TPSA BRE Bank Securities BRE Bank Securities 29 May 2009 Special comment
Coal Mining Poland LW BOGDANKA
Not Your Usual Coal Mine Free float 32.34% LW Bogdanka, located in the Lubelskie Coal Basin in eastern Poland, is one of the leading and most cost-effective steam-coal mines in the country. The coal from Bogdanka’s deposits is characterized by properties (calorific value, sulfur content) which fully meet the requirements of the energy Shareholder structure after C-stock share issue industry, buyer of 80 percent of the mine’s production. In Poland, 56% of State Treasury 65.50% electrical power is generated from bituminous coal, and 36% is produced Kozienice Power Plant 1.43% from lignite. In 2008, with sales approximating 5.5 million tons, Bogdanka New shares 32.34% produced 6.6% of Poland’s total coal output, and achieved a 10.8% market share in supplies to commercial power plants. In the absence of viable alternatives, coal is going to remain the main source of energy in Poland in Others 0.73% the next 20 years.
Sector Outlook A unit cost of PLN 144 per metric ton ranks Bogdanka among the cheapest Over 50% of energy in Poland is generated from coal producers in Poland (the industry average is PLN 222.6 per ton). The bituminous coal, and new projects are coal-based as mine is ideally poised to benefit from issues faced by producers in the well. Output at Silesian mines is decreasing by the south-western coal-producing region of Upper Silesia (mines there are year. Due to these factors, LW Bogdanka, which is one struggling with decreasing output, lack of investment in exploration, of the cheapest producers, will find it easy to sell its mounting technological and geological obstacles, escalating salary output, including coal from the new field currently being demands), which currently meet 80% of national demand, but which incur launched. increasing unit costs (PLN 245/ton in early 2009). By selling its coal at prices below the costs incurred by competition in the Upper Silesian Coal Company profile Basin, Bogdanka minimizes earnings risks and maximizes the potential for LW Bogdanka is one of Poland’s biggest and most- future growth. cost effective steam-coal mines. In 2008, with 5.5 million tons of coal sold, it had a 6.6% share in In the best-case scenario for Silesian mines (in which they continue to break domestic production and a 10.8% share in supplies to even), as the price of crude oil increases, which is likely, the price of ARA commercial power plants. coal will go up as well (at present it is lower than the price of coal extracted in Poland), allowing the mines to keep prices at the current high levels. In case of LW Bogdanka, this entails a per-ton profit of at least PLN 50. In the Important dates more likely alternative scenario, there will be a decline in prices of 29.05 - Price range announced domestically-extracted coal (by 10-20%), entailing heavy losses for 1-5.06 - Individual and employee subscriptions producers, social turmoil and the need to reduce output (it is estimated that 4-5.06 - Bookbuilding of the 84m tons total output, ca. 20m tons are permanently unprofitable). 5.06 - Final price announced Given what happened with Polish shipyards, it is very unlikely that the 8-10.06 - Institutional subscriptions government should opt to grant state aid to the mines in need. For LW 19.06 - Share allocation Bogdanka, this means that selling coal from the Stefanów field will be easier. Given the growing share of imports in domestic consumption, the price of coal from the Polish mines should be more tightly correlated with ARA prices.
Michał Marczak (48 22) 697 47 38 [email protected] Kamil Kliszcz (48 22) 697 47 06 [email protected] www.dibre.com.pl
THIS29 maja DOCUMENT 2009 MAY NOT BE DISTRIBUTED IN THE UNITED STATES, JAPAN OR CANADA. BREBRE Bank Bank Securities Securities LW Bogdanka
Being aware of the upcoming opportunities, in 2004, Bogdanka’s Management embarked on a project aimed at doubling the mine’s production capacity by expanding operations into the “Stefanów” coal field. To date, the company has spent over 466.5 million zlotys on the project. Mining in Stefanów is set start in 2011 (the expected additional coal output is 7.8 million tons), and the target capacity will be achieved in 2014. In addition to boosting output, the project will facilitate a 20 percent reduction in production costs. At the moment, Bogdanka’s licensed mine sites can yield an estimated 11.1 million tons (MMT) of coal a year until 2034. However, extraction from the recoverable reserves will be extended until 2043 through the upcoming implementation of an automated longwall plow system.
Approximately 40 percent of installed power capacity in Poland is more than 30 years old, and will be shut down within the next 15-20 years, necessitating replacement of about 14 gigawatts of capacity (including 12 GW of coal-fired capacity) with budgets ranging between EUR 15 billion and EUR 20 billion depending on the type of fuel. From the point of view of Bogdanka, the most important aspect of these upgrades is that many of the coal-fired power plants which have started, or are about to start modernizing, are located within its sales territory. Equally importantly, some of these plants (including in Kozienice, Ostroł ęka, and Siekierki) are very likely to become eligible for free emission credits under the EU Energy and Climate package. This suggests that coal demand in eastern Poland in 2014 and 2015 will increase to a level well exceeding Bogdanka’s capacity as it will be after the launch of the “Stefanów” mine.
Bodanka’s past and future earnings results factor in the costs related to the Stefanów project. In 2009, the company will book an additional one-time charge of PLN 36m, representing compensation paid to employees who will not receive stock options. Our financial projections for Bogdanka indicate an upturn in EBITDA after FY2011, driven by the launch of production from the first Stefanów longwall panel, paired with a decrease in costs (incl. the Stefanów OPEX, and unit costs of production). Bogdanka is expected to break even on the Stefanów investment in 2014.
29 May 2009 2 BREBRE Bank Bank Securities Securities LW Bogdanka
IPO and Its Objectives
Bogdanka is offering 11 million shares of “C” stock with a par value of PLN 5 each. The expected proceeds of PLN 450m will be used to complete the expansion of the mine site within the Stefanów coal field, in line with the company’s 2009-2015 Strategy. Stefanów is expected to double the mine’s annual coal capacity from 5.5MMT to 11.1MMT in 2014, and its launch will help to improve mining efficiency as well as to reduce unit costs.
Specific allocations within the Stefanów project budget include: • An extraction and drilling shaft - PLN 53.4m; • Expansion of the “ZPMW” coal-handling facilities (including an increase in capacity from 1,200 to 2,400 tons per hour, a transportation system to move coal from the Stefanów field, and enlargement of the waste-dump area) – PLN 319.7m; • Other coalfield infrastructure (buildings, underground air-conditioning) – PLN 61.6m; • Expansion of the mine railway infrastructure – PLN 10.1m. Any remaining expenses related to the Stefanów field will be covered from Bogdanka’s own cash resources, and with external debt. Details of the expansion work and its outcomes are outlined later in this report.
The IPO will increase Bogdanka’s share capital to PLN 301.2m. Holders of the C shares will have a combined interest in the mine of 32.34%, and the State Treasury will retain a stake of 65.5%. Minority shareholder the Kozienice Power Plant will hold 1.43% after dilution, and remaining interests will total 0.73%.
Pre- and Post-IPO Shareholder Structure
C shares Others Others 32.3% Kozienice 1.1% 0.7% Power Plant 2.1%
State Kozienice Treasury Power State 96.8% Plant Treasury 1.4% 65.5%
Source: LW Bogdanka
29 May 2009 3 BREBRE Bank Bank Securities Securities LW Bogdanka
Business Profile
Located in the Lubelskie Coal Basin in eastern Poland, Bogdanka is one of the leading and most cost-effective bituminous-coal mines in the country. The properties of the coal from Bogdanka fields (calorific value, sulfur content) fully meet the requirements of the Polish energy industry, which buys 80 percent of the mine’s output. In 2008, with sales approximating 5.5 million tons, Bogdanka produced 6.6% of Poland’s total coal output, and achieved a 10.8% market share in supplies to power plants.
A unit cost of PLN 144 per ton (2008 IAS estimate) ranks Bogdanka among the cheapest producers in Poland (the average unit cost in the industry, as calculated using Polish Accounting Standards, is PLN 222.6/T). The company is developing a new mining site (“Stefanów”) which expected to double its capacity, and which cost a total of PLN 520m between 1999 and 2008. Mining in Stefanów is set start in 2011 (the expected additional coal output is 7.8MMT), and the target annual capacity of 11.1 MMT will be achieved in 2014.
Bogdanka’s licensed recoverable resources are currently estimated at 11.1MMT annually until 2034, but they will increase once the company implements an automated longwall plowing system which facilitates cost-effective extraction from coal seams as thin as 1.2 meters.
Coal resources in the Lubelskie Coal Basin
• Expansion of the mine site in April 2008 increased the recoverable reserves to 260MMT. • The recoverable tonnage will increase further after the implementation of an automated longwall plowing system which enables cost-effective recovery of coal from thin seams. • There are more undeveloped coal fields in the Lubelskie Coal Basin, where Bogdanka is not likely to ever face competition from other producers.
