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Sinocoking Coal In The Coal Markets Finance Essay

SinoCoking Coal and Coke Chemical Industries Inc, (SCOK) is a China-based producer, seller and trader of coal and coke products. The company primarily produces two types of coke, metallurgical coke mostly used in steel manufacturing, and chemical coke used mainly for synthesis gas production. It also sells raw coal, washed coal and other byproducts such as coal tar. SCOK operates an underground coal mine (Baofeng mine) located in the central part of Hunan Province, which has total in-place proven and probable reserves of 2.5 million tonnes of coal, of which 1.2 million tonnes are recoverable. It has a vertically integrated manufacturing facility wherein the extracted coal from its Baofeng mine is transported to its coal washing plant and then the washed coal goes to coke processing facility to produce coke. The coal washing facility has an annual production capacity to process 750,000 tonnes of coal while coke processing plant has an annual production capacity of 250,000 tonnes, which will expand to handle annual production of 900,000 tonnes by 3Q11. During FY09, the company sold 162,277 tonnes of coke products and 284,840 tons of coal products. The company either sells its products to distributors or trading companies depending upon the type of product sold. SCOK currently employs 545 employees, of them 385 are mine workers, 122 are coking plant workers and 38 are in an administrative or executive capacity.

SinoCoking, formerly Ableauctions.com Inc., was founded on September 30, 1996 under the laws of the state of Florida. It ceased its historical auctions and real estate-related businesses in Feb-10 when it acquired Top Favour Ltd, a British Virgin Islands company engaged in the business of coal and coke products, through a reverse merger transaction. Top Favour commenced with the formation of Henan Province Pingdingshan Hongli Coal & Coke Co. Ltd. in 1996, with a focus on coal mining. It later expanded its business activities to include coke production and electricity generation. The company’s common stock trades on the Nasdaq Capital Market under the symbol “SCOK”.

Source: Company Report, RODM Research

SCOK’s Corporate Structure

Private placements of common shares

SinoCoking recently raised aggregate gross proceeds of $44.1 million through a series of common shares issuances to finance the construction of a new coke manufacturing facility and associated working capital needs. It privately placed 1.2 million of its units in Feb-10, and 6.2 million units in Mar-10. All the units above were issued at a price of $6.00 per share. Each unit consists of one common share and one warrant for the purchase of 0.5 common shares with an exercise price of $12.00 per share. In aggregate, the company issued a total of 7.3 million shares of common stock, and five-year warrants for the purchase of an additional 5.3 million shares of common stock.

Capital Raised

Number of Shares

Issue Price Per Share

Gross proceeds

Warrants equivalent to common shares

Exercise price per share

Warrants Validity

Feb-10 Private Placement

1,180,892

$6.00

7,085,352

590,446

$12.00

5 years

Mar-10 Private Placement

6,164,043

$6.00

36,984,258

3,082,022

$12.00

5 years

Total

7,344,935

$6.00

44,069,610

3,672,468

$12.00

5 years

As of May 10, 2010, the company had 20.87 million of basic shares outstanding, and 24.54 million of diluted shares outstanding.

Industry Overview

SinoCoking is primary involved in selling coal and coke products. The company produces two types of coke, metallurgical coke mostly used in steel manufacturing, and chemical coke used mainly for synthesis gas production.

World Coal Reserves

Coal is a natural resource, formed from organic matter that undergoes a series of complex transformations found beneath sedimentary layers. According to World Coal Institute, there are four types of coal, namely, bituminous, sub-bituminous, lignite, and anthracite, each accounting for 52%, 30%, 7% and 1% of total global coal supply, respectively. Bituminous Coal is split into steam coal used for power generation and cement-making and coking coal used in steelmaking.

According to US Energy Information Administration (EIA), total world recoverable coal reserves stood at 930.4 billion tonnes (down 19% from 2001), which at current production levels could last for 122 years. Despite coal deposits are widely distributed worldwide, 80% of recoverable coal deposits are located in five countries: the U.S has the largest coal reserve with 28% of the world reserve, followed by Russia (19%), China (14%), India (10%) and Australia (9%).

The Global Coal Industry

Global demand for coal has been growing, particularly in Asia, as a result of increasing demand for power, growing industrial production and the competitiveness of coal as a cost-efficient energy source. According to EIA, the global coal consumption has grown by over 42% in the last 13 years to 7.23 billion tonnes in 2008 and is expected to grow 32% by 2015 and by 59% by 2030. Interestingly, more than 85% of the expected increase in demand is expected to come from China. China is the world’s largest coal producer with 2.84 billion tonnes, representing ~40% of the total world coal production in 2008, up from 26% in 2000. China consumed 2.83 billion tonnes in 2008 and also remained the largest coal consumer in the world. Australia is largest coal exporter in the world.

