Walter Energy: Overvalued and Overbought

Walter Energy (WLT) is a Tampa producer of metallurgical coal for the global steel industry. Walter’s export markets according to Walter’s 2008 annual report are: North America 3.2%, South America 31.5%, Europe 62.3%, and other 3%. Walter is the largest US exporter of coal to the South American metals industry. This annual report may be viewed here (pdf warning).

Walter’s coal is of very high quality, high BTU content. Additionally, Walter has traditionally maintained higher margins than its competitors in its coal business. Walter has transitioned this year away from a diversified conglomerate to focus on its coal business, spinning off homebuilding and REIT business. This is certainly likely to be a good move given the current environment. There is little doubt that Walter is an attractive company on a fundamental basis.

However, while a company may be attractive on a fundamental basis, that does not mean that it is attractive from a relative value perspective at this time. According to consensus estimates for 2009 earnings, Walter should earn $1.67 this year. At current stock prices, that would make for a P/E ratio of 25.74. For comparison here are some other coal companies with their respective P/Es based on full year 2009 estimates arrived at by dividing current stock prices by Thompson/First Call estimates:

Ticker: P/E

ANR:12.71

FCL: 16.54

BTU: 15.42

MEE: 17.45

These estimates would give us an average P/E for these companies of 15.53. Walter, by this analysis, trades at a 66% premium to its competitors.

Is this a reasonable valuation? I certainly think not. If we were to apply a 15 P/E to the 2009 estimate we would arrive at 26.72, and if we were to attribute a more generous estimate of a 20 P/E, we would arrive at a value of 33.40, well below the current share price of $43.00.

This sentiment was also echoed in the recent Brean Murray downgrade from buy to hold based on valuation given that WLT has surpassed their $37.00 price target, though they are still favorable on the stock from a fundamental/longer term basis.

What is the cause for this apparent price discrepancy? I would attribute this anomaly to four causes:

1. Enthusiasm over China and the “reflation trade,” which does not directly affect WLT, as WLT does not export to China, but may have a tertiary effect if indeed China demand were to push up metallurgical coal prices.

2. Speculation over M&A in the coal space, particularly after ANR’s bid for FCL. However after the recent run up in WLT share price and market cap, it is likely that coal producers may look for less costly acquisitions.

3. Momentum and technical traders who are viewing recent chart patterns and apparent breakouts as positives. Given the low average volume traded in WLT relative to a more liquid issue like BTU, momentum players can much more easily bid up an issue like WLT. Additionally with a relatively low float shorts are easily pushed out of this stock.

Once again Walter Energy is an attractive company from a fundamental perspective, and may well be worth far in excess of its current price when the economy, and therefore the metals industry, returns to normal growth.

However, it is premature to speculate on any resumption in metals production on a scale even close to that seen in early 2008. If one does wish to make such a bet on economic recovery, they should do so in the most cost effective manner possible.

Accordingly, if one is looking for metallurgical coal exposure, it would be far more reasonable to purchase the shares in a company such as ANR, which trades at a very reasonable P/E. For those looking for a pairs trade, long ANR/short WLT may be appropriate.

If one is looking merely for coal exposure, without a preference for metallurgical coal, an issue like JRCC with a P/E of approximately 6 looks significantly more attractive.

For China exposure, BTU, which exports metallurgical coal to China, is likely the best play and trades at a very reasonable P/E of just over 15.

While technically WLT appears to have “broken out” recently, the stock is now significantly overbought from an RSI and/or stochastic perspective. This stock is very much due for a near-term pullback on this basis.

If earnings disappoint from Peabody (BTU) and particularly from Walter itself this week, that correction could be rather severe given how crowded this particular trade has become. WLT is an attractive fundamental issue, but relative value has become excessive.

This article is a reflection of my opinions and analysis and should not be construed as an investment recommendation. You must evaluate for yourself what investments are appropriate given your individual circumstances.

Disclosure: Short WLT

Comments

[1shilah:]

unfortunately the earnings bar is so low, WLT may beat -.04 that analysts have est. a far cry from the .94 for Q2 2008.