Coal Fields within the Lubelskie Coal Basin (LZW)
BELARUS
Puchaczów V UKRAINE
Bituminous Coal Resources A-C2 Bogdanka mine area
Non-recoverable coal resources
Borders of the Carboniferous coal-bearing strata Lubelskie Coal Basin (LZW) Faults
Source: LW Bogdanka
Until April 2009, Bogdanka's mining license covered an area (called “Puchaczów IV”) of 57 square kilometers, comprising three mine sites: “Bogdanka,” “Nadrybie” (both currently in operation) and “Stefanów” (currently being developed for mining), which hold a total of 96MMT
29 May 2009 4 BREBRE Bank Bank Securities Securities LW Bogdanka
of recoverable coal. Yielding an annual coal output of 5,500 tons, these reserves would have lasted 17 years. In April, Bogdanka extended its license to include the southern part of the Stefanów field (called “Puchaczów V”), increasing its operational area to 73 square kilometers and boosting the recoverable resources to 260MMT. At a target output of 11.1MMT a year, these resources will last 25 years.
The mining techniques (shearers) used to date limited the estimated recoverable resources to layers up to 1100 meters below the surface, and seams thicker than 1.2 meters. The implementation of an automated plowing system which maximizes efficiency and enables coal recovery from seams as thin as 1.2 meters will additionally augment the reserves.
Bogdanka’s mining sites are just a small portion of the Lubelskie Coal Basin (see map). The mine’s Management are considering further expansion of the Puchaczów VI mining area, which is estimated to contain 300MMT of recoverable coal. Such expansion requires a new mining license for the areas being added.
The emergence of competition in the Lubelskie Basin is highly unlikely. A newcomer to the area would have to spend enormous amounts of money to put in place a complete mining infrastructure above and under ground. Bogdanka itself will invest a whopping 1.5 billion zlotys just to extend its mining area (using existing aboveground infrastructure and shaft “2.1” which started to be built in the 1990s). With expenses this huge, it is unrealistic to think that a new player could compete with Bogdanka’s prices. Another problem would be to find skilled workforce (Bogdanka started to hire miners for the Stefanów field as early as in 2006 to ensure that they are properly trained). Finally, the hypothetical rival would have to obtain a mining license which, in Poland, requires the holder to start production within three years from issue.
Competitive Advantages of Bogdanka’s Coal
• Bogdanka’s target customers are primarily power plants (fine coal accounts for 93% of total sales compared to 80% for Kompania W ęglowa mines). • The coal mined from the Lubelskie Basin offers competitive calorific values and particle sizes, with properties that exactly match the industry averages for coal used to generate electricity. • Sulfur content in the deposits is higher than the industry average (1.2% vs. 0.9%), and that is why Bogdanka sells its coal at a discount to low-sulfur coal. There is a possibility that this discount will widen in the future, depending on prices of SOx emission credits (Poland is set to launch an emissions trading system this year). • With a location close to major buyers (including power stations in Kozienice, Ostroł ęka, Połaniec, Puławy, and Siekierki), Bogdanka benefits from a proximity premium (i.e. lower costs of rail transportation, no transshipment charges) which reinforces its position amid increasing competition from imports. • Coal mines in the Upper Silesian Coal Basin are supported by government subsidies, which allows them to periodically reduce prices (total government subsidies allocated toward restructuring the mining industry between 2006 and 2008 exceeded PLN 1.2 billion). • Bogdanka’s key advantages from the standpoint of power plants are its high- quality coal (guaranteed energy values) and reliable deliveries.
Calorific Value and Particle Size The two properties that determine the value of coal are its calorific value and particle size. About 80% of steam-coal sales in Poland is fine coal (with particles sized between 0 and 20 mm) with calorific values which range from 18 to 30 MJ/kg (the average calorific value of coal used by Polish power plants is 21.55 MJ/kg). Bogdanka’s coal dust, which accounts for 93% of total sales volumes (well above the industry average because of the coal properties and the mine’s automation capacity), offers between 20 and 22 megajoules of energy per kilogram, and makes an ideal source of energy for power stations and combined-cycle plants. Note that demand for fuel with higher energy content is created mainly by plants that use supercritical steam boilers which facilitate more efficient burning of more expensive coal with high heating values. At the moment, most energy producers in Poland use technology which demands calorific values of 20-22 MJ/kg, and Bogdanka’s coal is fully competitive in that respect (the same goes for ash content). It is worth noting that the average calorific values of coal used by Polish power plants are significantly lower than those of coal from Russia or coal traded via ARA ports (i.e. 25-26 MJ/kg). That is why imported coal, even though it contains more energy (and costs more per ton), forces Polish power plants mix it with less efficient coal so that it can
29 May 2009 5 BREBRE Bank Bank Securities Securities LW Bogdanka
be handled by their combustion technology. Bogdanka’s advantage over international producers, especially Russian suppliers, is that it guarantees consistent heating values. In turn, Russian mines usually do not operate coal-preparation plants, and their shipments can vary in quality, making it hard for power plants to apply fixed formulas for compounding the most effective fuel inputs.
Sulfur Content Sulfur content has been a crucial factor for fuel buyers since the SOx emission quotas for EU countries were lowered in 2008, reducing the allowed average daily emission value to 400 Mg from 2350 Mg per cubic meter. Most power producers required to comply with emission limits installed desulfurization systems (FGD units) on at least some of their boilers so as to be able to continue production (depending on the efficiency of an FGD unit, to meet the emission quotas, desulfurization only needs to cover between 65% and 85% of installed capacity). Other plants chose to reduce purchases of high-sulfur coal in favor of low-sulfur coal, which resulted in greater price variations between different grades of coal sold by mines (coal with higher sulfur content is sold at a discount of several percent). Coal from Polish mines offers sulfur concentrations between 0.6% and 1.5%, with half of our resources containing concentrations between 0.8% and 1.0%. The sulfur content of Bogdanka coal is about 1.2%, which makes it unsuitable as the single energy source for some of the power plants located in close proximity to the mine (but these plants have to diversify their suppliers anyway). Otherwise, except for price discounts, sulfur content does not affect sales because most of Bogdanka’s customers have desulfurization systems in place. After the launch of SOx emissions trading in Poland (a law to that effect is being developed by the Environment Ministry), the discount in high-sulfur- coal prices may change depending on the prices of emission credits, which are likely to increase as Poland gradually reduces emissions to the levels imposed by the European Union (the Accession Treaty orders Poland to reduce cut SOx emissions to 454,000 tons in 2008, 426,000 tons in 2010, and 358,000 tons in 2012). These changes are difficult to predict at the moment.
Logistics Aside from coal quality, logistics is a key determinant of the sales success and competitiveness of a coal producer. The bulk of Poland’s power-generation capacity is located in Upper Silesia and western Poland, outside of Bogdanka’s sales territory. However, the mine has among its neighbors three major coal-fired power plants and several combined-cycle plants which generate an aggregate demand far exceeding its capacity, and which maximize the “proximity premium” which gives Bogdanka edge over rivals like Kompania W ęglowa and KHW, as well as over imports from Russia and ARA ports. Fuel costs incurred by energy producers include per-ton rail freight charges as well as prices of logistics services. For example, the Kozienice Power Plant burns approximately 14,000 tons of coal per day, meaning that it receives between 4 and 7 shipments every day (40 freight cars carrying 60 tons each). Long-term contracts with suppliers can make the logistics of handling shipments which arrive every three hours each day on average much easier. That is why, leaving aside the fact that freight costs increase with distance (at rates currently charged by freight rail operator PKP Cargo, the cost variations between Bogdanka’s main customers can reach PLN 50 per ton), seaborne coal imports via the port in Gda ńsk can only be treated as a secondary, additional source of supplies. Uninterrupted and regular coal shipments from Gda ńsk require complex logistics, in particular at the stage of port operations (storage space has to be secured in advance, sea shipments have to be synchronized, plus, there is a risk of traffic congestion in the harbor during peak demand periods).
29 May 2009 6 BREBRE Bank Bank Securities Securities LW Bogdanka
Existing and Planned Power-Plant Locations in Poland ( ● )
Installed Capacity 1GW and more 0.5GW to 1GW 0.2GW to 0.5GW Less than 0.2GW Source: CIRE, BRE Bank Securities
For Bogdanka, the greatest competitive pressure comes from the Upper Silesian mines which may be seen as equally cost-efficient suppliers by some of the energy producers in the east. The pressure is further enhanced by the fact that, for years, the Upper Silesian producers have received different forms of financial aid from the government (capital injections, forgiven debts) which can temporarily boost their price competitiveness (in the last three years, the government spent in excess of PLN 1.2 billion on restructuring the Upper Silesia coal Basin). Bogdanka’s defense against such potential rivalry are low production costs (the cost of 1 ton of coal is about 36% lower than the average for Polish mines) which allow the company to charge lower prices while maintaining break-even margins. The table below shows our estimations of potential costs of coal for the Kozienice Power Plant depending on the place of origin.