Coal remains a key source of energy in the world and generates ~30% of the world’s electricity. Coal is the world’s most abundant and widely distributed fossil fuel and primarily considered as one of the most affordable sources of energy in the world.

China Coal Industry

According to National Statistics Bureau of China, Coal production has grown from 1.27 billion tonnes in 2000 to 3.05 billion tonnes in 2009 and is estimated to grow 4% CAGR to reach 3.75 billion tonnes in 2015. Similarly, consumption of coal increased from 1.24 billion tonnes in 2000 to 3.02 billion tonnes in 2009 and is estimated to grow to 3.7 billion tonnes in 2015. The rising coal consumption is primarily driven by several factors like rapid economic growth, urbanization, heavy industrial growth, and increasing per-capita income.

The energy sector consumes bulk of coal production in China, accounting for 56% of coal consumption in 2009, followed by steel and cement sectors, accounting for 17% and 15% respectively. The rest is consumed by the chemicals and others sectors. Although China has a smaller coal reserve base than the United States and Russia, it is more dependent on coal as a primary source of energy.

Source: National Statistics Bureau of China (NBS), Bloomberg, Rodman & Research Equity Research

China to remain a net importer of Coal

China has been a net exporter of coal for many years now, exporting around 83 million metric tonnes more than it imported internationally in 2003. However, imports started rising after 2003 because imported coal prices including transportation became competitive with domestic production prices. During 2009, lower coal prices in the Asia Pacific market and a substantial reduction in sea freight encouraged more imports and helped China turn from a net exporter with 18.4 million tonnes in 2008 to a net importer with 103.4 million tonnes in 2009.

Source: Bloomberg, Rodman &Renshaw Research

Looking ahead, the coal spot price and sea freight of Asia Pacific region are expected to rebound in 2010 with the visible recovery in the demand of major coal importing countries. The surge in international coal prices and freight rates will weaken the relative price advantage of imported coal over the domestic coal, which could reduce the coal import volume to a certain extent but China will still remain as a net importer in 2010.

Coal Prices to Move Up

The coal prices in China witnessed a phenomenal rise over the past few years mainly due to tight supply demand relationship. The annual average price of coal prices at Qinhuangdao port, the benchmark price in China, has risen sharply on supply shortages that emerged in the second half of 2003. It rose from $26 per metric ton in 2002 to $36 in 2003 and $130 in 2008, almost four fold increases from 2003 levels. However, the price fell to $92 in 2009 amid recessionary conditions in the domestic market. As the major coal consuming nations have delayed their power projects in 2009, Coal supply exceeded demand thereby dragging the international prices. The Newcastle Coal price, the world’s biggest coal harbor for Coal, declined as much as 46% in 2009 to $71 from 2008, while Qinhuangdao coal prices declined 28% during the same period. Taking advantage of lower international prices, China absorbed the excess coal supply in the Asia Pacific market, with imports increasing by ~150%.

Source: Bloomberg, Rodman &Renshaw Research

Another factor that has supported strong prices over the last few years has been the government effort to restructure the coal industry. Towards bringing efficiency and consolidating the Coal industry, the government has forced the closure of several thousands of small mines. Between 2006 and 2009, the government has closed 14,000 mines that had a total capacity of ~530 million tonnes per annum. In addition, the government has adopted a very strenuous approval process making it impossible for new players to enter the industry. As a result of all these, the supply of Coal has lagged the demand, which visibly lifted the coal prices higher. Looking ahead, we believe the prices will stay at higher levels given they buoyant Chinese economy and gradual recovery in the rest of world.

Consolidation to Tighten Coal Supply in 2010

China Coal industry is subject to extensive regulations by the China government. These regulations govern a wide range of areas including investments, exploration, production, mining rights, distribution, trading, transportation, and exports & imports of Coal.

China’s 11th Five Year Plan (2006-2010) is considered as main catalyst for the Coal industry as it addresses the core issues like efficiency and safety. According to the plan, there will be 10 surface coalmines with annual output at 10 million tonnes each and another 10 underground mines with the same capacity annually each. Moreover, the plan aims to consolidate the industry with 8-10 large coal enterprises with 50 million tonnes output annually each, which in aggregate will produce over 50% of the domestic coal supply. Additionally, 300 coal mines will be built up accounting for 45% of the total coal output in China.

At the beginning of 2009, the government implemented its consolidation plan in Shanxi province, which represents 20% of the total coal production in China. According to the plan, small mines with annual production capacity lower than 300,000 tonnes have all been phased out. In 2009, 1000 coal mines were closed in Shanxi, bringing the total coal production from that region to 615 million tonnes, down 6.2% from 2008. Additionally, the plan aims to bring to cut down the number of mines to 1,000 by end of 2010 and to 800 by 2015. We believe the coal production in the region is expected to come down dramatically, which could tighten the coal supply in the near term. However, after these mines are acquired and merged by large coal mines, the supply will resume back in the long term, but may not boost output any time soon.

