Edmond Jackson's Stockwatch: A huge dividend and re-rating to follow?

Why you should look a gift horse in the mouth! A plunge in FTSE SmallCap Anglo Pacific Group means a prospective dividend yield of about 9% after a 14 October update "further underpins the board's commitment to maintain our dividend for the current year."

Last August's interim results had similar promises such as "accelerating income growth through acquiring royalties...it is an objective of the company to pay a substantial portion of these royalties to shareholders as dividends." Are they real teeth?

Mining royalties offer an intelligent risk/reward profile

Anglo Pacific was born of two entrepreneurial accountants, taking stakes in mining operations via royalties - entitling a percentage of sales revenue but without liability for production costs or capital expenditure; and generally lasting for the life of a resource.

They can be existing agreements e.g. owned by exploration companies, or new ones linked to providing finance. Such a special approach re-rated Anglo Pacific from small cap to Mid 250 status, benefiting from the commodities boom linked to Chinese growth. But iron ore and coking coal prices have slumped amid doubts whether Chinese spending on infrastructure is sustainable, which largely explains Anglo Pacific's bear chart.

The group's commodity overview is 88% weighted to coal and iron ore and "we continue to believe in the long-term demand from China and India for commodities linked to the production of steel".

But since global production capacity for coking coal and iron ore expanded in the 2008-10 boom it has accentuated the drop in prices. If China is heading for trouble and/or the global slowdown intensifies then the stockmarket is justifiably exacting a high dividend yield to compensate for risks.

Strategy for acquisitions and dividend growth looks exposed

"Timetable for growth" on the company's website shows a target of acquiring two to three new royalties each year, which seems ambitious alongside an expensive dividend commitment, if the economic cycle is turning down. The five-year financial summary - while simple - gives an indication how things look tight. Simply maintaining the annual dividend of 10.2p a share requires some £11 million (2013 cash flow statement) and the end-June interims showed cash of £14.4 million down from £16.4 million like-for-like.

This supports both interim and final dividends for 2014, but runs down Anglo Pacific's "war chest" quite to pocket money - just when an attractive period may be approaching to acquire further royalties. The directors impart confidence that cash flow will recover to annual rates during 2009-11 (see table again) but their share buying implies they under-estimate the risks of a downturn.

When taking office a year ago the chief executive bought the lion's share of a £2.5 million share issue at 195p when his fellow new executive director - the chief investment officer - bought 81,281 shares. He increased his stake to 100,000 shares, adding at 162p on 12 September.

Such actions are commendable for executives aligning their interests with shareholders, if worrying how the last purchase does not convey experience how intense the cycles in coal can be. Gathering storm clouds have been obvious for a while.

Kestrel Coal royalty is the medium-term key

Due to variability in exactly where Rio Tinto expects to mine in Queensland, Australia, Anglo Pacific announced on 18 August that it expected about 43% of production from Kestrel to be within its royalty lands for the second half of 2014, then minimal royalty income during the first half of 2015 and a substantial recovery thereafter.

Just recently the share price fall was arrested at 110p, currently 125p, due to a 14 October update citing better than expected royalty income for the first half of 2015, with 22% of Kestrel production within the company's royalty lands. "This is positive news for our cash flow profile and further underpins our commitment to maintain our dividend for the current year."

Some investors have bought this line. However, the temporary drop for the key royalty remains big and the longer-term outlook is guesswork as regards global commodities demand. More positively the new management has initiated closer relations with Rio Tinto for greater information rights on this asset.

Disclosure ideally needs to improve

Investment trust shares often trade at a significant discount to the value of shares they own, and anyone can check it precisely - e.g. in published tables. With this royalties company it becomes trickier, partly because true valuation is discounted cash flow which can imply a range of net present values. Yet Anglo Pacific doesn't make things easier to understand, for example its interim statement investment review says "the value of the Kestrel royalty decreased by £14.7 million to £116.7 million," but the basis is not adequately explained, nor are values provide for other royalties.

A potential investor can get the impression of dependence on one project, this being risky. The end-June balance sheet cites net assets near £192 million against a market capitalisation of about £145 million currently. Mind that recent US dollar appreciation will have undermined net assets somewhat.

Are directors telling good news but not the bad?

Another example for better disclosure is the demise of London Mining amid claims that Anglo Pacific paid some £19 million equivalent for a now potentially worthless royalty. The news coincided with further falls in Anglo Pacific's share price, but the company has not used its latest update to clarify what might be the impact; or at least that they are aware. Understandably, it will take time for matters to be confirmed although Blackrock World Mining Trust has been sharply criticised for its exposure to London Mining and its managers have conceded they could have said more.

Conclusions

Anglo Pacific shares have dropped to a level making it now more interesting to follow; and if the dividend is anywhere near being sustained for 2015 then the price will re-rate. In the long run it will anyway. But I would not regard the growing cyclical risks casually, where the new management appears less in tune.

For more information see anglopacificgroup.com.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.