Estimated costs of coal imports from Russia and ARA ports 2007 2008 Present Coal CIF ARA (USD/T) 86.4 147.1 66.4 Coal CIF ARA (USD/GJ) 3.4 5.9 2.6 USD/PLN exchange rate 2.77 2.41 3.48 Coal CIF ARA (PLN/GJ) 9.5 14.1 9.2 Freight costs, ARA-Gda ńsk (USD/T) 4.0 4.0 1.6 Freight costs, ARA-Gda ńsk (PLN/T) 11.1 9.8 5.5 Transshipment (USD/T) 4.0 4.0 4.0 Transshipment (PLN/T) 11.1 9.6 13.9 Rail freight (PLN/T) 40.0 40.0 40.0 Cost of ARA coal for Kozienice PP (PLN/GJ) 12.0 16.5 11.6
Russian coal FOB Gda ńsk (USD/T) 72.8 133.6 57.5 Russian coal FOB Gda ńsk (USD/GJ) 2.9 5.3 2.3 Russian coal FOB Gda ńsk (PLN/GJ) 8.0 12.8 8.0 Logistics services (PLN/T) 51.1 49.6 53.9 Cost of Russian coal (PLN/GJ) 10.1 14.8 10.1
Price of Bogdanka coal (PLN/T) 163.1 182.8 223.4 Price of Bogdanka coal (PLN/GJ) 7.8 8.7 10.6
Price average for Polish mines (PLN/T) 170.7 214.9 270.0 Price average for Polish mines (PLN/GJ) 7.2 9.0 11.3 Source: BRE Bank Securities
29 May 2009 7 BREBRE Bank Bank Securities Securities LW Bogdanka
In the current economic environment, the cheapest option for fuel buyers seems to be Russian coal, which is 5% cheaper than Bogdanka coal. At a USD/PLN exchange rate of 3.48, the average price of Polish coal is comparable with ARA prices according to our estimates. This explains the current situation in the Polish coal-mining industry and the rapid increase in imports observed in the last few months (in addition to regular volumes contracted in 2008). If prices of coal quoted on world exchanges do not move from their current levels, Polish producers will have to adapt, but the adjustment will not be significant in case of Bogdanka.
Cost Advantage The basic measures of labor productivity for coal mines include total productivity (output per employee-day; “ED”) and underground productivity (output per miner-day; “MD”). Bogdanka boasts outstanding productivity indicators which leave competition lagging far behind (total productivity is at 8112 kg/ED, and underground productivity is 18415 kg/MD, compared to the Polish industry averages of 3593 kg/ED and 7338 kg/MD respectively). Given that labor costs are a big component of overall mine costs, productivity influences unit costs, and hence the profitability of mine operations. Bogdanka has been building its productivity advantage for many years, among others by offering incentives to miners (in a corporate culture which is very different to the practices observed in Upper Silesian mines), maximizing the benefits of outsourcing (reduced costs of weekend operations and certain maintenance and preparation work, greater flexibility), investing in high-end machines, committing to a constant streamlining of production processes (the commitment comes from the Management as well as the workers), and synchronizing production with investment and site-development processes (to fully leverage existing potential and avoid costly downtime). Today, the mine is able to produce coal at a cost of PLN 141 per ton compared to PLN 220 incurred by its rivals from Upper Silesia. A comparison across the Polish mining industry shows that, while the aggregate average unit cost has surged 58% over the last six years, Bogdanka has seen an increase by just 18%. Going forward, we predict that the mine will continue to improve productivity relative to competition thanks to an 11% increase in the worker headcount over the past two years in preparation for the launch of the “Stefanów” site in 2011. Bogdanka Management say that achievement of twice the current capacity in 2014 will be accompanied by an addition of just about one thousand new workers, and this accomplishment will give a new boost to the mine’s productivity performance.
Productivity indicators, Bogdanka vs. polish mining industry
Underground Productivity (kg/ED) Average cost per ton of output (PLN)
20000 250
200 15000 150 10000 100 5000 50
0 0 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008
LW Bogdanka Polish coal-mining industry LW Bogdanka Polish coal-mining industry Source: LW Bogdanka, Ministry of the Economy
A prudent spending policy allows Bogdanka to maintain steady margins during periods of coal price volatility, and achieve superior margins when economic conditions are as favorable as they were last year. Again, a comparison shows that Bogdanka does much better than competition during different economic cycles, even though it produces coal with lower heating values (21 MJ/kg vs. industry average of 23.8 MJ/kg), and therefore sells it for less. Further, Bogdanka is able to charge below-average prices thanks to a favorable make-up of its customer base, which is mostly power plants and large industrial buyers (the share of high- margin retail buyers is very small at 3.5%).
29 May 2009 8 BREBRE Bank Bank Securities Securities LW Bogdanka
Realized coal prices and margins, Bogdanka vs. Polish mining industry
Average realized prices of coal Margins earned on coal sales
25.0% 230 215 210 20.0% 183 190 171 162 164 163 170 155 153 158 15.0% 142 150 137 133 10.0% 130 110 5.0% 90 70 0.0% 2003 2004 2005 2006 2007 2008 2003 2004 2005 2006 2007 2008
LW Bogdanka Polish coal-mining industry LW Bogdanka Polish coal-mining industry Source: LW Bogdanka, Ministry of the Economy
Natural Hazards Natural hazards most commonly encountered in mining operations include methane and coal dust explosions, bumps, and gas and rock bursts. The hazard level in case of Bogdanka is lower than for other mines. The danger of methane explosion is very low in the Lubelskie Coal Basin (it is rated at 1 on a 4-point scale, compared to a danger level of 4 assessed for 15 out of 33 active Polish mines). Small methane leakage from the coalbeds reduces the risk of accidents and related expenses, and enhances productivity (no stoppages due to exceeded methane levels). The danger of bumps and rock-bursts is also limited thanks to the seismic characteristics of the area (evenly-bedded coal layers, greater rock softness which reduces the rock stress that causes slides and bumps). Yet another advantage provided by the location of the Bogdanka mine sites is that the area is sparsely populated, which means lower costs of any potential damage (e.g. due to rock slides or flooding). While the geological benefits are not readily quantifiable, they do provide competitive advantage and enhance the efficiency of Bogdanka’s operations.
Revenue Structure
• Bogdanka generated 95% of revenue from sales of steam coal, and sells 80% of total output to commercial power plants. • 81% of total sales volumes go to three key power-plant customers.
Bogdanka generates over 95% of revenue from sales of steam coal which, because of its properties (energy density at 32.2, lower calorific values than for Upper Silesian coal, high sulfur content), is 80% bought by commercial power plants. The remaining 20% goes to manufacturers who operate their own FGD systems (including fertilizer producer ZA Puławy).
Revenue Structure 2005 2006 2007 2008 Sales (PLN m) 903.4 836.9 862.5 1 033.3 Coal 786.8 776.0 801.0 996.2 Ceramic bricks 8.0 13.1 18.0 2.5 Other 99.9 38.5 34.8 26.1 Sales of goods and materials 8.7 9.3 8.8 8.4
Percentage Breakdown Coal 87.1% 92.7% 92.9% 96.4% Ceramic bricks 0.9% 1.6% 2.1% 0.2% Other 11.1% 4.6% 4.0% 2.5% Sales of goods and materials 1.0% 1.1% 1.0% 0.8% Source: LW Bogdanka
29 May 2009 9 BREBRE Bank Bank Securities Securities LW Bogdanka
Sales to the three key customers located in the closest proximity to the mine (power plants in Kozienice, Połaniec, and Ostroł ęka) accounted for 76% of revenue and 80.6% of volumes sold in 2008. Bogdanka’s supplies to these customers are regulated by agreements which specify the shipment volumes, penalties for incompliant energy values, a detailed breakdown of freight costs, and potential causes of termination.
Key Accounts of Bogdanka Coal Mine Guaranteed Volumes Contract Expires (thousands of tons) Kozienice Power Plant 31.12.2010 3 500 Połaniec Power Plant 31.12.2012 1 000 Ostroł ęka Power Plant 31.12.2009 n/a Source: LW Bogdanka
In 2008, Bogdanka sold 5.577 million tons of coal, 8.9% more than a year earlier, and generated a revenue of PLN 996.2m. The average revenue per ton of coal approximated PLN 178.6, which was 14.2% more than in 2007. 2008 saw a strong upward momentum in coal prices driven by favorable industry trends and growing demand for electricity, accompanied by a decreasing fuel supply from Polish mines. The Upper Silesian mines failed to meet the guaranteed supplies ordered by power stations, leading to a sell-out of coal inventories, an increase in imports of expensive coal from Russia and ARA ports to 10 million tons, and an uptrend in domestic coal prices.
Bogdanka’s coal sales, average revenue per ton, market share (2005-2008)
190 5.75,7 12,0%12.0% PLN/t MMT Share in sales to power plants 180 5.65,6 Sales volumes 10,0%10.0% Total market share 5.55,5 170 Revenue per ton
5.45,4 160 8,0%8.0% 5.35,3 150 5.25,2 6,0%6.0%
140
5.15,1 130 4,0%4.0% 5.05,0
120 4.94,9 2,0%2.0%
110 4.84,8
4.7 0,0%0.0% 100 4,7
2005 2006 2007 2008 2005 2006 2007 2008
Source: LW Bogdanka
2009 has seen a dramatic shift in market conditions. After domestic producers failed to meet demand the year before, power plants placed larger orders with foreign suppliers. Increased imports coincide with dwindling demand for energy from a slumping manufacturing industry, leading to a rapid build-up of coal stocks at power plants as well as mines. Coal prices remain high, but sales volumes have dropped over 20% compared to the first quarter of 2008. In Q1 2009, Bogdanka sold its output at per-ton prices ranging between PLN 213 and PLN 232, much higher than a year ago. Going forward, the profitability of coal sales (currently at PLN 56.4 per ton) is going to decrease (read on for details).