Jul 20 11:39 AM

[epeon:]

I agree. I have been a big fan of coal in general. My biggest holding was ARLP. However, when it went north of 36.50, I sold it. I may buy back in when it crosses below 35. Obviously the federal government is opposed to coal and the economy is slow. However, in the longrun, Coal is going to do well. I just think, right now, it is a little expensive.

Jul 20 11:46 AM

[Mark Mansfield:]

Yes... Looks like today the ANR long/WLT short would have been a nice trade. Met coal demand will remain depressed as long as steel demand remains depressed. I believe some of the optimism that we are seeing out there in relation to China materials demand may be overdone. However regardless of whether I am right or wrong in that regard, WLT trades at an excessive valuation to its peers.

Jul 20 05:50 PM

[bassmaster17:]

CLF and BTU are the best long term bets...I think this rally has legs eventhough Cramer is going megabull. That in its own right is scary. I'm looking for short strategies when the Euphoria manifests, which won't be long. Good luck to all.

Jul 20 08:50 PM

[Intuitive MGMT:]

I think that you make a very interesting argument for why WLT looks like it should be a short but you are missing some details that would make WLT a dangerous short. First off WLT has sizable cash flow's that are lined up from contracts that were signed during the peak of Met Coal prices ($300). WLT is also unlike any other coal producer based on its low cost of production due to its longwall mines, and its low cost of shipping to ports which is 50% less than its competitors. It also should be pointed out that WLT's coal isn't just good Met Coal, its the best Met Coal we have in this country next to Cliffs Pinnacle Mine and Consol's Buchannan Mine. WLT is a takeout candidate, and would be a jewel for any major mining co that wanted to enter the international Met Coal market.

Jul 21 12:57 PM

[James Levy:]

Nice article. Well written shorting proposals are scarce, thanks for the input. I would add another reason to short coal: the left wingers who are running Washington these days hate coal, as it gives off carbon dioxide, which they foolishly (or it the case of all Gore, for financial reasons) believe endagers public health. They will do everything possible to make life difficult for domestic coal producers, even if this requires importing coal from foreign producers who are not as environmentally politically correct.

Jul 21 12:59 PM

[Pax Americana:]

Nicely written in a clear and clinical prose, you give us some background on the stock,,and fill in why you think its a prospective short, an suggest suitable ways to play the stock. based on fundamentals as you see them. very impressive from start to finish.!

Jul 21 05:08 PM

[Mark Mansfield:]

Thanks for the nice comments guys. And thanks for the additional insight Intuitive Mgmt... The acquisition risk has been rumored since the spring of last year, it is certainly always possible. Long ANR / short WLT has worked since the writing of this article, but of course earnings on WLT are tomorrow afternoon, so it will be interesting to see how WLT reacts to that. We could see a sell the news given the recent run, but of course if there is a significant beat and guide higher, WLT may well trade up. We'll see tomorrow afternoon!

Jul 21 07:30 PM

[1shilah:]

mike

check out today's financialmirror.com article about european steel being depressed for some time.



On Jul 20 05:50 PM Mark Mansfield wrote:

> Yes... Looks like today the ANR long/WLT short would have been a
> nice trade. Met coal demand will remain depressed as long as steel
> demand remains depressed. I believe some of the optimism that we
> are seeing out there in relation to China materials demand may be
> overdone. However regardless of whether I am right or wrong in that
> regard, WLT trades at an excessive valuation to its peers.

Jul 22 01:05 PM

[1shilah:]

sorry mark, i wrote mark.

otherwise all else is ok.

fianancialmirror.com quotes moody's on state of euro steel. since WLT sells 60%+ to euro, it's on point to determine met coal sales.

Jul 22 02:21 PM

[Mark Mansfield:]

Nice!

Jul 22 02:33 PM

[1shilah:]

cash flow based on $300/t ???

per WLT Q1 report, sales were based on $133/t. w/ gross margin of $54.55/t.

Q2 they have they guided only $8-10 gross margin on sales of 1Mt. at Q1 prices that's sales of $133M plus coke and NG. Gross Margin of $8-10M. that starts to look a lot like Q1-2008. net of .01/share.

we'll see today where the truth is.




