Value Investors Club / Mongolian Mining Corp (975)

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What is the most contrarian thing you can buy today? How about owning the equity in a bankrupt

Mongolian coal miner? I think Mongolian Mining Corp (MMC) has the makings of a multi-bagger

(possibly even 20-bagger). Crazy right? That’s why it’s called contrarian investing. Apologies in advance,

this write-up will be short on numbers and tangible data and long on Mongolian politics. In the end,

that’s really the thesis here. The past no longer matters.

MMC owns the Ukhaa Khudag (UKG) coking coal mine, which makes up a tiny fraction of the massive

Tavan Tolgoi (TT) coking coal deposit. TT is the world’s largest coking coal deposit situated about 200 km

from the border of China, the largest user of the stuff. Due to the size and seam width of the deposit, it

is one of the lowest cost coking coal mines in the world and its proximity to China should effectively

knock Australian seaborne coal out of the market. In a perfect world, UKG and TT coal should be mined

and railroaded directly to Chinese steel plants from the mine-mouth, saving substantially in handling

cost when compared to Australian chipping costs. The Aussies on the other hand railroad it to a port,

put it on a ship, unload the ship in China and then ship it by train to the steel mill in China. It’s the

handling costs that are expensive and Australian coal should not be going to China when compared with

Mongolian coal that can be shipped anywhere in China directly from the mine-mouth by rail.

Unfortunately, due to domestic politics (more below), MMC now trucks the coal in huge caravans of

trucks nearly 200 km to the border, where it is dumped in large piles to be picked up by Chinese traders

who then drive it to railheads in China before finally getting on a railroad. Due to this dysfunctional

supply chain MMC coal is not competitive currently. This has led to a near ceasing of production and the

default of MMC’s approximately US $700 million debt burden. I believe that over the next few months

there will be a clear path to resolving the debt and railroad issues which should lead to a very

substantial revaluation of the shares which have effectively been left for dead.

Let’s talk politics

Mongolian politics is notoriously colorful and dysfunctional where personal feuds and interests often

overshadow national interests. There are 2 key parties, Democratic Party (DP) and Mongolian People’s

Party (MPP). When the DP won the election in 2012, they immediately set out to destroy all MPP owned

companies and interests. MMC is the largest MPP owned company and it was directly targeted for

destruction. During the past four years, the country changed the tax and royalty rates on coal

companies, selectively closed and moved border crossings to inhibit MMC coal from being sold,

confiscated MMC’s existing paved road to the border, banned MMC from building a railroad to the

border and generally succeeded in destroying the company’s ability to operate or succeed. Adding insult

to injury, the government owns the TT deposit and has consistently produced coal and sold it for less

than market prices, effectively undercutting MMC coal—while also creating a glut at the border and

largely bankrupting the government’s coal company (ETT) in the process. MMC stopped production, but

the government’s ETT continues to produce at massive losses for no logical reason.

In 2015, MMC was able to put together a consortium of leading Chinese and Japanese firms (including

Shenhua Energy and Sumitomo) that would pay to build a railroad to the border, build a power plant

and then operate the TT mine so that the government of Mongolia would no longer be in the coal

business. Instead, the government was to earn royalties and taxes. MMC would benefit as project

operator, but more importantly, they would get access to the new railroad that would make their coal

cheaper than Australian coal and let them once again ramp up production from almost nothing to nearly

10 million tons a year without substantial additional capital investment as all mining is done by a

contractor. It was a brilliant deal for all involved, but the DP government was so focused on destroying

MMC that they refused a deal that would have improved the government’s own finances.

The economic disruption caused by the DP became their undoing. When they took over in 2012, the

economy under MPP leadership was growing at 17%. Following a war on MPP and foreign businesses,

confiscations of assets and arbitrary imprisonment of many foreign business leaders the economy has

collapsed. Today, the GDP is rapidly contracting. The government’s deficit is over 20% of GDP, the

central bank has a negative balance sheet and the government hasn’t paid workers in months. It

appears that an IMF bailout is imminent and that the government may default on its sovereign debt. In

June, the MPP won a landslide victory where they secured 65 out of 76 seats in parliament, giving them

a clear mandate to fix the disaster created by the DP and much more importantly, to reward key MPP

businesses. No Mongolian owned business in Mongolia is larger than MMC and the key MMC

shareholders directly funded much of the MPP election campaign. I suspect that those shareholders will

now reap the rewards.