In addition to coal, Bogdanka also sells ceramic bricks which it produces from coal waste at its “EkoKlinkier” factory. Sales of ceramic bricks fell to PLN 2.5m in 2008 from PLN 18m in 2007 after a fire destroyed the manufacturing site. The factory has been rebuilt, and its annual capacity has been increased from 16 million to 19 million bricks. Bogdanka’s other revenue sources include transportation services (the company holds a freight license and its own rolling stock), and sales of scrap metal from closed mine workings.
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Operating Expenses
• Compared to the Upper Silesian mines, Bogdanka incurs low unit costs which are facilitated by the geological structure of the coal fields, production efficiency supported by state-of-the-art mining technology, process automation, and the Management’s expertise in handling operational matters. • Salaries and utilities are the major cost components at Bogdanka. Over the past few years, annual expenditure was inflated by outlays related to the Stefanów field (site development, workforce hiring), which also affects depreciation expenses.
One of Bogdanka’s main competitive strengths are low costs of output, which stood at an estimated PLN 144 per ton (cost – production for in-house purposes / sales volumes, IAS) compared to a national average of PLN 222.6/T (PAS). Costs are kept down through a combination of effective operational management, the Management’s approach to ensuring cost-effectiveness, and the geological properties of the coal fields. The commitment to profit maximization displayed by Bogdanka’s Management is truly unique in an industry which, most of the time, struggles to at least break even. But sound financial performance is also a matter of vital importance for the workers, whose extra pay depends on it (10% of the mine’s annual profits are earmarked for bonus payments). The structure of the Bogdanka coal deposits allows for longwall mining across long stretches. In turn, the nature of the Upper Silesian coal beds necessitates frequent machine retooling which increases maintenance expenses (the machines have shorter useful lives). What is more, shortage of funding for technology upgrades leads to more frequent failures and downtime at the Upper Silesian mines (which often means stoppage along the entire longwall block). Another advantage of the Lubelskie Basin coal fields is low methane hazard and bump and rock-burst hazard, which means lower health and safety expenses. Finally, the fact that the basin mostly consists of scarcely populated farmland minimizes the costs related to potential mine damage.
Cost breakdown for Bogdanka
energy 23.8% Salaries 37.0% Other Depreciation 2.6% 14.9%
materials 76.2%
other transport drilling and Materials & 8.7% mining 22.4% Taxes energy services 5.6% Outsourcing 21.4% 30.3% 18.6%
maintenan ce 38.5%
Source: LW Bogdanka
Payroll expenses represent the bulk (37%) of Bogdanka’s costs, which is typical for the mining industry (the average is more than 50%). The mine currently employs 3.7 thousand people, including about 350 workers employed specifically to work in the Stefanów field (miner training takes about three years). The increased worker headcount amplifies expenses, which will continue to increase until the launch of mining operations on the Stefanów site. By 2011, the company will employ 4.4 thousand people. 66% of Bogdanka miners are members of four trade unions which, so far, have been reasonable in making salary demands, in stark contrast to the workers of the Upper Silesian mines. What gives Bogdanka’s Management leverage in dealing with its workers is the fact that the mine is the only major employer in the region, and a relatively generous one at that (in 2008, the average monthly “naked” salary at the company was PLN 5,950). The company outsources certain operations (including drilling and maintenance) to bring down payroll expenses.
Materials and utilities are another major cost item, which represented 21.4% of the total costs generated in 2008. Bogdanka purchases large quantities of steel to prepare its coal fields for mining (mine roadways). Steel, smelting products, and copper (mainly cables) make for nearly half of the annual materials costs, which are closely correlated with prices quoted on global
29 May 2009 11 BREBRE Bank Bank Securities Securities LW Bogdanka
metal exchanges and the zloty exchange rates. Note, however, that uptrends in metal prices are usually aligned with uptrends in oil prices, and imply higher coal prices. So, global trends in commodity prices do not have much influence on Bogdanka’s earnings. Electricity accounted for 5% of total costs in 2008. The company does not use much natural gas, which is needed mainly for the manufacture of ceramic bricks. After the 2007 fire, usage and costs of natural gas in 2008 dropped 80% compared to 2006.
The third largest cost item (18.6%) is outsourcing of maintenance, drilling (during mine site development), and transportation. Drilling expenses at the moment are elevated as the Stefanów field is being prepared for launch.
Less than 6% of costs are charges related to mining taxes, environmental taxes, and waste storage (until 2007, a portion of these costs was recognized under transportation expenses).
Financial Standing
At 31st December 2008, Bogdanka had PLN 99.9m of free cash and PLN 41.1m of cash locked in a mandatory liquidation reserve required of all Polish mines, which must be maintained at a level equivalent to 3% of annual depreciation and amortization charges. At the moment, Bogdanka’s liquidation reserve is much bigger than the expected liquidation costs projected for 2034. In 2008, the mine generated operating cash flows in the amount of PLN 395.3m, and purchased plant and equipment and intangible assets for a total PLN 329m, which included a PLN 191.7m allocation toward capacity expansion (replacement expenses amounted to PLN 77m). Moreover, the company took out a PLN 100m loan with Bank PKO BP.
During the first four months of 2009, Bogdanka spent PLN 54m on expansion of the infrastructure of the Stefanów field, and signed an agreement to purchase the first plowing system for EUR 40m (making a 10% downpayment). Toward the end of March, the company increased its loan facility with PKO BP by PLN 50m, and has at its disposal PLN 250m in credit, of which it has drawn PLN 120m to date (Bogdanka can cancel the remaining PLN 130m line without penalty). In addition to PKO BP, Bogdanka also has working-capital credit lines with Kredyt Bank (a PLN 15m drawdown to date) and Bank Millennium.
All in all, Bogdanka’s net debt (loans – cash) stood at PLN 37.6m at 31 March 2009. In May, the company’s controlling shareholder decided to distribute PLN 88.8m out of 2008 profits as dividends. The FY2008 Net Debt/EBITDA ratio implied by these factors figures to of 0.37. Assuming that the IPO can fetch at least PLN 450m, the future ratios of net debt to EBITDA for the duration of the Stefanów project will not exceed 0.5. In a scenario without the IPO proceeds and with financing from external sources, the ratio would reach a peak level of 1.6 in 2010. Based on these estimations, we can safely say that Bogdanka is in sound financial health.
Investment Plans
• The CAPEX budget through to 2015 totals PLN 2.7 billion. • Annual capacity expansion from 5.5MMT to 11.1MMT by 2014 will be achieved following the launch of the Stefanów coal field. • Bogadnka aims to maximize mining efficiency by reducing unit costs through economies of scale and the application of plow mining technology. • The investment plans include capacity upgrades at the “Energetyka Łęczy ńska” heat and water utility (combined-cycle generation, green and red energy certificates).
The CAPEX budget established by the 2009-2015 Strategy is PLN 2.7 billion, of which PLN 2.1bn is earmarked toward coal production, and PLN 0.6bn is allocated toward the heat and power generation operations of Bogdanka’s subsidiary Energetyka Ł ęczy ńska. The CAPEX budget will be funded with IPO proceeds, Bogdanka’s own cash resources, and bank loans.
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Investment in coal capacity 2009F 2010F 2010-2015F Total Expansion of the Stefanów coal field, including: 331 446 198 975 Surface infrastructure (shaft 2.1, extension of ZPMW coal-handling facilities, etc.) 189 255 123 567 Access to new deposits (cross-cutting) 142 191 75 408 Purchases, including 145 20 661 827 System for mining deep coal beds 140 0 426 566 Replacements 51 38 171 260 Environmental protection 3 3 3 9 Total 530 507 1 034 2 071 Source: LW Bogdanka
The PLN 2.1bn 2009-2015 CAPEX budget includes a PLN 1bn allocation toward development of the Stefanów field, and a PLN 1.1bn allocation toward replacements and environmental- protection systems (PLN 566m of that amount will cover the acquisition of plow-mining technology).
The capacity upgrades and the expansion of the Stefanów field will be carried out in two stages. In the first one, set for completion in 2011, Bogdanka plans to launch the 2.1 shaft directly on the Stefanów field, and build a track system to enable ROM coal to be transported to the ZPMW handling facilities. Further, the company will set up necessary surface infrastructure (ventilation system, shaft switching station, storage and maintenance space), and underground crosscuts, expand the rail freight system, and install underground air conditioning in the Stefanów mine. Mining on the first Stefanów longwall block will start in 2011, marking the end of the first and most intense stage of the development efforts.
During this period, Bogdanka will also be expanding the capacity of the ZPMW coal-handling facilities from 1 200T/h to 2 400 T/h. The target capacity is expected to be achieved in 2013, one year before the launch of the second longwall in the Stefanów field (which is the last milestone of the investment program).
In the period from 2012 to 2015, aside from finalizing the expansion (PLN 198m allocated toward site development), the bulk of expenses will be on purchases of new machines and tools.
By 2014, Bogdanka plans to implement an innovative plow-mining system which will partly replace the shearing technique used to date. In 2009, 2012, and 2015, the company has scheduled purchases of three dedicated systems for mining deep deposits lying below 1.6m, for an estimated total price of PLN 566m. This technology, which has never been used before in Poland, is expected to provide access to larger recoverable coal resources, and help improve the efficiency of coal recovery. At the moment, the coal yield on total output is 70%, and it will increase to 75% after the introduction of the plowing system. Plow-mining on the first longwall is set for launch in 2010.
