In an industry decimated by shrinking demand, huge inventories, increased competition, and new environmental regulations, one company has managed to differentiate itself enough to stand at the front of the pack. Westmoreland Coal Company (WLB) stands in the shadows of the coal behemoths in terms of market capitalization ($162mm), but the company's unique "mine-to-mouth" niche makes them the industry's most attractive investment going forward.
The Westmoreland Niche; Hidden Value
In 2012 WLB derived 75% of its revenues from mine-to-mouth coal production, which is defined as coal that is mined for distribution under long-term contracts to neighboring power plants. WLB has carved out a low-cost, high-efficiency niche for its customer base by strategically partnering with customers based on locality to their mines.
The graphics above detail:
- The strategic locations of the WLB mines, primarily in the northern middle states
- The competitive advantage of proximity
Coal companies struggle with the cost of freight; a significant piece of many competitors' cost structure is how to transport the finished product to the destination. Companies like CSX and Norfolk Southern (NSC) build much of their business alone on the transportation of coal. Without the staggering cost of transportation, WLB is able to offer its customers more attractive long-term contracts while also achieving industry-leading levels of profitability. In 2012 WLB reported an adjusted EBITDA margin of 23%.
In addition to the growth the company has seen in profitability, it should also be noted that, despite two years of lower-than-normal coal tonnage sales, top line revenues also increased 20% in 2012 to $600 million.
Relative Performance Strength
It is not only equity investors that have seen relative strength in WLB over its iffy counterparts; ratings agencies Moody's and S&P have recently upgraded the debt ratings on the company to Caa1 and B-, respectively. The company's two major outstanding issuances of debt are $103.5 million and $252 million of senior notes yielding 10.75%. Comparatively, WLB's industry peers have all seen major debt downgrades over the past eight months. The chart below details the comparison of eight major coal companies, the performance in stock price since 2010, and the company's current S&P credit rating.
As noted, since the beginning of 2010, shares of WLB have significantly outperformed those of most competitors. However, there is cause for concern that, while the ratings agencies have begun to upgrade the credit of WLB, they are still ranked second to last despite their stock outperformance. S&P defines the B-rating as a speculative investment that is "more vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments."
The financial strength of WLB is largely dependent on the strength of its customers. Given the nature of the business - 95% of the company's revenues in 2012 were sourced from long-term deals - the more certainty there is that WLB's customers will have the liquidity to pay for already agreed upon future deliveries, the more faith creditors will have in the company's solvency.
Finally, the reason behind the upgrade in credit rating was largely due to the company's diligent work at bolstering their free cash flow and improving the state of their balance sheet. The acquisition of the Kemmerer Mine contributed to $43 million in EBITDA in 2012 and will continue to add strength to the business, generating free cash flow (180% increase, year over year). Additionally, 2012 saw the company pay down $45 million in debt, bringing total liquidity to $75 million. As a last-measure stop-gap the company has the ability to sell its non-core power generation unit to generate cash flow should a liquidity crisis should arise.
For any liquidity issues in 2013 we can look to a simple cash flow analysis to quell those fears. FY2013 started with liquidity of $75 million (cash and revolving credit line). FY2013 EBITDA must be extrapolated from previous data. According to the 10-K, the company forecasts increased growth in coal ton deliveries, revenues, profits, and operating cash flows "due to one additional month of our Kemmerer Mine operating in 2013 and due to the fact that our 2012 results were adversely impacted by customer shutdowns and reduced tonnage demand due to increased wind generation and mild weather conditions." Given that analysis, we can forecast FY2013 EBITDA to be $120 million. When the forecast capital expenditures ($28 million on the high-side) and interest expense and revolver cost ($23 million) are subtracted out, the investor is left with a projected year end liquidity of $144 million. It seems that, given market conditions and current company fundamentals, WLB will continue to bolster its free cash flow this fiscal year.
Broader Market Outlook
There is no doubt that the coal industry at least has short-term staying power. Despite the growing negative sentiment in the industry, cost efficiency will continue to be the driving factor in the determination of energy sourcing. WLB is predominately a producer of thermal coal - 88% of the company's 2012 revenues were driven by thermal production. Additionally, the company derives its revenues domestically. Any slowdown in Chinese, Indian, or any other foreign growth will have less of an effect on WLB than its counterparts.
As shown above, trends show that coal (though slowly losing traction) will remain the primary source for US power generation by a significant margin through 2014. One step further, because of the aforementioned niche that WLB has exploited in the northern states, the company will continue to be able to provide customers with cost advantage over Appalachian coal producers.
Additionally, coal's price advantage over natural gas continues to widen. At current natural gas prices, there is a $15/MWh premium to using coal.
Any investment in the coal industry right now - whether it's in a diversified conglomerate or a smaller company with a singular focus in thermal production - can only be made after understanding the implied risk. While there is certainly short-term staying power, as detailed above, the coal industry is losing its luster. WLB, while small in stature, is a force to be reckoned with among its peers; the company has made an excellent case of differentiation and value-added. By being a low-cost provider, WLB has set itself apart and continues to develop long-term, revenue-generating strategic partnerships in the northern states. If you're keen on a coal recovery, put your chips on WLB.
*All graphics courtesy of WLB 10-K and Investor Presentations.