Coke industry

Coke is the solid carbonaceous material derived from destructive distillation of low-ash, low-sulfur bituminous coal. Major Coke types include metallurgical coke and chemical coke, which are used in the manufacture of pig iron, a major component in the production of steel.

World Coke Industry

The world coke production has been growing at 6.5% CAGR from 346 million tonnes in 2000 to 571 million tonnes in 2008, before declining 10% to 511 million tonnes in 2009. The growth in coke production has been in line with the world pig iron production that has been growing at 6.1% CAGR from 576 million tonnes in 2000 to 927 million tonnes in 2008. The top five major coke producers in the world, China (60%), Japan (7%), Russia (5.6%), India (3.9%) and Ukraine (3.4%) together represent ~80% of the world coke production in 2008, according to EIA.

Source: EIA, Rodman & Renshaw Research

China Coke Industry

China is the leading coke producer, consumer and exporter in the world. China’s coke production increased from 137 million tonnes in 2003 to 348 million tonnes in 2009 while exports have increased from 10.2 million tonnes in 2004 to 15.3 million tonnes in 2007, which was almost 50% of the world’s trading volume of coke. However, in the wake of downturn, exports declined to 12 million tonnes in 2008 and further fell to 0.54 million tonnes in 2009. Part of the reason was also attributable to the increase in export tax on coke from 25% to 40%.

Coke consumption has been rising phenomenally due to higher steel demand on the back of rapid infrastructure development. The growing appetite of steel has turned the country into a steel importer as opposed to its traditional status of being a steel exporter. Coke consumption mirrored pig iron production, which is used in steel making. Between 2000 and 2008, pig iron production has almost grown by four times from 131 million tonnes in 2000 to 456 million tonnes in 2008. Coke consumption increased from xx million tonnes in 2001 to xx million tonnes in 2009 and is expected to reach 380 million tonnes in 2010, according to China Coking Industry Association.

Source: Bloomberg, Rodman & Renshaw Research

Coke Prices to Edge up on Supply Concerns

China 2nd Grade Coke Spot Price Shanghai, the benchmark coke price in China has increased significantly over the course of 2007. From RMB 1150 per metric ton at the end of 2006, coke prices reached RMB 3150 at early 2008. However, recessionary conditions pulled the prices down in later 2008 as many steel plants started cutting back the productions. Aid by stimulus package, the demand started recovering in mid 2009 and since then the coke prices have started moving up. Coke prices moved up from RMB 1700 in December 2008 to RMB 1950 in December 2009. During the first three month in 2010, the prices have remained almost in the range of RMB 1950-2050.

Looking ahead, we believe the coke prices will go up due to supply tensions arising from governments thrust in closing thousands of small- and medium-size coke plants to save energy and reduce emissions. It is estimated that China will eliminate roughly 70 million tonnes of coke production capacity in future, according to National Development and Reform Commission. Morover, the central government has introduced a new regulation to close down all the coke manufacturing facilites that have furnace height of less than 4.3 meters, which could seriously pose a threat for coke supply in China. Additionaly, the tax on coke exports in China is also likely to stay, which means approximately 14-15 million tonnes is removed from the international trading market. The loss of Chinese exports could imbalance the international trade, causing the prices to go higher. However, this will not reduce the domestic prices due to aforementioned reasons.

Source: Bloomberg, Rodman & Renshaw Research

Growth Drivers

Economic Expansion

In 2009, the global financial crisis exerted negative impact on China’s macro economy. Under the drive of the State’s economic stimulus policies, China’s macro economy are stabilizing and recovering. Industrial production improved quarter by quarter and investments continued to grow rapidly. In 2009, China’s GDP grew by 8.7% compared to 2008 while the growth in the fourth quarter of 2009 increased by 10.7% year-over -year.

In 2010, China’s macro economy is expected to grow fast and steady. The Central Government targets to achieve a GDP growth of approximately 8% for 2010. Fast and steady macro economic growth will also result in more demand for energy such as coal.

Power Sector

Economic reforms and the opening up of the Chinese market have led to tremendous growth in the power industry. According to China State Electricity Regulatory Commission, China has the highest power generating capacity in the world with installed capacity of 792.5 million kilowatts in 2008. According to a study conducted by Massachusetts Institute of Technology (MIT), rapid urbanization and industrialization caused the annual per capita electricity consumption in China to reach 1,700 kilowatt-hours (kWh), still lower than developed countries consumption levels of 8,500 kWh. This indicates the future potential demand for electricity production in China. According to IEA, electricity production in China is expected to more than double to ~5,000 Terawatts-hours (TWh) by 2015 from 2,300 TWh in 2004, thereby indicating huge demand for coal.