Other replacements will include: • New transportation machines. • Rebuilding of the EkoKLINKIER brick factory and capacity expansion to 19.2 million from 15.6 million bricks per year (completion is set for H209). • New facilities in the “Nadrybie” and “Bogdanka” coal fields. • Overhauls of a 110 kV switching station, winding engines, and power wiring. • Modernization of existing buildings and mining machines.
Environmental initiatives: • Site flooding to create a recreational water basin. • Expansion of waste-rock storage facilities to accommodate increased output. • Construction of water-drainage systems for “Bogdanka” and “Nadrybie” coal fields.
Bogdanka’s subsidiary utility Energetyka Łęczy ńska put in place a 2009-2015 investment plan aimed at including combined-cycle power generation into the business mix (which requires a fluidized-bed furnace with a turbine set), and supplying power to meet the increased needs of its parent. The CAPEX allocated toward these initiatives is PLN 595m. The future benefits of these projects include reduced power-supply expenses, as Bogdanka will no longer have to pay transmission charges to distributors. What is more, the combined-cycle unit will use as input the coal-processing waste produced by the mine (coal sludge, wastewater sediment),
29 May 2009 13 BREBRE Bank Bank Securities Securities LW Bogdanka
and biofuel (in quantities needed to obtain green energy certificates). In 2008, Bogdanka purchased 174 MWh of electricity for ca. PLN 40m.
Steam Coal Market
Structure of the Power Industry in Poland
• Coal-fired units prevail (58% bituminous coal, 36% lignite). Power-plants tend to be located in the vicinity of mines. Coal is projected to retain its dominant position (45% of energy generated in 2015). • Energy consumption will increase in line with the GDP. Demand for power is forecasted to grow at a CAGR of 1.8% in 2010-2020. In the next two years, however, a reduction in demand is possible by ca. 9% due to the macroeconomic environment. • Reserve capacity is low, especially at demand peaks. New units will need to be created within 5-10 years. • Household prices remain regulated; a cross-subsidy effect has emerged after industrial prices were freed in 2008. Energy prices have a significant impact on the price of coal (quasi-regulated market). • Energy prices in Poland converged with the average prices seen in European spot transactions in 2008 (trade at the Polish Power Exchange (TGE) accounts for a mere 3% of sales to end-users, however). The current correction is a consequence of the deteriorating economy. • In a longer-term perspective, however, energy prices can be expected to keep increasing in real terms as full market deregulation approaches, the interconnection infrastructure expands and EU directives on emissions get more restrictive.
Coal-fired units predominate in the Polish power sector. Needless to say, this is a consequence of Poland's huge coal reserves, which made coal the fuel of choice when new power units were being constructed in the seventies. As a result, 56% of energy currently generated in Poland comes from bituminous coal and a further 36% from lignite, with most power-plants located in the Upper Silesian region. A big part of demand for power comes from energy-intensive industries which are also concentrated in that region. When we look at the power-generation projects currently under planning (details are provided further down in this report), it appears that coal will retain its key role in the next few years, despite the mounting pressure from the EU carbon dioxide emission reduction program and the fact that the cost advantage of coal is systematically declining (cost of emission rights, environmental charges). Significant changes to industry structure can be expected in the horizon of 10 years, due to further environmental requirements, age degradation of the existing units and nuclear power projects currently contemplated. It is hard to imagine, however, the structure of fuel consumption in Poland will approach the EU average any time soon. In this light, the demand side appears to be very stable as far as Bogdanka is concerned and we see no threats to its volumes, all the more so that medium-term forecasts for the power market suggest that existing capacity will have to be more fully employed. As has been the case so far, a supplier's attractiveness will be a function of its distance from the buyer, which means that the current trading relationships will be maintained; moreover, the potential demand limitations discussed below might open opportunities for new customer acquisition.
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Power generation by type of fuel
100% 100%
90% 90%
80% 80%
70% 70%
60% 60%
50% 50%
40% 40%
30% 30%
20% 20%
10% 10%
0% 0% EU-27 EU-25 Bulgaria Czech Germany Spain France Hungary Poland Romania Slovakia Turkey Republic Hydropow er Nuclear energy Bituminous coal Lignite Natural gas Other total coal Source: Eurostat, analysis by BRE Bank Securities
Over the last dozen or so years, growth in energy consumption in Poland was strongly correlated with GDP growth. On average, demand increased by ca. 1%, which was fully covered by increased output at Polish power plants. In 2008, consumption amounted to ca. 155 TWh, with production at 159 TWh. While the net surplus appears safe, full supply could not always be ensured at demand peaks (cf. high failure rate, shrinking power reserve buffer). In the first 9 months of 2008, we saw a clear increase in the demand for fuel (by 2.5% on average), which, especially in the first half of the year, led to public concerns over the risk of insufficient supply during the summer. As the economic crisis unfolded, however, consumption growth slowed down, which reduced the pressure on the market. In the final months of the year, when the breakdown in global demand forced Polish companies to significantly reduce their output, negative y/y growth was observed, especially in November and December (-6.2% and -5.9%, respectively). All in all, the demand for energy increased in 2008 by a mere 0.4%. In 2009, given the expected slowdown in GDP growth (or negative growth as per some forecasts), we can expect a y/y decline in the demand for energy. In Q1’09, the decline amounted to over 4.3%; the April data (-10.8%) give few reasons to expect an improvement in the following months. According to forecasts ARE (Energy Market Agency) prepared for the Polish government, the demand for electrical power in 2010 will amount to 141 TWh, which entails a 9% decline vs. 2008 (average growth rate in 2009-10 at -4.6%) and a return to 2003 levels of demand. In the following years, however, the upwards trend should continue, and UCTE’s forecast of a 1.8% CAGR may prove accurate (according to ARE, the 2010-15 CAGR will be 1.6%, in 2015-2020, ca. 2.1%).
Energy consumption in Poland vs. GDP growth and per-capita consumption in the EU
200 170 8000 165 7000 180 160 6000 160 155 5000 150 4000 140 169 145 3000 120 154 155 140 2000 151 153 145 146 135 1000 100 140 141 139 139 139 141 141 136 137 137 130 0 80 125 Spain EU-25 EU-27 Poland France Czech Bulgaria Slovakia Republic Hungary Romania Germany 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2010 2015 2020 electrical energy consumption, TWh cumulative GDP index (1995=100) electrical energy consumption, KWh per capita Source: Eurostat, ARE, URE, GUS, UCTE
From the point of view of a coal producer, another important aspect of the energy market are the price-setting mechanisms. As will be explained in detail further down in this report, the price of energy determines the price ceiling for fuels which cannot be exceeded if energy producers are to remain profitable. In a free market, there would be natural adjustments on both sides (price of energy <> price of coal); in a regulated market, the "price of coal > price of energy" mechanism is not fully operational. Household energy prices in Poland are still regulated and have to be approved by the energy regulator URE, which chose not to free them despite the previous announcements that this was to come at the start of 2009. Because households account for ca. 25% consumption, this has a significant impact on the sector. In the process of price determination, URE does take into account the power producer's
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operating expenses, energy origin guarantees and a margin, but it also takes into account the consumers' interest. This means that the tariffs that emerge constitute a compromise between the competing interests of both parties and they are rarely satisfactory for producers, who in the current circumstances attempt to offset this by hiking prices for industry (which can be seen in the next chart). Institutional customers, as shown by recent protests, are more and more resistant to such cross-subsidies. Should the current regulatory regime persist, with the potential for fuel imports limited for logistical reasons, the price of steam coal is unlikely to be determined by market factors. Therefore, the promised full deregulation will be an important development for Polish mines. The process has been halted, however, due to the financial crisis (in fact, opinions are voiced that full regulation should return); we expect that it will not be restarted until 1-2 years elapse.
Change in average energy prices by tariff category
50.0% 40.0% 40.0%
30.0%
20.0% 11.4% 12.4% 10.0% 6.8% 2.2% 0.4% 2.7% 0.7% 0.9% -0.4% 0.0%
-10.0% 2004 2005 2006 2007 2008 A,B,C- industrial customers G- households Source: ENEA, URE
In January 2009, URE decided to increase prices for retail consumers by 10% and power producers increased prices for industrial customers by 30-40% on average, which was meant to fully reflect the increase in wholesale prices at the Polish Energy Exchange observed in 2008 (as a reminder, the exchange accounts for a mere 3% of energy trade in Poland, so the TGE spot prices are not fully representative for the market). This entailed a considerable convergence between energy price is Poland on the one hand and average prices in Germany or France on the other, as illustrated in the chart below. It appears, however, that in the upcoming quarters industrial buyers will be renegotiating prices (cf. for example the announcement ZAP made on the appendix to its January agreement in PGE, reducing the price was by 5%). In the current macroeconomic situation, we can expect a correction in electricity prices, mirroring the trends observed in the developed European markets. ARE’s long term forecasts indicate, however, that further price increases are inevitable, due to the expected growth in demand, investment needs and costs entailed by the Energy Package (which aims for full auctioning of carbon dioxide emission certificates). This trend will probably coincide with the construction of power transfer infrastructure that will integrate the Polish system with the neighboring countries and with full market deregulation.