It has now been 2 months since the elections, the key ministers have been chosen and I think everyone

is ready to get down to business. To start with, the government will stop selling coal for $25/ton when

the price at the border is over $50. This became clear when the head of ETT, the government’s coal

company was replaced on Friday with an MPP executive. The head of Erdenes Mongol, the state owned

company that owns MMC's confiscated road, along with ETT is stepping down next week

It seems pretty obvious that the consortium deal is back on the table and will probably become sweeter

for MMC than the prior version—or at least, that was the speculation last week at a dinner party I

hosted where multiple people close to the talks attended. In addition, there’s also a strong likelihood

that MMC’s 18 million ton wash plant will be used to wash ETT coal in a toll mining situation.

The new railroad, a toll washing agreement on ETT coal, management of the ETT mine all will create

huge value. No one knows the terms yet, but people are throwing around cash flow estimates to MMC

in the hundreds of millions (possibly even a billion) annually at current coal prices--coal prices keep rallying

as well. There’s just one problem with this all playing out, MMC still owes globs of debt that it has defaulted

on—the creditors are still in control (sort of).

Let me state the obvious—the creditors have no idea what to do with this debt. It’s not like they can

seize the crown jewel of one of the most powerful guys in Mongolia and then operate it when he controls the

government. In one of the craziest bankruptcies I have ever seen, the creditors have agreed to take a

massive haircut on their debt (US $750m becomes $570m) with the new bonds paying interest in PIK

format along with varied payments based on coal prices. In exchange, creditors are getting 10% of the

equity. As I said, I’ve never seen anything like it. The only holdup now is BNP Paribas who is fighting for

better terms on their $93 million of debt. Fortunately, the joint provisional liquidator (JPL) seems to be

pushing back against them and is likely to force a deal soon.

As you can imagine, MMC wants to look as broke as possible during bankruptcy negotiations and any

deal on the consortium is very much on the back-burner and out of sight as well. For this reason, despite

an increase in coal prices to a level that is quite profitable, MMC has not increased production—heck,

they even took an impairment on their coal stockpile to make their first half loss look worse.

So, that’s the roadmap as I see it. At some point in the next month or 2, MMC will have settled with

creditors and no longer have onerous cash interest costs. At that point, it can start producing coal and

selling it into a market that is no longer saturated with underpriced ETT coal. A consortium deal will be

announced before year-end and suddenly there will be a roadmap towards a company that can produce

hundreds of millions a year in cash flow. Not bad for a company with a market cap today of only a

hundred million. By the way, if you don’t believe me, look at the stock trading lately. Since the election,

lots of plugged in Mongolians are buying all that they can get and many of these guys are the

parliamentarians who will approve the consortium deal this fall.

I apologize in advance if this is the most unorthodox VIC write-up of all time. Any analysis of the past is

almost irrelevant. All that matters is that there’s an MPP government, an MPP controlled company and a

country that is totally broke and in desperate need of good news, jobs, taxes and royalties. A deal was

on the table last year, it’s still on the table (silently) and MMC is going to clinch it this year.

It’s worth noting that when the consortium deal was only talk in the back rooms of parliament, the MPP

shareholders did a rights offering at 28c and fully subscribed for their shares in order to increase their

ownership, even though it was unlikely that the consortium deal could get through a DP government. If

they thought the shares were cheap at 28c, they must think it’s a much better deal today at 11c with a

higher coal price and full control of the government.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Finalization of debt renegotiations

Agreement on consortium deal to produce 50-75m tons per year of coking coal

Higher coal prices

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			2016	2017
Price:	0.11	EPS	0	0
Shares Out. (in M):	9,263	P/E	0	0
Market Cap (in $M):	134	P/FCF	0	0
Net Debt (in $M):	750	EBIT	0	0
TEV (in $M):	900	TEV/EBIT	0	0