Source: International Energy Agency

Demand for Power Generation in China

To meet the growing electricity demand, China is supporting construction of supercritical and extra-supercritical generating units with capacities in excess of 600 MW. Under the 11th "Five-Year Plan" period (2006-2010), the government has planned to develop medium- and large-scale coal-fired projects. The development and growth of the power generation industry would also sound good for the coal industry as coal is used to produce 70-75% of the total power generated in China, and its power-generating capacity is expected to expand another 10% this year.

Rapid Steel Consumption Driving Coal Demand

China – the World’s Largest Producer and Consumer of Crude and Finished Steel

Since 1996, the Chinese steel industry has been expanding at a phenomenal rate and is now the largest in the world, both in terms of production and consumption. Aided by government support, the industry rapidly scaled up its capacity to support growing domestic demand arising from rapid economic progress. During 1999-2009, the country’s crude steel output more than tripled from 124.3 million tonnes in 1999 to 567.8 million tonnes in 2009, registering a CAGR of 16.4%, according to China’s National Bureau of Statistics (NBS), China Iron and Steel Association (CISA) and Bloomberg.

According to the CISA, China’s crude steel demand is expected to grow 8-10% during 2010 to between 610-620 million tonnes driven by the continuing stimulus package, increasing fixed-asset investment, strong retail sales, and higher exports arising from global economic recovery.

Sources: China’s NBS, CISA, WSA, Bloomberg, RODM Research

According to the World Steel Association (WSA), China’s per capita apparent finished steel consumption more than doubled from 148.5 kg in 2002 to 318.5 kg in 2008, growing at 13.6% annually. During 2008, the country’s per capita apparent finished steel consumption surpassed that of the United States (315.6 kg) for the first time. The main drivers behind this rapid growth have been the government’s stimulus package, increasing fixed-asset investment, rapid industrialization, surging automotive sales and a growing household appliances market. We believe the country’s finished steel demand to grow by 12-13% YoY in 2010, in line with the country’s per capita apparent finished steel consumption trend. Despite being the world’s largest steel manufacturer, China is still in short supply of high-end/value added finished steel products; largely relies on imports for such high-end steel products. Record steel output supports coking coal demand, with steel capacity utilization in China at about 86% as compared to the rest of the world’s <70%.

Competitive Landscape

The Coal industry in China is highly fragmented among large state-owned coal mines, local state-owned coal mines, and thousands of town and village coal mines. According to EIA, the top three state-owned coal companies produce less than 15% of the domestic consumption.

In response to the highly fragmented nature of the industry, the government has been pushing towards consolidation. Since 2004, the government has closed 14,000 small coal mines and about 500 million tonnes of capacity was removed. There are still 9,000 small coal mines, holding a sizeable portion of the market, which are inefficient.

PRODUCT PROFILE

Optimizes product mix for profit potential

SinoCoking produces basic and value added coal products like raw coal, chemical and metallurgical coke, washed coal, and coal by products like coal tar. During 2009, the company sold 229,480 tonnes of raw coal, 154,631 tonnes of coke, 55,360 tonnes of washed coal and 7,646 tonnes of coal tar.

Source: Company Reports, Rodman &Renshaw Research

SinoCoking changes its product-mix between coke products and coal products based on prevailing market prices of those products. When the metallurgical coke market witnessed a substantial weakness starting the last quarter of calendar year 2008 due to lower demand from steel industry, the company reduced coke production levels and increased coal sales and trading, in order to maintain cash flow and profitability. It also changed the composition of coal products sold to include higher-value thermal coal.

This shift toward coal sales and trading, along with the change in composition of coal products sold led to a substantial increase in revenue from coal sales, and helped the company to partially offset the adverse impact of slowdown in its principal coke product’s market. The contribution of raw coal revenue in total revenue surged to 25.6% in FY2009 from 0.6% in FY2008, while that of washed coal increased to 12.7% from 0.3%. At the same time, the share of coke revenue declined to 59.4% from 94.0% a year ago. We expect the company to tilt product-mix towards coke products during the upcoming period as the demand and prices for coke have started recovering on the back of improving global economy. Also, the start of new coke facility would raise the contribution of coke revenue in total revenue. The coke products command higher margin compared to coal trading, which should improve the company’s gross margin once the new coke capacity comes online.

Coke (59% of revenues)

Coke, SinoCoking’s principal product, is a hardened and a solid carbonaceous material derived from destructive distillation of low-ash, low-sulfur bituminous coal. The company produces two types of coke (metallurgical coke and chemical coke) from coal that it mines as well as from the coal that it purchases. The Metallurgical coke is mainly used as a fuel by steel manufacturers to smelt iron ore in a blast furnace. The chemical coke, also known as gas coke, is used to produce synthesis gas. The synthesis gas is a combustible gas made of hydrogen and carbon monoxide and is used as a fuel source or for the production of other chemicals including methanol, formaldehyde and ammonia.

