Noble Group - Offer for Gloucester Coal closed, Acquires 87.7% of Gloucester Coal

Acquired 87.7% of Gloucester Coal. Noble’s A$7/share offer for ASX-listed Gloucester Coal has closed, with the company now having an 87.7% stake vs. 21.7% prior to the offer. A$7/share equates to 10.3x CY10 P/E, based on consensus estimates. We estimate the outlay for the additional 66% stake at US$301m, with funding likely to come from Noble’s internal sources, given its ample cash of US$1.2bn as at 1Q09. However, the 87.7% stake is below the 90% hurdle required for compulsory acquisition, implying that Gloucester Coal will remain listed. We understand that Credit Suisse and Itochu together own more than 10% of Gloucester. With Noble taking control of Gloucester Coal, a new Gloucester board has been appointed, which now includes Noble’s COO, Mr. Ricardo Leiman, and Noble’s Group Head of Coal and Coke, Mr. William Randall.

Outright acquisitions are not the norm. Noble prefers to take minority stakes mostly to secure the supply of commodities. While ownership of assets could bring greater margins (from value-add as producers), earnings volatility is also higher from product price changes and operating cost variability, and higher capital outlays to acquire assets outright. We believe that this acquisition was triggered by Noble’s view that Gloucester’s proposed merger with Whitehaven would not be in its best interests, and also recognition that Gloucester Coal is undervalued. An independent expert, PwCS,has offered a valuation estimate of A$8-11/share. Noble is familiar with Gloucester Coal, having taken a 21.7% equity stake earlier, and buys around 25% of Gloucester’s coal output. In 2007, Noble blocked Xstrata’s A$4.75/share bid for Gloucester Coal. With Gloucester Coal keeping its ASX listing, there is a possibility that Noble’s other Australian coal assets, such as Donaldson Coal, may be injected into Gloucester, rather than opt for a separate listing. The listing of Donaldson Coal, 70% owned by Noble, had been scuttled by the market downturn in 2H08.

Improving outlook. The outlook for soft commodities is a little mixed in the near term with lower prices, reduced fertiliser use, and poor weather contributing to lower production of soybeans in South America. Estimates are calling for 711m fewer bushels (19m tonnes) of soybeans this year over last year. While the reduced production could constrain volume in the near term, the resultant price rise will likely lead to increased plantings and fertiliser use in the next planting season, implying abumper harvest next year. The supply boost next year would benefit Noble when its new crushing plant in Argentina commences operations as the plant will be purchasing in a buyers’ market. The outlook for iron ore has also improved with prices rising and China’s steel manufacturers raising prices, suggesting stronger demand.

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Noble Group Ltd: Good performance despite harsh operating conditions

Laudable market share gains. Noble Group Ltd's (Noble) 1Q09 results exceeded expectations. The group managed to grow its volume across all business segments despite challenging operating conditions, demonstrating its ability to expand market share by delivering superior service quality. Total tonnage rose 26% to a record 49.3m MT. Revenue and earnings fell as a result of the slump in commodities prices, but this was to be expected. Revenue declined by 36.0% YoY to US$6.1b while net profit contracted 46.0% to US$90.2m, forming 24% of our full year earnings estimate. Stripping away the impact of one-off gains in 1Q08, core net profit would have contracted by a smaller 24.4%.

Agriculture - a steady pillar of support. Not surprisingly, the Agriculture segment helped to steady the group's earnings, turning in a 11.7% YoY growth in gross profit. All other segments registered lower gross profits as the global recession crimped demand for energy and hard commodities. Gross profit from the Energy segment declined by 64.0%, while that from Metals, Minerals & Ores (MMO) fell by 75.5%. This resulted in the group's total gross profit falling 37.3% to US$222.7m. On the bright side, the MMO segment returned to profitability in 1Q09 after suffering two quarters of losses, suggesting that the worst may be over and that markets could be normalising.