Exchange prices of energy in Poland, France and Germany, EUR/MWh
100.0
90.0
80.0
70.0
60.0
50.0
40.0
30.0
20.0
10.0
0.0 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 Q307 Q407 Q108 Q208 Q308 Q408 Q109
Germany France Poland
Source: Bloomberg, TGE
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Steam Coal: Demand vs. Supply
• Two opposing trends were observed in the steam coal market in 2008: increasing demand on the part of power plants and declining output at mines. In 2008, Poland became a net importer of coal (imports up by over 60%, exports down by 30%). • As a result of the 2008 supply problems, power plants secured more imported coal for 2009 through take or pay contracts, which, given the decline of in energy production and the increase in the power producers’ coal stockpiles (to almost 6 MMT) reduced their purchases at Polish mines. • Output is set to decline further in Silesia, especially at KHW. In 2011-2012, only KW and LW Bogdanka will increase supply (by 2 MMT each). • ARE forecasts a decline in the demand for steam coal in Poland, from 71 MMT in 2008 to 66 MMT in 2010 and 62 MMT in 2015 as a consequence of carbon dioxide emission regulations and improved energy efficiency across the economy. Given the planned construction of additional coal-fired generators, this demand-reduction scenario appears highly conservative. • LW Bogdanka will have an opportunity to expand its market share from the current 8% to 15-17%, thanks to its cost advantage and its current investment projects.
Over the recent years, the steam coal market in Poland was affected by two opposing tendencies in the areas of demand and supply. On the one hand, economic growth led to a systematic increase in the demand for energy (2.5-3% per annum); power plants increased their output and signaled ever higher demand for coal (supplies increased by almost 5 MMT in the past five years, i.e. almost 11%). On the other hand, Polish mines were facing ever more difficulties with sustaining their levels of output, due both to restructuring, which meant that some coal fields were closed, and to underinvestment, which meant that some new deposits were not prepared for exploitation. As a result, we saw demand increase and supply decrease (over the past 5 years, combined output at mines declined by almost 12 MMT p.a.) This situation reached a new height last year, when, for the first time in history, Poland imported more coal than it exported. At the same time, the mines’ stockpiles plunged, which led at significant increases in spot prices, allowing coal producers to sell some of their volumes outside of long-term contracts, at a premium (last year, Bogdanka sold 200,000 tons of coal this way, i.e. 3.5% of its total sales volume).
Polish energy balance, millions of tons
25.0 95.0 84.3 82.7 83.0 79.8 85.0 20.0 73.8 70.8 75.0 15.0 65.0 10.0 47.9 47.8 55.0 46.0 47.2 5.0 42.9 39.1 45.0
0.0 35.0 2003 2004 2005 2006 2007 2008
exports imports coal use in the energy sector steam coal production
Source: Ministry of the Economy, Central Statistical Office (GUS)
The biggest supply problems in 2008 were observed in Silesia, which has the highest concentration of coal-fired power plants with a total capacity of 8.3 GW. The Silesian mines, facing structural problems in production, were unable to deliver the volumes contracted (according to unofficial information, at KHW, the production plan was undershot by a dozen percent or so). Some of the customers had therefore to recur to imports (URE requires mandatory reserves sufficient for 30 days of production), which were both more costly than domestic coal supplies, and generated considerable logistic difficulties. In such circumstances, some of the power producers chose to forestall future difficulties by entering into forward contracts for imported coal for 2009. However, due to the economic crisis, the demand for energy fell; it turned out that there was too much coal in the market. In the first months of 2009, when coal-based energy generation declined by 3.4% y/y, energy producers, facing their
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expanding stockpiles (the current 6 MMT would suffice for 70 days of production vs. 3.6 MMT at the end of 2008 and 2.2 MMT at the end of 2007), started to reduce domestic purchases in favor of foreign coal, whose price started to go down (also, they were constrained by take or pay contracts they had previously entered into). This fairly quickly led to a decline in coal sales by Polish mines and increase in their stockpiles. At the end of March 2009, sector-wide reserves amounted to 3.5 MMT, while at the height of the 2008 season, they had fallen as low as 1.2 MMT. The increase in reserves was not prevented by the ca. 5.5% y/y decline in coal production (all coal, including coking coal). According to some observers, the mines’ stockpiles may reach 8 MMT at the end of the year.
Coal-based energy generation (GWh) and coal stockpiles at Polish mines (thousand tons)
Coal-based energy production Coal stockpiles at Polish mines
9 500 5 500 9 000 5 000 4 500 8 500 4 000 8 000 3 500 7 500 3 000 7 000 2 500 6 500 2 000 6 000 1 500 5 500 1 000 5 000 J u ly M a y April J u n e M arc h J u ly August M a y April J u n e O ctober January F ebruary M arc h November December August Septem ber O ctober J anuary F ebruary November December September 2007 2008 2009 2006 2007 2008 2009 Source: PSE Operator, Ministry of the Economy
We believe the mines will not allow their stockpiles to expand to such levels, and they will adjust to the market, in terms of both price and output. In this context, it cannot be precluded that some mines – those with the highest unit cost of production – will have to be thoroughly restructured and might even be closed (LW Bogdanka's efficiency in comparison to peers is discussed further down in this report). Power producers, in turn, after the previously-signed contracts for imported coal expire, should start buying more coal from domestic producers, as soon as H2'09.
Coal sales, power production and demand coverage by domestic purchases
9500 1.40 9000 1.30 8500 1.20 8000 7500 1.10 7000 1.00 6500 0.90 6000 0.80 5500 5000 0.70 4500 0.60 Jul-08 Jul-07 Jan-09 Jan-08 Jan-07 Mar-09 Mar-08 Mar-07 Sep-08 Nov-08 Sep-07 Nov-07 May-08 May-07
Coverage by domestic purchases Steam coal sales (thousand tons) Coal-based energy production (GWh)
Source: PSE Operator, Ministry of the Economy, analysis by BRE Bank Securities
ARE expects that, given the expected demand for energy, the demand for steam coal will decline by 15-20% in 2009 and subsequently stabilize at ca. 66 MMT (vs. 71.4 MMT in 2008). We believe this is a fairly conservative assumption, considering the investment plans of the Polish energy producers, which we outline further down in this report and which are mostly based on new coal-fired units.
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Demand for steam coal in Poland and forecast by ARE, MMT
90.0 82.4 82.4 80.5 78.7 80.0 73.2 71.4 70.0 66.1 61.7 60.4 60.0 50.0 40.0 30.0 20.0 10.0 0.0 2003 2004 2005 2006 2007 2008 2010F 2015F 2020F
Source: ARE, Ministry of the Economy
The analysis of most investment projects in the bituminous coal sector in Poland over the past few years shows that the mines’ professed commitment to achieving higher output within five years is not reflected by appropriate preparatory work. In the sector as a whole, CAPEX amounts to 10-12% of revenues, in the case of Bogdanka, the ratio exceeds 30%. In the recent years, LWB’s investment projects accounted for over 13% of all investment in the sector (including coking coal), while its share of the total output was merely 6.6%. The current economic deterioration can only broaden this discrepancy, as the Silesian mines downscale their CAPEX further. Combined with the potential closures of loss-making coal fields, the aggregate supply of steam coal in Poland will decline; in the next two years, it will adjust to the expected lower demand. These tendencies will work to the advantage of the cost-effective Bogdanka, which is planning to increase its output by 2 MMT in 2011 and a further 3.7 MMT in 2014. As a result, the company should be able to strengthen its standing as the supplier to its current customers (Kozienice, Połaniec, Ostoł ęka and Puławy power plants), and enable it to supply coal to buyers in more remote regions of Poland (there were inquiries from Silesian companies already in 2008). All in all, LWB’s share of the steam coal market should increase from the current 7.8% to 15-17% in 2014.
CAPEX/revenues in the Polish mining industry
35% 33% 33%
30% 28% 25% 25%
20%
15% 12% 12% 12% 11% 10% 8% 9% 10% 7% 5%
0% 2003 2004 2005 2006 2007 2008
LW Bogdanka Bituminous coal sector in Poland Source: Ministry of the Economy, LW Bogdanka
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Power plants: coal use and distance to Bogdanka
Distance Estimated from Installed annual coal Bogdanka, Coal-fired power plants capacity, MW usage, MMT km Kozienice 2 820 5.2 105 Ostroł ęka 647 1.3 237 Połaniec 1 800 3.5 161 Stalowa Wola 350 0.7 109 Dolna Odra group 1 742 3.6 697 Opole 1 532 3.1 384 Jaworzno 1 535 3.6 305 Łagisza 840 1.2 309 Łaziska 1 155 2.6 339 Rybnik 1 775 4.0 363 Skawina 490 1.0 283 Siersza 786 1.4 294 Halemba 200 0.2 331 Other commercial power plants and CHPs 5 020 12.3 - TOTAL 20 692 43.7 - Source: Enea, PKE, PGE, estimates by BRE Bank Securities
The list above includes projects which have not been finally approved yet; it presents the optimistic variant for the segment and the company.
