All the Coal in China

02/12/2008 12:00 am EST

Focus: GLOBAL

Robert Hsu

Editor, China Strategy and Asia Edge

Robert Hsu, editor of China Strategy, says coal is central to China’s energy future and he suggests a good way for investors to play it.

China is the world's biggest producer and user of coal, which accounts for 61% of its power generation. China's energy demand grew by a staggering 8% in 2006, nearly four times the 2.4% annual growth rate for the rest of the world. Because of China's vast coal reserves, the fossil fuel was the natural choice to run Chinese power plants and drive its economy.

In order to fuel its fast-growing economy, China must increase its number of power generators. Every week, the country builds the equivalent of two 500-megawatt coal-fired plants. By 2020, China will account for 40%—or almost half—of global coal consumption, according to the International Energy Agency. In fact, China's coal prices have increased almost threefold over the past five years.

Right now, the best way to profit from China's rising energy demand is to own a major Chinese coal producer. Yanzhou Coal Mining (NYSE: YZC), a leading coal miner in Shandong, Eastern China, not only supplies coal, but also owns a large stake in railroad assets. It has six coal mines in China, as well as a regional railway network that links these mines with the national railway grid.

YZC's main products are high-quality clean coals, which are suitable for use in large-scale power plants. Much of the pollution in China is due to years of using coal as a fuel source. The Chinese government recognizes this problem and has vowed to crack down on its air pollution. Over the next three years, China aims to cut harmful sulfur dioxide emissions by 10% from 2005 levels.

In order to reach this goal, the country will continue to close down its smaller coal mines. I expect YZC, one of the largest coal miners in China, to show strong production growth over the next couple of years as it shoulders the burden of meeting the exploding coal demand. YZC [also] is one of two Chinese coal companies that have achieved a large economy of scale, which allows it to compete efficiently with other world-class coal producers.

Yanzhou also has a strong balance sheet. In October, YZC reported fantastic third-quarter earnings. Net profit soared an impressive 60%, while operating revenue climbed 26%.

To sum things up, I want you to buy YZC because of its strong industry position, escalating earnings growth, and increasing coal prices. I expect coal prices to appreciate at least 5% to 10% per year over the next few years, which will be a major driver for YZC's share price.

The company is currently trading at a P/E ratio of less than 15x projected 2008 earnings, and pays a 2.5% dividend yield. Buy YZC under $95. (It closed below $85 Monday—Editor.) I expect the stock to hit $125 by the end of this year.

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