The national standards classify metallurgical coke into three grades - Grade I, Grade II and Grade III - with Grade I being the highest quality. The company’s customers have historically required Grade II and III metallurgical coke. The company’s production of metallurgical coke has increased from 48,321 tonnes in FY2006 to 143,092 tonnes in FY2009, whereas that of chemical coke declined from 23,699 tonnes to 11,550 tonnes.

Metallurgical Coke

Raw Coal (26% of revenues)

SinoCoking extracts coal from Baofeng mine, where it holds mining rights to extract 2.5 million tonnes of coal. The Baofeng mine contains bituminous coal, a coal of higher quality than lignite coal but of poorer quality than anthracite coal. Around 8% of the coal extracted from the mine has properties that are suitable for coking process. The coal extracted from the mine normally has a sulfur content of less than 0.6% and energy content of 5,200-6,200 kcal/kg. The extracted coal is transported to the company’s coal-washing facility for washing and sorting. The company also purchases raw coal from third party suppliers as the amount of metallurgical-quality coal supplied by the Baofeng mine is not sufficient for its full production capacity. Apart from utilizing coal for coking process, the company occasionally also sells raw coal to its customers. The production of coal from the Baofeng mine has almost doubled over the last four years; it grew from 131,148 tonnes in FY2006 to 245,773 tonnes in FY2009.

Washed Coal (13% of revenues)

Raw coal is required to be washed in order to reduce its ash and sulfur content, and to increase its thermal value. As per the Chinese coking industry standards, raw coal with no more than 1% sulfur content is deemed appropriate for coking. Besides low sulfur content, the customers prefer coal with lower ash content and volatile matter. The company generates one ton washed coal from approximately 1.33 - 1.38 tonnes of raw coal. The company either sells washed coal to external customers or uses it for producing coke.

The coal-washing process produces two byproducts: medium coal, a coal having inadequate thermal value for coking; and coal slurries, the castoffs and debris from the washing process. Medium coal is mixed with raw coal or coal slurries, and sold for home and industrial heating purposes; and coal slurries are used as a fuel with low thermal value, and are sold “as is” or mixed with medium coal. During the period of FY2006 to FY2009, the production of washed coal raised more than two-folds to 243,958 tonnes, and the production of medium coal grew 73.1% to 17,523 tonnes of medium coal. In contrast, total tonnes of coal slurries produced by the company have declined 19.9% to 16,051 tonnes.

Coal Tar (2% of revenues)

Coal tar is a brown or black liquid of high viscosity derived as a byproduct of coke making process. Coal tar is produced from the condensation of raw coal gas generated during the coal heating process. Coal tar is a component of coal tar pitch used in the aluminum industry. The coal tar pitch is utilized by the aluminum industry to manufacture of anode blocks. Coal tar can be further refined to create chemicals and additives, such as fine phenol, fine naphthalene and modified pitch useful for making concrete sealant, wood treatment compounds, agricultural pesticides and other chemical products. It is also used in medicated shampoo, soap and ointment, as a treatment for dandruff and psoriasis.

The coal tar industry in China is currently fragmented, and characterized by large number of small producers. SinoCoking produced 7,646 tonnes of coal tar during FY2009, a 131.2% higher than the quantity of coal tar produced in FY2006. The coking process also generates other byproducts, including benzene, sulfur-based chemicals and methanol, which the company plans to produce once its new coke facility starts production.

tracted from the mine generally has a sulfur content

 of less than 0.6% and energy content of 5,200-6,200 kcal/kg

 The extracted coal is transported to SinoCoking’s plant located

 two miles from the mine site and processed at the Company’s

 coal-washing facility

The coal extracted from the mine generally has a sulfur content

 of less than 0.6% and energy content of 5,200-6,200 kcal/kg

 The extracted coal is transported to SinoCoking’s plant located

 two miles from the mine site and processed at the Company’s

 coal-washing facility

The coal extracted from the mine generally has a sulfur content

 of less than 0.6% and energy content of 5,200-6,200 kcal/kg

 The extracted coal is transported to SinoCoking’s plant located

 two miles from the mine site and processed at the Company’s

 coal-washing facility

Purified Coal Gas (new product introduced in 2011)

The purified coal gas derived after coal tar is separated from raw coal gas is used to generate electricity at its two onsite 3,000-kilowatt power stations. The each power station has an estimated maximum generating capacity of 26.3 million kilowatts per year. In FY2008, SinoCoking generated around 7.2 million kilowatt-hours of useable electrical power. The electricity that is generated is used primarily at the company’s plant and mine sites. The management believes that the replacement cost of this electricity, if it had to be purchased from outside, would be more than $1.0 million per year. After the initiation of new coke facility, the company plan to sell excess coal gas to local government for use in residential grid, which would further increase the company’s product base.