Coal Prices In Poland and Globally
• Energy prices in Poland exert a quasi-regulatory impact on steam coal prices, which leads to a discrepancy between prices achieved by Polish mines and spot prices at global exchanges (this was particularly clear during last year's boom, when ARA prices approached USD 200 per ton, and the Polish mines' ex- works price did not exceed USD 100/Ton). • Prices in contracts with energy producers rose by ca. 25% in 2009, but due to the strong downward pressure on energy prices exerted by industry (the current contracts foresee a 30-40% increase in electricity prices) and competition from imports, there is a risk that coal prices will be renegotiated. • Globally, coal prices are strongly correlated with crude oil prices. Assuming long-term crude oil price of USD 90/bbl, coal should be priced at around USD 118/T. After 2013, this correlation may be somewhat disturbed in Europe as the provisions of the Climate Package are implemented, but due to the EU's low share in global coal consumption (10%), this effect should not be very big.
The strained situation in the Polish market for bituminous coal that we sketched above could not but impact prices. It is worthwhile, however, to analyze the prices in Polish mines' contracts in the light of global price trends, so as to better understand the nature of the Polish market. In H1 2008 (practically speaking through August) coal prices at global exchanges rose very fast (ARA prices went up from USD 125/T to USD 215/T), due to several factors such as China's administrative decision to stop coal exports, railroad logistics problems in Russia, production problems faced by top producers, decline in global stockpiles and a clear increase in investors’ activity on forward markets. As the financial crisis unfolded, however, bringing about liquidity problems that impacted the number of transactions and a decline in demand, coal prices followed other commodity prices south; at year-end, the ARA price was USD 80/T. Pricing trends in the Polish market were similar, although fluctuations were much more limited, reflecting the structure of the market: most of the output (67%) is sold to the energy sector, whose regulated prices put a cap on how much prices can increase. The price of coal accounts for approximately 2/3 of the cost of energy generation, which makes it a key determinant of profitability; therefore, it cannot be decoupled from energy prices.
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European coal prices
250.0
200.0
150.0
100.0
50.0
0.0 Jul-06 Jul-07 Jul-08 Jan-06 Jan-07 Jan-08 Jan-09 Mar-06 Mar-07 Mar-08 Mar-09 Sep-06 Nov-06 Sep-07 Nov-07 Sep-08 Nov-08 May-06 May-07 May-08
price for coal from Polish mines, PLN/t (MoE) price for CIF ARA coal, USD/t price for Russian coal, fob Baltic sea, USD/t
Price for Polish coal with average energy content of ca. 23 MJ/kg. Price of ARA coal with energy content of 25 MJ/kg. Source: Ministry of the Economy, Bloomberg
It is precisely because of the quasi-regulatory pricing mechanism we described above that the Polish mines were able to increase their prices by only 24% in average (a little less for the energy sector), while the increase at European ports was no less than 70%. This significant discrepancy has by and large disappeared, however, due to the drastic plunges in European coal prices over the past few months. The current price of coal at Polish mines is similar to ARA prices (inclusive of transportation); it appears all but certain that mines will attempt to keep prices in their contracts with energy producers at the current level. This entails an increase in the average costs borne by the energy sector by 10-20% vs. 2008. Power producers have already factored that into their industrial pricelists, hiking prices by 30-40% on average, but URE blocked their attempt to transfer these costs onto retail consumers as well, allowing only a 10% increase. The regulator also demanded that the energy sector renegotiate its contracts with industry (these prices are not regulated). If energy prices increase much less than the power plants expect (which is very likely given the declining demand), they might exert pressure on mines and attempt to renegotiate contracts for coal purchases. For now, it is difficult to say how likely this scenario is to play out as far as LWB is concerned. A lot will depend on the situation in the European market, where the unfolding crisis could lead to a decline in coal prices (decreased output at steel mills, reduction in the demand for energy). It should be stressed, however, that LWB has the lowest production cost in the sector, which might allow it to benefit from the current market turmoil in the medium term.
Coal prices at Polish mines vs. energy prices
320.0
273 276 268 270.0 243 235 230 224 212 215 215 220.0 207 208 198 202 192 179 179 179 172 173 170 170 173 175 165 167 166 166 165 167 161 161 162 165 163 164 170.0 159 159 158
120.0
70.0 Jul-08 Jul-07 Jul-06 Jan-09 Jan-08 Jan-07 Jan-06 Mar-09 Mar-08 Mar-07 Mar-06 Sep-08 Nov-08 Sep-07 Nov-07 Sep-06 Nov-06 May-08 May-07 May-06 price for coal from Polish mines, PLN/t (MoE) baseload energy price, PLN/MWh (RDN) Source: Ministry of the Economy, Polish Energy Exchange, estimates by BRE Bank Securities
In a longer-term perspective, given the expected deregulation of the Polish energy market, and its upcoming integration with the European infrastructure, Polish coal prices should correlate better with the global prices. It is worth pointing out here the close relationship between coal and crude oil prices, which is illustrated on the next chart. Assuming that in a few years the price of Brent petroleum returns to USD 90/bbl, and using a simple regression, we can project the price of ARA coal at USD 118/T in the medium term. When we take into account energy
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content, and assume a USD/PLN exchange rate of 3.0, the price can be estimated at PLN 14.2/GJ, i.e. much more than Bogdanka was paid throughout 2008. To be sure, the question arises whether the correlation will remain as strong after 2013, i.e. when the partial auctioning of carbon dioxide emission rights begins. At present, this is difficult to predict, but EU’s low share of global coal consumption (ca. 10%) may make it difficult for energy producers to transfer a significant part of the costs associated with the Climate Package onto coal suppliers.
Past and forecasted prices of European steam coal vs. crude oil prices
250.0 160.0 148 140.0 200.0 118 118 120.0 105 90 92 150.0 100.0 80.0 72 70 60 64 100.0 60.0 39 43 32 50.0 40.0 20.0 0.0 0.0
2010F Feb 05 Feb 06 Feb 07 Feb 08 Feb 09 2001 2002 2003 2004 2005 2006 2007 2008 Feb 01 Feb 04 2009F 2011F 2012F 2013F Feb 02 Feb 03
steam coal (USD/t) Brent crude (USD/Bbl) steam coal (USD/t) Brent crude (USD/Bbl)
Source: Bloomberg, estimates by BRE Bank Securities
Investment Plans and the Climate Package
• Approximately 40% if installed capacity is over 30 years old and requires replacement. Replacement CAPEX is estimated at EUR 15-20bn. Growth in the demand for energy requires a further 6,000 MW. • Coal will retain its dominant position only if carbon dioxide capture and storage installations are improved and installed in large power-generation units. Without this technology, on the assumption of full auctioning of emission rights, the construction of coal-fired units will be uneconomical, even if the price of coal is lower than the price of gas. • Whether the plans to construct new power units with total capacity of 16 GW are carried out depends on the rules for awarding free carbon dioxide emission rights, starting in 2013; there are no clear criteria for now. • Many of the planned units are to be built in Bogdanka’s sales area. It appears certain that there will be sufficient demand for new production capacity; in addition, the plans appear to be aligned well as far as their timing is concerned. There will be an opportunity to acquire additional, more remote customers as output declines at Silesian mines.
The Polish energy sector is in dire need of investment, not just because of the forecasted growth in the demand for electricity and the need to expand output capacity, but also because there are many units whose lifecycle is nearing its end and which will therefore need replacement. Approximately 40% of installed capacity is over 30 years old and will need to be withdrawn within 15-20 years. This entails replacement CAPEX needs amounting to ca. 14 GW (including 12 GW in bituminous coal), which might cost between EUR 15-20bn, depending on the fuel. Polish energy producers will not be able to incur such expenses without support from banks and foreign industry investors. Financing will be secured only if there are prospects for market deregulation, which would allow the sector to improve its profitability and which would constitute a "collateral" for the banks and a bait for foreign energy giants.
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Power-generation capacity by age, estimates
16 000
14 000
12 000
10 000
8 000
6 000
4 000
2 000
0 0-5 years 5-10 years 10-20 years 20-30 years Over 30 years Installed capacity in MW by age category Source: ARE
In addition to the issue of financing for individual projects, one of the key factors impacting the investment situation in the Polish energy sector is the EU Climate Package and the reduction in carbon dioxide emissions it will mandate. Emission limits for sulfur and nitrogen will be relevant as well, although in this case the power plants that already have desulfurization and NOx reduction installations may actually benefit from the introduction of emission rights trading, scheduled for this year (positive cashflows from the sale of their surpluses). As far as carbon dioxide is concerned, however, the impact cannot be but negative. EU regulations require Polish power plants to buy 30% of emission rights at auctions, starting in 2013, and this share will increase systematically to 100% in 2020. Free allowances will only be granted to units already in existence, or those whose construction was launched before the end of 2008. Others will have to buy 100% emission rights in the market, which, given the forecasted increase in their price (the EC estimates that the price may exceed EUR 30/T) makes the construction of new coal-fired unit economically questionable. Under this scenario, coal-based energy generation will only be salvaged by the construction of carbon dioxide capture and storage installations (CCS), which will be subsidized at 15% from the funds obtained through emission rights auctions. At present it is too early to say what the impact of the Climate Package will be on the new power unit construction plans presented below, as we still do not know how exactly the clause requiring an investment to be “physically launched” will be interpreted, which will determine whether they get free emission rights in 2013-2020. We can expect that the viability of these projects will be verified for the first time in mid-2009, but we can be sure that there will be some changes to these plans. An important question is how effective the CCS technology is – at present it is only being employed at Vattenfall's pilot 30 MW project in Germany (RWE and EON are working on similar projects, and PGE is also expected to install one at its new units at the Bełchatów power plant); it is also hard to say how effective it will be with bigger units, all the more so that the capture and storage process reduces the efficiency of a power plant by 10%.
