Walter Energy: Solidly Capable Of Navigating A Prolonged Met Coal Market Slump

Jun.17.13 | About: Walter Energy, (WLT)

Walter Energy (NYSE:WLT) is a company that specializes in the production of metallurgical coal. With China's slowing growth and Europe's continuing economic problems, the metallurgical coal market has faced some tough times that has resulted in steep price declines. Like many other coal companies Walter Energy is highly leveraged and the key questions that need to be answered are how long can it weather current market conditions without facing a liquidity crisis, and how much of a market recovery is needed for it to reach various levels of profitability.

Investors are nervous about Walter Energy's financial situation, as demonstrated by Walter Energy falling 17% on June 14, on news that it had cancelled a proposed debt financing. The company later put out a statement mentioning that the debt refinancing would not have generated additional capital, and that it did not have any incremental funding needs currently. From the stock action earlier, it is apparent that many investors were thinking that Walter Energy was in a more immediate liquidity crunch.

We are going to look at its liquidity and estimate how long it can go under current market conditions without needing to secure additional funds. Then we are going to calculate EBITDA and estimated cash flow under various market recovery situations.

Debt and Liquidity

Walter Energy has $2.6 billion in long-term debt, leading to interest expenses of approximately $175 million per year. One positive for Walter Energy is that its earliest listed debt maturity is in April 2016, when $657 million of their 2011 term loan A becomes due. