Stockwatch: Double-digit yield is reward for risk

Have shares in mining royalties group Anglo Pacific reached a turning point? In recent years they have been a dreadful bear market from 360p with the fall accelerating last autumn as fears of deflation hit miners.

Down at 82p however, the stock has bounced near 90p after the company announced an acquisition financed by a placing and open offer at 80p, also a $30 million (£19.7 million) three-year revolving credit facility. Existing shareholders are being diluted some 40% in order to buy a private royalty interest in Narrabri, a major thermal coal operation in Australia. For context, the price agreed is £42 million equivalent relative to a market cap of £102 million.

On the same day there was a separate announcement, "Dividend Policy", citing it "revised...a commitment to a minimum total dividend of 8p a share (so far as practicable) and in the longer term a distribution of at least 65% of adjusted earnings." If realistic, such a policy would be shareholder-friendly and also likely to drive a stock re-rating once the market can see adequate earnings cover (see table).

The price of thermal coal is near a five-year low and management contends it is opportune to acquire further coal royalties and then diversify; furthermore this Narrabri mine is a low-cost producer with an estimated 22 years of life, i.e. a potentially very valuable royalty. Fine in principle if strongly weighting Anglo to risk/reward factors affecting coal prices in the short to medium term.

A shrewd or desperate, contra-cyclical move to bolster the dividend?

A 9 January trading update showed gross royalty income for 2014 expected at £3.2 million to £3.6 million, with gross proceeds from disposals of about £8.7 m million This compares with about £11 million paid in annual dividends in each of the last two years.

Royalty income has been depressed due to temporary suspension of mining on land for the Kestrel royalty which should recommence this year. But if for any reason it doesn't then Anglo would look compromised in terms of declared objectives. Entitling Anglo to royalty income from 1 January 2015, Narrabri appears to bolster security of the dividend; therefore it could also be seen as an urgently defensive move, besides the logic for a shrewd deal at what may be a low range in the coal cycle.

Hedge fund managers turned royalties' financiers

There may also be a behavioural aspect: a vigorous management doesnt sit still for long. Respectively, Julian Treger and Mark Potter were appointed as chief executive and chief investment officer in October 2013, also being principals in the hedge fund Audley Capital.

Treger has a long history of shareholder activism i.e. persuading company boards to adopt policies that improve returns to shareholders. This type of buccaneer can generate useful returns; but bear in mind also that no one has a crystal ball. My recollection is Audley/Treger being enthusiasts for the acquisition of AIM-listed Western Canadian Coal (where they were substantial shareholders) by US-listed Walter Energy structured in a mixture of shares and cash. But this move proved a classic "deal too far" at the top of the last coal bull market, since when miners have struggled with over-capacity.

Walter's stock has plunged from $140 in 2011 to $1 as a result of the group becoming over-indebted versus oil and natural gas being too cheap to make coal viable. Various Canadian coking coal-mines have had to be idled. Even if Audley exited on the way down, this deal testifies to managers and financiers doing the wrong things for shareholder value and security of firms, at the wrong time. The cycles in coal mining can be capricious.

As recently as a 22 December portfolio update the chief executive had said: "The future prospects for Anglo Pacific continue to be positive given no debt, the quality of our royalty portfolio, etc." So there appears some departure from stated conservative principles, towards more radical action.

Course of the Chinese economy will be a principal influence

This vigour can be justified in the sense that no-one will call the floor of the current commodities’ downturn; just as you might average into a stock to roughly exploit a low in its cycle, these managers are generating firepower to do deals in the mining sector - say over the next two years. But unless coal markets improve soon it looks like they will have to keep issuing shares at the very least.

So it depends on the course of the Chinese economy as the critical determinant of commodity pricing; whether the Communist Party can manage through its challenges or the debt bubble bursts. Economic history informs us, it is never possible for a nation to run up debts as quickly as China has done, without escaping a slump. Obviously, there have been stark warnings of this for a few years and yet Chinese growth remains relatively superior. Latest trade data shows imports down sharply in January though, as if demand is slowing.

Chief executive has bought substantially; and higher

Through investment companies, Treger bought 1.2 million Anglo shares at 195p in a placing when he joined in October 2013, while Potter subscribed for 51,281. Confirmation of the latest placing showed Treger subscribing for a total 5,362,599 shares taking his stake to 3.86% of the enlarged group. While one can question some of his actions, it’s hard to find a better example of a director backing deeds with money.

So take your view as to the cycle and your risk preference

Whether to buy/hold ultimately depends on how long and deep this commodities downturn will last; what extent of risk you want to engage. If "secular stagnation" applies then the stock may not perform greatly; the market could continue to price it modestly, ensuring a high yield for the risks involved. Yet this could be fair compensation to shareholders if management can capably acquire more royalties to position Anglo well for the next upturn - without excess debt or dilution. The big risk is over-opportunism meeting a Chinese bust.

For more information see anglopacificgroup.com.