On Jul 21 12:57 PM Intuitive MGMT wrote:

> I think that you make a very interesting argument for why WLT looks
> like it should be a short but you are missing some details that would
> make WLT a dangerous short. First off WLT has sizable cash flow's
> that are lined up from contracts that were signed during the peak
> of Met Coal prices ($300). WLT is also unlike any other coal producer
> based on its low cost of production due to its longwall mines, and
> its low cost of shipping to ports which is 50% less than its competitors.
> It also should be pointed out that WLT's coal isn't just good Met
> Coal, its the best Met Coal we have in this country next to Cliffs
> Pinnacle Mine and Consol's Buchannan Mine. WLT is a takeout candidate,
> and would be a jewel for any major mining co that wanted to enter
> the international Met Coal market.

Jul 22 03:04 PM

[Mark Mansfield:]

They beat on EPS fairly handedly (though certainly down significantly y/y as would be expected), AH trading in the stock is pretty much nonexistant. We will have to see tomorrow whether the beat was enough to justify the recent run and move the stock higher or whether after this extended move folks sell the news. Should also be interesting to see if the analyst community has any reaction.

Jul 22 06:23 PM

[Intuitive MGMT:]

I did not say that all of their tons were going to be signed at 300 a ton...What I meant was that they have tonnage signed at 300 on contracts which have yet to be delivered on, and these contracts will cash flow in the next couple of years.


On Jul 22 03:04 PM 1shilah wrote:

> cash flow based on $300/t ???
>
> per WLT Q1 report, sales were based on $133/t. w/ gross margin of
> $54.55/t.
>
> Q2 they have they guided only $8-10 gross margin on sales of 1Mt.
> at Q1 prices that's sales of $133M plus coke and NG. Gross Margin
> of $8-10M. that starts to look a lot like Q1-2008. net of .01/share.
>
>
> we'll see today where the truth is.
>
>

Jul 22 07:05 PM

[1shilah:]

i see the "beat".

however, i was on the call and there are some troubling items w/ WLT and the analyst comm. should wheigh in.

as Intuit brought out there is $300 "carryover" coal. but here's the catch. It's been around for at least 2Qs unresolved w/ Braizilian customers.
the facts. "carryover" coal is priced at $315/T. there are 1.5MT at issue. WLT continues to sell to these same cutomers at benchmark prices mol $129/T as last negotiated by BMI/Aussies. I am having hard time reconciling expenses. assuming they produced this coal- WLT's own figures (mol $70/T mining costs) would mean they spent $105M. cannot find in financials how this expense is treated. going to be tough to get these same clients to give them $315/T or $472M for this coal in light of price decreases? ($187/T premium-$315-$129) while selling them provisional coal. no timeline just that they are working w/ customers.

WLT's current numbers their gross margin is down 52% comparing Q2-'08 (26.2%) w/ Q2-'09 (12.6%). not sure if expense of 1.5MT is reason.

Last-given the guidance-Q3 mol similar outcome as Q2. cannot understand why there are analysts forecasting -.55 EPS when they just reported .21 after forecast of -.05!!. all that does is bring down the avg. forecast so they can beat again. seems like a game.


60% sales to Europe, S. America 30%. according to annual report 2 customers make up 25% of all sales-no disclosure.







On Jul 22 06:23 PM Mark Mansfield wrote:

> They beat on EPS fairly handedly (though certainly down significantly
> y/y as would be expected), AH trading in the stock is pretty much
> nonexistant. We will have to see tomorrow whether the beat was enough
> to justify the recent run and move the stock higher or whether after
> this extended move folks sell the news. Should also be interesting
> to see if the analyst community has any reaction.

Jul 27 09:27 AM

[einstein p ...:]

Bought this stock at 22 and averaged down to 11. Got out at 32, which was too early, but I'm not going to complain.

Think the natural gas stocks are far too cheap in relation to the price of oil. Have been accumulating positions in both American and Canadian Trusts and MLPs. Some have paid off handsomely, such as LINE and ATN, others are treading water, collecting dividends. In this market, that's okay. Dollar is heading down and oil is heading back up to the mid seventies.

Jul 30 01:23 AM