OPERATIONS

Manufacturing – a vertically integrated manufacturer and marketer of coal products

SCOK is a vertically integrated manufacturer and marketer of coal products, strategically based in the coal-rich Henan province in the central part of China. The company extracts raw coal from an underground mine, known as Baofeng mine, in the Zhaozhuang village in Baofeng County. This extracted coal is then transported to its plant site in the nearby Hangzhuang village, 2 miles from the mine site, where these mined coal are processed to manufacture coke. The finished coke is loaded onsite onto railcars through its private rail line, and transported to customers through the connected state-owned rail system. The castoffs of the coal-washing process are sold to industrial end users and traders primarily as fuel for electricity and heat. The coal tar is extracted from the gas emitted during the coking process and sold, and the remaining gas is then used to produce electricity to power its operations. Excess electricity is sold to the state-owned electricity grid. We believe that the company’s vertical integration would immune its profitability up to a certain extent from temporary volatility in coal prices due to less dependence on third-party suppliers for raw materials. It also provides flexibility to the company to change the product-mix as per the prevailing market condition. Apart from these, the vertical integration also brings others benefits to the company such as easy access to raw materials, better control over the quality and cost of products, and faster throughput.

Coal Mining Operations-

Pursuant to the acquisition of mining rights in July 2005 and a resource mining permit in July 2007 from the Henan Province Department of Land and Resources, SCOK operates an underground coal mine (known as Baofeng mine) through its wholly-owned subsidiary, Hongchang Coal. The Baofeng mine contains total in-place proven and probable reserves of about 2.5 million tonnes of coal, of which the company is permitted to extract up to 1.2 million tonnes of coal. Out of total 1.2 million of recoverable reserve, the company has already extracted 0.9 million tonnes of coal.

Taking advantage of the Chinese government’s policy to close small-sized coal mines due to safety and productivity concerns, SinoCoking has identified ten mine-owning companies for acquiring a majority interest in them before the end of calendar year 2010. These target companies have an aggregate licensed production capacity of 1.5 million tonnes per year, and the aggregate coal reserves of 25 million tonnes as per Chinese geological standards. The government intends to consolidate coal mines with a production capacity below 300,000 tonnes per year, and will only approve new mines with a production capacity of no less than 450,000 tonnes per year.

Coal Washing and Processing

The company’s a coal-washing facility has the capacity to process up to 750,000 tonnes of coal per year. The company’s sorting machines, which sort the washed coal according to size, have a capacity to process up to 600 tonnes of coal per hour. Approximately 1.33 - 1.38 tonnes of raw coal generally yields one ton of washed coal.

Coke manufacturing – New facility to expand capacity, product-base and margins

SinoCoking’s coking facility has a capacity to produce 250,000 tonnes of coke annually. The company is poised to witness a substantial growth in its revenue and earnings once its planned capacity expansion goes online. It is constructing a new coking factory with a theoretical production capacity of 900,000 tonnes of coke per year and a practical capacity of 850,000 tonnes per year. The new facility is anticipated to start production during the first quarter of calendar year 2011 (3Q FY2011), and would place the company in a better position to tap the opportunity in the world’s largest coke market. New coking factory will be capable of processing inferior washed coal (low input cost) that can be acquired from third-parties, while the company’s present coking factory can only use raw coal with a G-index of 75 or higher (high input cost). Besides reducing input costs, the new facility will also add other coal byproducts including crude benzol, sulfur and ammonium sulfate to the company’s product portfolio. The new facility is also anticipated to generate an additional 66.5 million Kilowatt hours of electricity each year. Moreover, the company has already received approval from the city of Daying to sell purified coal gas, to be generated from the new facility, as a fuel source to city residents.

For the construction of this new coking facility and related facilities, the company has signed an agreement with the Henan Province Pingdingshan Municipal Bureau of Land and Resources to acquire a 50-year land use rights for 1.3 million square meters of industrial-zoned vacant land in Baofeng County at a total cost of $22.0 million. The company had not made any payments towards these rights as of December 2009. It has the option to acquire these rights by making payment by the end of June 30, 2010.

Source: Company Filing, RODM Research

Research and Development

Although SinoCoking did not conduct any research and development activities during the recent past, it plans to begin a research and development program for the extraction of chemicals from coal. At present, the company is considering the anticipated costs and benefits of the production and sale of such byproducts.

Sales and Marketing

SinoCoking sells all of its products within China. The channel of distribution employed by SinoCoking varies according to the type products. It sells coke to distributors and the state-owned trading company Wu Han Tie Ying Trading Corp. It enters into non-binding annual letters of intent with almost all of its coke customers at the beginning of each year. These letters of intent set forth current year supply quantities, suggested pricing, and monthly delivery, and the terms of which are usually negotiated during the Annual National Coal Trading Convention organized by the China Coal Transport and Distribution Association. Any party making changes to delivery quantity and pricing, based on open market pricing at the time of delivery, is required to give 30-day advance notice, and the changes is documented in a final written contract. Raw coal is sold to power plants through distributors, while washed coal is sold to a trading company who then resells to Wu Han Tie Ying Trading Corp. SCOK sells byproducts including coal tar to trading companies who resell to end users. The company is almost immune from bad debt risks as it either asks for payment upon delivery of products or advances for the orders placed with it.