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Bituminous-coal-fired power units in Poland currently under planning
Distance Coal from demand, Construction Estimated launch Bogdanka, Investors Location Capacity MMT cost date km RWE, Kompania W ęglowa Wola near Pszczyna 800 1.6 MMT EUR 1.3-1.4bn 2013 340 PKE- TAURON Łagisza in B ędzin 460 0.9 MMT EUR 0.5bn 1Q 2009 309 PKE- TAURON Jaworzno 900 1.8 MMT EUR 1.4bn permit pending 305 Halemba in Ruda PKE- TAURON Śląska 460 0.9 MMT EUR 0.69bn permit pending 331 PKE- TAURON Blachownia 900 1.8 MMT EUR 1.4bn permit pending 300 Enea Kozienice 2 000 4.1 MMT PLN 10.5bn 2014-15 105 Vattenfall Gniew 1 600 3.3 MMT PLN 8bn 2013 429 Fortum Cz ęstochowa CHP 120 0.2 MMT ? 2010 290 PGE Opole 2 000 4.1 MMT EUR 3bn 2014-14 384 PGE ZE DO 800 1.6 MMT EUR 1.2bn 2015 697 PGE Turów 500 1.0 MMT EUR 0.75bn 2015-15 600 Energa Ostroł ęka 1 000 2.0 MMT EUR 1.5bn 2015 237 Vattenfall Siekierki 480 1.0 MMT EUR 0.7bn 2014 177 Electrabel ? 460 0.9 MMT EUR 0.69bn 2012 - EDF Rybnik 900 1.8 MMT EUR 1.5bn ? 363 PGE Bogdanka 1 600 3.3 MMT EUR 1.8bn 2015 0 Vattenfall, ZA Puławy Puławy 1 400 2.9 MMT EUR 2.1bn 2014 70 TOTAL - 16 380 33.4 MMT EUR 23.9bn - - Source: analysis by BRE Bank Securities, PGE, PKE, ZAP, newspapers
As far as Bogdanka is concerned, an important aspect is the fact that many of these new coal- fired power units are to be located in the company’s sales area. Importantly, some of them (the units in Kozienice, Ostroł ęka or Siekierki) are quite likely to qualify for “free” emission trading rights under the Climate Package, since the projects in question have already been launched. Even if ZAP’s ambitious plans to create a giant chemical complex comprising a coal gasification plant and a power plant fall through, the demand for coal in Eastern Poland will increase by 2014-2015 much more than Bogdanka's supply does, even after the Stefanów field is opened. To be sure, timeline may be an issue, posing sales-management problems, as the different projects are set to be concluded at different points in time. Nonetheless, given the expected decline in output in Silesia, selling additional volumes to new buyers, located at a greater distance from Bogdanka, may not be such a challenge after all. To sum up, it appears all but certain that even in a disadvantageous regulatory environment, the company should be able to sell all its additional coal output. Demand may become a problem after 2020, should it prove impossible to successfully use the CCS technology with large units, and to provide appropriate carbon dioxide storage infrastructure.
Potential new projects in the vicinity of Bogdanka vs. output 2009-11 2011 2012-13 2014 2015 Output at Bogdanka 5.4 MMT 7.4 MMT 8.8-9.0 MMT 11.1 MMT 11.1 MMT Change in output at Polish mines
New unit at Ostroł ęka PP, 1,000 MW* +2 MMT New units at Kozienice PP, 2x 1,000 MW +2 MMT +2 MMT Puławy PP (ZAP, Vattenfall) 1,400 MW +2.9 MMT Coal gasification at Puławy +1.2 MMT PGE PP at Bogdanka, 1,600 MW* +4 MMT Siekierki PP, 480 MW +1 MMT
Total additional demand for coal +1.2 MMT +5.9 MMT +7 MMT Source: BRE Bank Securities analysis based on the prospectus, information from power producers; it is unrealistic to expect projects located so close to each other, a safer assumption is the construction of one of them.
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Income Statement (PLN m) 2006 2007 2008 Revenue 836.9 862.5 1 033.3 change -7.4% 3.1% 19.8%
COGS 628.8 643.4 727.9
EBIT 128.8 121.4 203.5 change 8.8% -5.8% 67.7% EBIT margin 15.4% 14.1% 19.7%
Profit on financing activity 4.4 0.8 -1.6 Extraordinary gains/losses 0.0 0.0 0.0 Other 0.0 0.0 0.0
Pre-tax income 133.1 122.1 201.9 Tax 27.4 27.8 46.1 Minority interests 0.0 -0.2 0.2
Net income 105.7 94.1 156.0 change 7.4% -11.0% 65.8% margin 12.6% 10.9% 15.1%
Amortization and depreciation 112.6 122.1 136.2 EBITDA 241.4 243.4 339.6 change 13.6% 0.8% 39.5% EBITDA margin 28.8% 28.2% 32.9%
Shares at year-end (millions) 23.0 23.0 23.0 EPS 4.6 4.1 6.8 CEPS 14.0 15.4 21.0
ROAE 12.0% 10.1% 15.1% ROAA 8.5% 7.0% 10.2%
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Balance Sheet (PLN m) 2006 2007 2008 ASSETS 1 280.8 1 398.4 1 657.4 Fixed assets 1 066.2 1 206.5 1 386.0 Intangible assets 11.2 11.4 10.1 Property, plant and equipment 1 023.4 1 158.3 1 334.0 Long-term receivables 0.5 0.5 0.9 Long-term investments 0.5 0.1 0.0 Cash and cash equivalents 30.7 36.3 41.1
Current assets 214.6 191.9 271.4 Inventories 34.3 41.8 35.1 Short-term receivables 83.7 101.6 135.8 Overpaid tax 5.9 0.0 0.7 Cash and cash equivalents 90.7 48.5 99.9
(PLN m) 2006 2007 2008 LIABILITIES 1 280.8 1 398.4 1 657.4 EQUITY 911.8 955.9 1 106.3 Share capital 246.2 246.2 246.2 Reserves 299.1 325.5 400.0 Other 366.5 384.2 460.1 Minority interests 9.6 9.7 9.5
Long-term liabilities 212.3 231.1 222.9 Debt 0.0 30.0 0.0 Other 212.3 201.1 222.9
Short-term liabilities 147.2 201.7 318.8 Debt 0.0 20.0 100.0 Other 147.2 181.7 218.8
Debt 0.0 50.0 100.0 Net debt -90.7 1.5 0.1 (Net debt / Equity) -10.0% 0.2% 0.0% (Net debt / EBITDA) -0.4 0.0 0.0
BVPS 39.6 41.5 48.1
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Cash Flows (PLN m) 2006 2007 2008 Cash flows from operating activities 216.6 214.6 333.1 Net income 105.7 94.1 156.0 Amortization and depreciation 112.6 122.1 136.2 Working capital -1.7 -1.6 40.9
Cash flows from investing activities -216.8 -260.8 -327.9 CAPEX -216.8 -260.8 -327.9
Cash flows from financing activities -38.6 3.5 46.2 Debt 0.0 50.0 50.0 Dividends/share buy-back -43.5 -50.0 -5.6 Other 5.0 3.6 1.9
Change in cash -38.7 -42.6 51.4 Cash at the end of period 90.8 48.1 99.9
DPS (PLN) 1.9 2.2 0.2 FCF -3.6 -46.6 6.2 (CAPEX / Sales) 25.9% 30.2% 31.7%
Market multiples 2006 2007 2008 P/E 10.5 11.7 7.1 P/CE 3.4 3.1 2.3 P/BV 1.2 1.2 1.0 P/S 1.3 1.3 1.1
FCF/EV -0.4% -4.2% 0.6% EV/EBITDA 4.2 4.6 3.3 EV/EBIT 8.0 9.2 5.5 EV/S 1.2 1.3 1.1
DYield 3.9% 4.5% 0.5%
Price (PLN) 48.0 Shares at year-end (millions) 23.0 23.0 23.0 MC (PLN m) 1105.6 1105.6 1105.6 Equity attributable to minority shareholders (PLN m) 9.6 9.7 9.5 EV (PLN m) 1 024 1 116.8 1 115.2
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29 May 2009 28 BREBRE Bank Bank Securities Securities LW Bogdanka
List of abbreviations and ratios contained in the report. EV – net debt + market value (EV – economic value) EBIT – Earnings Before Interest and Taxes EBITDA – EBIT + Depreciation and Amortisation PBA – Profit on Banking Activity P/CE – price to earnings with amortisation MC/S – market capitalisation to sales EBIT/EV – operating profit to economic value P/E – (Price/Earnings) – price divided by annual net profit per share ROE – (Return on Equity) – annual net profit divided by average equity P/BV – (Price/Book Value) – price divided by book value per share Net debt – credits + debt papers + interest bearing loans – cash and cash equivalents EBITDA margin – EBITDA/Sales
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