Macro Tsimmis

intelligently hedged investment

BUY Fording Canadian Coal Trust (FDG)—steel coal at a steal

Posted by intelledgement on Tue, 20 Mar 07

OK, this one requires a bit of explaining. Well…of course, we explain them all, but this one really needs it.

Fording is an open-ended mutual trust whose main asset is a 60% interest in Elk Valley Coal Partnership, which produces and sells hard coking coal, the premium flavor of metallurgical coal used in the integrated steel mill process. There are a large number of Canadian energy trusts, most in the oil and natural gas business, and for years they have been known as rock solid widow-and-orphan operations that pay a large dividend and deliver solid if unspectacular growth. Not the usual profile for an ISOP equity.

But a funny thing happened to FDG on the way to 2007—the stock dropped by more than 50%. Actually, two funny things happened, which the precipitous decline in the value of the stock was just reflecting. The first things was a severe cyclical drop in premium coking coal demand. Ironically, it was a “too much of a good thing” situation, whereby high demand for steel had driven up the price of premium coking coal to the point where a lot of companies opted to use cheaper, lower quality coal. FDG were forced to cut their precious dividend (which is essentially a share of ongoing profits, and of course they were down) and over the course of five months or so, the stock price fell about 40% from the low $40s to around US$25/share.

This was round about late last summer, early last fall…folks were basically thinking that FDG would be back when demand picked back up, even if it were at a lower price point for coking coal…the stock rallied once from US$25 to US$30 and then came back down to test $25 again…it appeared to be bouncing northwards again…was US$25 finally the bottom, then? And then the second funny thing: the Halloween Massacre!

The Canadian energy trusts exist because of a feature of Canadian tax law that enables trusts to pass profits along to shareholders untaxed. On 31 October 2006, Conservative Party Finance Minister Jim Flaherty staggered the investment world with an announcement that the government was no longer allowing royal trusts to form and that all existing ones (except for REITs) would have to start paying the standard 31% corporate tax in 2011. The reason Flaherty cited was too much foreign ownership of the trust stock meant that the income was mostly evading Canada’s coffers. This sort of move might have been expected from a Liberal government, but coming from a Conservative government, it was a shock.

FDG stock plunged another 20% in a week. This time, it had lots of company, as all the Canadian energy trusts tanked.

Which brings us to our purchase thesis: the underlying value of the assets controlled by the trust is now greater than the current marketcap (US$3.3B) with the price still hovering around US$22/share here. We are not sure how much Fording’s premier coking coal interests are worth on the open market, but with all the steel demand in Asia, it’s gotta be pushing US$6B. (T’would be delicious irony if the Canadian government, worried about losing income to foreign investors and solving that problem by forcing the trusts to restructure/sell assets to extract value ends up with large swathes of Canada’s energy assets foreign controlled…afterall, who else has that sort of cash to throw around? Hmmm…does anyone know if the Chinese government contributed to Jim Flaherty’s last election campaign? They should mos def help him out the next time around!)

Of course, all the Canadian energy trusts are down now in the wake of the Halloween Massacre…but FDG is down the most due to the earlier cyclical coking coal pricing decline. And we believe it has the most potential to move back on up.

And—here’s the kicker—in the meantime, FDG are still paying a 7% dividend…a lot lower than it used to be, but nice money to be paid while waiting the The Street to wake up and smell the coke.


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