SCOK has concentrated base of customers. Its top four customers accounted for 64.6% of total revenue in FY2009, while its single largest customer contributed 28.8% of total revenue. Wuhan Zhengtong Industry Co. Ltd. was the company’s largest coke customer, with a share of 20.2% in total coke products sold during FY2009. A 68.4 of the coal products sold by SCOK in FY2008 was purchased by Wuhan Tieying Trading Co. Ltd. Mr. Fashun Wang was the company’s biggest coal tar customer with a contribution of 31.1% in total coal tar sold in FY2009.

Source: Company Report, RODM Research

Top 4 customers by revenue in FY2009

FINANCIALS

Since the acquisition of coking factory from a state-owned enterprise in 2005, SinoCoking has demonstrated a significant improvement in its financials mainly through organic route. The company’s revenue registered a 3-year CAGR of 67.0%, increasing from $11.0 million in FY2006 to $51.4 million in FY2009. Gross profit grew from $2.5 million to $23.4 million, resulting in a 3-year CAGR of 112.6%. The company earned $17.0 million in FY2009 as against net loss of $2.9 million in FY2006.

The revenue for FY2009 was down 12.3% compared to the previous year due to lower coke products’ prices and weak demand for coke by steel producers. The company’s majority of revenue (59% in FY2009) is generated from sales of coke products. The company changes its product-mix between coke products and coal products based on prevalent market prices of those products. During FY2009, the company reduced coke production as coke market turned unfavorable, and significantly increased the sales and trading of higher-value coal with greater heat content; helping the company to somewhat offset the adverse impact from slowdown in its major coke segment. Gross margin has improved from 22.5% in FY2006 to 52.7% in FY2008 before declining to 46.4% in FY2009 due to higher share of low-margin coal products revenue.

Even though the company generated operating cash flow of $11.9 million during FY2009, its cash and cash equivalents dropped to $0.28 million from $4.7 million a year earlier due to due to continued capital investments, increase in working capital to support an expanding business, and repayment to related parties and shareholders. The company recently raised equity funds amounting to $64.1 MM from its Feb-10 and Mar-10 private placements which it intends to use for the construction of new coke factory, purchase of mining rights, and payment for land use rights. It is required to pay $21.9 MM for the acquisition of the land use rights by the end of June 30, 2010. Additionally, the company is expected to spend $72.3 million towards capital expenditure and purchases of mining rights during FY2010. We expect the company to finance some portion of its capital investments through short-term debt. Thus, at the end of FY2010, we expect 81% of the company’s balance sheet to be funded through equity and only 19% through debt with the latter expected to drop going ahead.

Source: Company Report, RODM Research

For the entire fiscal 2010 (from July 1, 2009 to June 30, 2010), we expect SinoCoking to generate $69.1 million of total revenue, representing a YoY growth of 34.5%. We estimate that gross profit will reach $28.4 million, with a gross margin of 41.1%. We expect net income will reach $20.6 million, which corresponds to diluted EPS of $0.80. The completion of a 900,000-ton coke manufacturing facility in 3Q FY2011 will result in a significant growth in total revenue for FY2011 (from July 1, 2010 to June 30, 2011). We estimate SinoCoking’s total revenue to increase by 88.5% to $130.2 million, a 70.0% of which is likely to be contributed by coke sales. Due to initial high fixed overhead expenses and lower capacity utilization of new factory, we expect gross margin of 37.9%, which would improve in subsequent periods with an increase in share of high-margin coke products in total revenue. Subsequently, we estimate net income for the fiscal year will reach $30.7 million, up 48.9% YoY, and diluted EPS will be $1.04.

MANAGEMENT

Jianhua Lv – President, Chief Executive Officer and Chairman of the Board

Mr. Lv founded Henan Province Pingdingshan Hongli Coal & Coking Co. Ltd. (Hongli) in 1996, and has been serving as its executive director and chairman since then. Prior to that, he had been working with the Henan Province Pingdingshan Coal Group in a number of positions since 1989. He is a standing committee member of the Chinese People’s Political Consultative Conference and the National People’s Congress of Baofeng, Henan Province. Mr. Lv was honored as an outstanding entrepreneur of the year in 2003 and 2004. He is a bachelor in Chinese from Henan University, a master in economics from Henan University, and a master of law degree from the Central Party School.

