
The company has grown sales from $1.6 billion in 2006 to $5.15 billion in 2010. The growth in revenue has followed an increase in coal sales volume and the price per ton of coal. Total volume increased from 34,663 kilotonnes in 2006 to 49,634 kilotonnes in 2010, and the average price per tonne increased from 341 RMB per tonne in 2006 to 663 RMB per tonne in 2010.
Gross profit has remained relatively stable from 2006 through 2010, at about 53%.
The company's ratio of fixed costs to sales (SG&A / sales) has been in a declining trend; from 16.0% in 2006 to 12.3% in 2010. The effect of proportionally lower SG&A costs has been an increase in operating profit margin, from about 29.6% in 2006 to 30.5 % in 2010. The expanding margin has occurred as the company grew sales volume and total revenue, suggesting that coal mining exhibits scale economies. The practical implication for the company's shareholders is that if revenues increase without the need of additional SG&A spending, the company is more profitable.
The net profit margin increased from 18.3% in 2006 to 27.4% in 2010. The main driver behind the net margin increases has been the increases in operating profit.
The company's balance sheet has grown from $3.0 billion in 2006 to $11.0 billion in 2010. The company significantly expanded its balance sheet in 2009, nearly doubling in size from $4.7 billion in 2008 to $9.1 billion in 2009. The balance sheet expansion was mostly related to the purchase of Felix Resources, which in turn caused the overall increase of balance sheet leverage from a gearing ratio (assets / equity) of 1.2x in 2008 to 2.1x in 2009. Although an increased gearing ratio can cause higher ROE (assuming a constant ROA), the higher interest burden and capital needs (rolling over debt) can cause introduce other constraints.
The company sells coal either through contracts or with letters of intent (LOI) with its customers; the mix between the two impacts revenue because the prices are set differently. For sales made under contract, the price that buyers pay is negotiated when the contract is executed. For sales made through a letter of intent, the price that buyers pay is the prevailing market price when the actual sale is made (i.e. the spot price in the future). In both cases, the company sets the volume, therefore the mix between contractual and LOI sales can directly influence total revenue.
Coal mining can be a very capital intensive business, and there are significant up front and recurring costs. Up front costs include land use rights, equipment and material needed to dig and create underground tunnels, mining machinery, coal processing equipment, and the transport network connecting the mine to the market. Recurring costs include materials and labor, land costs (statutory rehabilitation, restoration, and related environmental costs), transportation costs (from mine to market), and depreciation.
The company's gross profit margin averaged about 46.0% from FY 2008 to FY 2010.
In terms of overhead expenses, the main component of SG&A expenses from 2008 - 2010 was labor. Assuming overhead labor expense is mostly management, and relatively fixed, it seems reasonable to conclude that the volume of coal is the key variable impacting operating profit.
Demand for coal in China driven by electricity demand
China's energy needs are driven by the overall growth of the economy. China's GDP has been growing at a nearly double-digit pace since the early 2000's which has increased the demand for electricity, from 1.1 trillion kilowatt hours in 2000 to 3.0 trillion kilowatt hours in 2010. Considering the Chinese government's focus on maintaining overall economic growth, it seems reasonable to conclude that demand for electricity will continue also.
There is a direct relationship between China's energy appetite and the demand for coal. Coal-fueled power plants are easier to manufacture (and arguably safer) than nuclear-powered alternatives. Because China's demand for electricity is rapidly increasing, and coal-fueled power plants can be built faster than nuclear plants, most power plants in China are coal-fueled.
Demand in the future will likely continue from power generators, and it seems possible that this demand could 'crowd out' demand from other sources (steel producers, etc.), potentially making the industry more interesting. Coal production arguably requires some lead-time before mines are able to supply the market (obtaining permits, building the mines and infrastructure, etc.). Considering potential demand dynamics, these entry barriers could shift coal producers into a relative advantage with respect to bargaining power with customers. The possibility of government interference overshadows the potential impact on domestic producers; the Chinese government has created Price controls in the past.