Stockwatch: Why I've downgraded this small-cap star

Diversification is following a trend but has a new generation of analysts underestimated economic risk. 

A trend is picking up for resources firms to diversify by product or renewables, especially those focused on coal, oil and gas, fossil fuels, which have a "rogue" status in environmentally-conscious times.

To date it's been a somewhat token gesture by big companies-with-a-war-chest; but in recent days a couple of London-listed smaller companies have jumped on the bandwagon, such deals potentially larger in context.  Will it make much difference to the stocks' risk/reward profile, and to whose benefit?

Anglo Pacific (LSE:APF), a £350 million natural resources production royalty group - chiefly a play on Australian coal - has started September with the acquisition of a 1.525% royalty over copper being produced at a Chilean mine – covering the current 16-year mine life plus any extension /expansion to it.

According to the company:

"This provides Anglo with its first significant exposure to a producing copper mine at an attractive entry point in the copper price cycle...will immediately add diversification...also fits strategy of investing in high quality commodities with smaller environmental footprints."

Making a move on copper

I'm quite a fan of Anglo Pacific notwithstanding coal's highly cyclical risks, and I drew attention as a 'buy' at 153p last January.  The stock rose to 226p by May but is down to 190p, I believe due to macro reasons: the US/China trade tensions hurting the global economy and Chinese industry – a main consumer of Australian coal – slowing down.  

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So, diversification has logic, though I'm hardly convinced by management's claim to be an attractive entry point.  Yes, copper charts show a current price of $2.57 per pound being down from $4.54 in early 2011, though in true long-term context it's still massively up from around $0.60 in 2002, prior to which it traded volatile-sideways since the mid 1960's.

There's a respected case that demand for copper and nickel has re-rated justifiably as developing countries raise living standards and require housing and stainless steel goods.  But I recall nickel crashing around the 2008 crisis, and you may have seen price volatility in copper reported this summer on dog days for financial markets.

In other words, if the global cycle is rolling over, many commodities will be affected.  Anglo may be referring to copper's current price being down 20% from a $3.20 high in summer 2018; quite whether portending a further drop as it ties well to trade tensions.  Anglo's own price initially rose a few pence in response to the news though settled around 190p having bounced off 180p in mid-August.  

Source: TradingView Past performance is not a guide to future performance

Small-cap corporate finance is prone to be cosy, though it should still be noted how Anglo's CEO owns a stake (via a trust) in the corporate owner of this mine - Audley Mining Advisors - and is also a non-executive director of Audley.  Though not strictly a related party transaction, it begs a question whether a listed plc is also being used in its boss's financial interests.

A similar story last week from Parkmead Group

On 30 August, Parkmead (LSE:PMG) - a £47 million oil & gas microcap – declared a genuine related party transaction, buying Pitreadie Farm which is 75% owned by the executive chairman's wife.  

There's potential for wind turbines, a solar farm and biomass production on its Scottish land, and Parkmead is to issue £4.9 million shares also assume £3.6 million debt held by Pitreadie.  The said rationale exemplifies energy industry transition towards lower-carbon fuels especially natural gas and renewable, although "oil and gas will have a very important role to play in the energy mix in future years."

While Parkmead shares have quite similarly fallen back from 73p last April, amid concerns for the global economy hence commodities, they are down about 10% to 46p on this deal.  For those wanting to investigate further, there’s more questions being posed online (just Google) linking chiefly to its related party nature.

All this aligns with change in investor demand

Many of the oil majors are investing in renewable as a push towards cleaner energy, albeit hesitatingly due to low - if mostly guaranteed - returns.  My initial sense of Parkmead's tactic is to position the group for long-term acquisition by say a mid-cap oil & gas group seeking to augment such operations.  Despite criticism about how Pitreadie looks incestuous, it’s a logical diversification like Anglo is making – otherwise risk of a "fossil fuel discount" as investors likewise change practice.

Among sovereign wealth funds for example, Saudi Arabia's "oil fund" has ironically sold its last oil & gas assets and Norway's is investing heavily in wind and solar as it divests £7 billion equivalent worth of oil & gas stocks – notably retaining firms such as BP (LSE:BP.) and Royal Dutch Shell (LSE:RDSB) given they have renewable energy divisions.

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Such a move by Norway thus affirms Parkmead's move and applies similarly to Anglo.  From the 1990's there was a reaction to firms' diversifying on grounds, portfolio managers could achieve this more capably than company managers – who should stay focused – but Norway has set precedent:

"You the fossil fuel industry will be sold off unless you adapt."

Anglo has shown strengthening momentum

Financial results this year have been encouraging albeit tinted lately on prospects for coal prices, which begs the question about whether the stock already discounts risk or will succumb to further downside.  Ultimately, that’s a macro call on whether the US and China can work out their trade differences.

The 2018 results for example enjoyed a 16% rise in royalty revenue to £46.1 million versus constant overheads, thus a 21% increase in operating profit.  Free cash flow per share of 22.8p was broadly in line with last year but well ahead of adjusted earnings per share (EPS) – the company puts at 18p, though databases may cite 16.7p.

This comfortably enables 14% dividend growth to 8p.  Guidance has lately risen to 9p in respect of 2019 for a 4.7% yield, although that could be seen as minimum requirement should global growth falter.  Net assets per share were 120p or 81p on a net tangible basis, which likewise puts attention on any change in Anglo's narrative – potentially affecting profits.

The 22 August interims benefited both in balance sheet and income terms.  A surge in overall valuation of financial royalties explains a 19% rise in end-June net assets to 143p a share or 105p on a net tangible basis.  The principal Kestrel coal royalty saw a 60% revenue increase to represent 73% of £31.3 million total – in line with the Kestrel owner's target to increase production volumes by 40% in 2019.

Other interests were up-and-down, although the Narrabri coal royalty – the next most significant - rebounded 56% to £2.3 million having overcome geotechnical issues.  It still computes impressively to adjusted interim EPS up 42% and operational cash flow up 78% to £26.6 million, which has enabled borrowings to be repaid in full – and left £14.5 million cash as of end-June, versus £3.1 million net debt at end-2018.

Such numbers are rear-view mirror however

The Anglo chief executive's review cites mixed issues for longer-term thermal coal demand after a strong run in prices since end-2017.  High demand from China and India conflated with supply disruptions in Australia, which encourages Indonesia and Russia to supply more and India to become less reliant on Australia via its own production.

Slowdown in the Chinese economy could mean less demand for power, hence thermal coal prices are expected to fall 16% in the second half of this year and 9% in 2020.  It's why Anglo's broker (Peel Hunt) is projecting adjusted EPS of 25.2p this year (a 40% surge on 2018), but only 24.3p of EPS in 2020.

If this is fair, then at 190p the stock represents at least a 'hold', but if you are a cynical veteran of commodity cycles, then you may fear that the latest generation of analysts under-estimates how economic downturns can hit prices – coal being especially exposed.  So, despite Anglo's justified attempt at diversification, with fresh money 'avoid'.  If such a view gains credence, then the stock can drift simply on buyer caution.

My gut tells me to be wary in the near term, although Anglo continues to develop well longer-term and evolve as a takeover target.  So, I moderate my 'buy' stance for now to counsel shareholders: Hold.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.