Balance sheet remains healthy. Noble maintained a healthy balance sheet with cash position stable at US$1.2b (vs. US$1.3b in 4Q08). The group remained in a net cash position after adjusting for readily marketable inventories. Cash conversion cycle improved to 11 days from 14 days a year ago, while proportion of hedged inventories remained robust at 93%. More significantly, operating cash inflow improved to US$77.4m vs. an outflow of US$120.3m a year ago, thanks to lower commodity prices. Lower commodity prices have helped to reduce the group's working capital requirements and need for debt, allowing it to retire US$45m of long term debt in 1Q09, and in turn, easing finance costs.

Poised to benefit from economic recovery. Having gained its foothold with greater market share, Noble is well poised to leverage on the global economic recovery as well as pump-priming activities. We are keeping our earnings estimate intact, and raising our fair value estimate to S$1.66 (from S$1.33) as we lift our valuation parameter to 10x from 8x to account for heightened risk appetite for cyclical recovery stocks. Maintain BUY.

Noble Downgrade to UNDERPERFORM as Staying cautious on cyclical core

Our recent discussions with Noble’s management, coupled with anecdotes from dry bulk shippers, reinforce our cautious view on the fundamentals of its core commodities business. Despite a firm grains outlook, coal and iron ore demand remains weak.

We have made modest adjustments to our model, raising agricultural margins but lowering volumes, and factoring in less optimistic assumptions for the energy and MMO segments, the latter on the back of new iron ore demand forecasts. We thus lower FY09E and raise FY10E earnings by 7% and 8%, respectively.

We now forecast aggregate volume growth of 0.8% YoY in FY09E, from 9.3% YoY previously, with core earnings to decline 53% YoY. In Noble’s recently published annual report, management explicitly targets to maintain FY08 volumes in the current year.

Noble trades at 14x P/E, versus its historical and peer averages of 8.5x and 12x, respectively. On our new DCF-based S$0.95 target price (from S$1.20) and given the recent rally then, we downgrade the stock from Neutral to UNDERPERFORM. We prefer Olam (OUTPERFORM) for its steadier volume and earnings growth.

Comments from dry bulk shippers at our AIC indicate that the recent BDI rebound could likely be driven by inventories restocking rather than a fundamental demand surge. This suggests that the BDI may be due for a correction in the near term, in view of China’s recent record iron ore imports but limited steel production growth. There are, however, expectations of a demand recovery in 2H09 as the stimulus packages globally take effect. While the conclusion of iron ore negotiations could be a BDI trigger, the impact could likely be muted with current spot prices close to contract prices.

Fundamentally, we remain cautious on the earnings outlook for Noble, as its product portfolio remains significantly more cyclical. Noble is involved in three core commodities – agriculture crops, energy products and industrial materials – and is facing considerable headwinds for the latter two of these segments, which in aggregate contributed 67% of total revenue and 34% of total profit in FY08. The outlook for grains is expected to remain firm, and remains the strongest amongst Noble’s three core commodity segments, as the soybean pipeline gains traction, supported by the integration of S. American origination activities. Management also expects prices to stay firm throughout 2009, with sufficient disruptions due to climate-related factors to keep supply/demand tight.

The China PMI rose to 52.4 in March 2009, the fourth consecutive monthly increase, and more importantly rose above 50, suggesting an expansion for the first time since August 2008. CS thus sees lower risks to our 8% China GDP growth forecast. We believe this is positive for sentiment, although it does not deviate from our view that the global recovery will start in 2H09, and improve into 2010E.

Our Global Metals & Mining team has revised its iron ore demand model to reflect lower steel production levels in most major seaborne importing countries. Iron ore had grappled for five years to keep pace with increasing steel demand (which dissipated in 2H08) even before the industry achieved structural oversupply. With iron ore supply brought on to provide for the steel industry at near full employment then, on CS estimates, demand may only return to 2007/8 levels by 2012E.

The coal market should continue to see a decline in prices, on the back of more subdued crude oil prices. Even with a recovery in demand for materials in 2H09, CS expects cement and steel to lead the way, given coal’s profile as a late cycle player. We therefore anticipate continued demand destruction for Noble’s energy and MMO product segments in the near term.

Noble Group - Changing tide - Sell

As a trader of industrial and agricultural raw materials, and a corporate and logistics services provider, Noble Group enjoys a formidable position in global commodity supply-chain management. However, most of its divisions are under pressure as volumes and margins succumb to global headwinds. The stock trades at 13x 09CL PE versus 10x for peers. Our S$0.70 target price is based on DCF and peer valuations, implying 32% downside. We initiate coverage on the stock with a SELL call.

Energy resources and metals make up more than 60% of Noble’s sales. Excess global metal inventories, peaking power demand and a policy shift away from coal towards greener energy sources means the long-term structural demand for these products is under pressure. While we see a silver lining in public pump-priming efforts, this would not be enough to offset weakness in private consumption. Together with weak prices, 2009 earnings should retreat 64% YoY. We believe the Street has yet to fully reflect this in its estimates, hence our below-consensus forecasts.

Biased towards staple commodities, Noble’s agribusiness volume will grow with global consumption in the long term. However, falling prices will squash margins. We expect agriculture gross-profit margins to return to levels seen before the 2008 commodity bubble (from 4.4% per tonne to 3.3% by 2010). Historically, Noble’s logistics profit does not gyrate in sympathy with the Baltic Dry Index (BDI). Hence, we argue that it is not a BDI play and we should not see the recent recovery of the index as a positive price catalyst.

Noble’s debt profile is biased towards long-term non-bank capital-market instruments, significantly reducing its refinancing risks. Also, falling commodity prices and hence lower working-capital requirements to fund inventories would translate into lower interest costs. Nevertheless, group EVA™ will turn negative in the medium term due to contracting earnings and limited capital-management initiatives.

At 13x 09CL PE, Noble is at a 62% premium to its long-term average. It is also trading at a large premium to the peer average of 10x and in line with higher-yielding Singapore mid caps. To reflect Noble’s transformation from a supplier to a producer, we base our target price on a blend of DCF using a 10% WACC and peer valuations, implying 32% downside.

Noble - Resilient performance

Proved its resilience in 4Q08. Noble Group Ltd (Noble) delivered a 19% YoY rise in 4Q08 revenue to US$6.8b accompanied by a 24% growth in net profit to US$138.9m. For FY08, the group reported a 54% gain in revenue to US$36.1b and a 124% surge in net profit to US$577.3m, which was a shade lower than our expectations but above the street's US$544.7m estimate. Excluding one-off items, we estimate that net profit would have risen 83.4% to US$473.4m. A 4.4 US cent dividend has been declared, translating to a yield of 5.8%.

Gross profits robust. All its key segments except for Metals, Minerals & Ores (MMO) posted higher gross profits in FY08. Agriculture was the strongest segment with a 117.5% growth. In contrast, MMO weakened by 28.5% due to sluggish demand for metals following the global economic crisis. Much of the year's growth was concentrated in 1H08. Growth momentum tapered off in 2H08 as the economic crisis struck, painting a less rosy outlook for 2009.

Balance sheet remains healthy. Noble's financial standing remains strong. The group has emerged to a net cash position (after adjusting for readily marketable inventories). Its financial strength is good (net cash) vs. its peer Olam with an adjusted gearing ratio of 0.74x. Noble's cash position improved to US$1.3b in Dec 08 (vs. US$0.7b a year ago), more than sufficient to cover its short term debt of US$0.5b. We expect low commodity prices to ease working capital requirements in FY09. Debt profile is also healthy with 80% of debt possessing maturities in excess of 18 months.

In good shape to ride out the storm. Noble has proven its resilience by performing well against a volatile backdrop in 2008, but it is not immune to the global economic downturn. Tonnage eased in 2H08 as the credit crunch led to a drought of Letters of Credit (LC) and counterparty risk grew more pronounced. This situation is likely to persist in 2009, and in the absence of counterparty credit insurance, we expect business activity to remain suppressed. We have trimmed our FY09 earnings estimate by 18% and expect core earnings to contract by 20%. Noble has announced an offer to acquire Australia listed Gloucester Coal for US$201.5m. It has the financial muscle to carry out an all-cash purchase given its robust US$1.3b cash position. We maintain our BUY rating, but ease our fair value estimate to S$1.33 (from S$1.58) on lower earnings forecast.