Liuchang Yang – Vice President, Secretary and Director

Mr. Yang has been serving as a director of Hongli since 2003 and as its Vice Chairman since January 2006. From 1983 to 2005, he held various offices at the company’s predecessors, including secretary, deputy director, director and general manager of human resources. He received his bachelor’s degree in Law from Beijing University, a degree from the Center Party School in Economics and Management, and a graduate degree in Finance and Banking from the Chinese Academy of Social Sciences. Mr. Yang brings to the company an extensive experience in the field of management, human resources and administration.

Zan Wu – Chief Financial Officer

Mr. Wu is a bachelor in accounting from the Capital University of Economics and Business, and a master degree in financial management and control from Aston Business School. Prior to joining SCOK in July 2009, he was the chief representative of Global American Inc. since 2006. Prior to that, he was an assistant manager and financial manager at Domino Scientific Equipment Ltd. from 2004 to 2006, a financial analyst at VIR Consultancy Ltd. from 2003 to 2004, and an auditor at the Zhong Rui Hui Accounting Firm from 2000 to 2001.

Hui Zheng – Vice President of Operations and Director

Mr. Zheng also serves as the Vice Manager of Human Resources at Hongli since 2006. From 1998 to 2006, he worked with the company as a statistician, secretary and vice-dean. Mr. Zheng holds a degree from Zhengzhou University, and has worked in the materials industry since 1996.

Hui Huang – Director

Mr. Huang is the chairman and CEO of Wuhan Pingdingshan Coal and Wuhan Steel Unification Coking Co. He served as its director of sales and administration from 1985 to 1996. He is also the chairman of the board at Wuhan Pingdingshan Coal and Wuhan Steel Unification Coking Co. Mr. Huang is currently a director of China Association of Comprehensive Resource Utilization, a vice-director of the Henan Institute of Coal, and vice-secretary of the Pingdingshan Youth Union.

Yushan Jiang – Director

Mr. Jiang is the CEO of Pingdingshan Coal Group Shoushan Coking Co. Ltd. since February 2007. He was chief engineer at the Henan Tianhong Coking Co. from 2001 to 2007, and has been working in extensive coking industry since 1972. Mr. Jiang is currently a vice-director and member of the Coking Committee of the Henan Province Metals Association, and vice-secretary of the Henan Province Institute of Coal & Coke. Mr. Jiang received his Bachelor’s degree in Coal and Chemistry from the Wuhan College of Iron & Steel.

MAJOR RISKS

Customer concentration

SinoCoking derived 65% of its revenue from its four largest customers and 29% of revenue from a single largest customer in FY2009. Product-wise, the company’s largest coke customer accounted for 20% of the coke sold in FY2009, and its largest coal customer represented 68% of the coal sales in FY2008. If any of these customers discontinues its relationship with the company and the company is unable to find similar customer in scope in time, its revenue and earnings could fall substantially within a short-term period of time.

Dependence on steel industry

The company’s business depends heavily on China’s industrial development and spending, specifically the steel industry as the metallurgical coke produced by the company is primarily used for steel manufacturing. Any slow-downs in the steel industry could decrease demand for metallurgical coke, which could lead to erosion in the company’s profit and a weaker growth prospect.

Uncertainty of capital availability

The company expects to spend $72.3 million for capital expenditure and purchase of mining rights during FY2010. It is also required to pay $22.0 million for the acquisition of land use rights by June 30, 2010. Though the company has already raised $64.0 million through common shares, it will require substantial additional working capital once its new coke factory starts operations. If the company fails to obtain fund requirements on favorable term, its future performance could be negatively affected.

Competition

SinoCoking mainly faces competition from coal and coke producers in the central, eastern and southern regions of China. Many of its competitors are in better position with regard to financial resources, mining rights, market reach and production capacity. Its major competitors include Shanxi Coking Co. Ltd., a major coke producer; Shenhua Group, a major coal producer; and Pingdingshan Coal Group, the largest regional coal producer. These competitors may prevent SinoCoking to increase its market shares with their better resource capabilities.

Political and regulatory risks

The company faces political, social, and regulatory risks from the Chinese government. Any potential adverse changes in the industry's regulatory environment, approval process, tax policy, and pricing restriction could limit the company’s ability to operate in its existing markets and expand into new product areas. For instance, the company had to temporarily halt its mining activities during 2Q09 when the government conducted an inspection at its Baofeng mine as a part of industry-wide coal mine safety inspections. Additionally, the company will have to close its existing coking facility, having furnace height of 3 meters, in the next two to three years as a result of the government’s recent orders to coking factories with a furnace height of less than 4.3 meters to phase out their operations in the next two to three years.

Execution risk

The ultimate success of the company also depends on the management’s ability to guide its current operations, to execute a sensible expansion strategy, and to develop new markets. The ability to effectively execute a sensible expansion strategy and to develop new market segments will be the key to the company’s long term success.

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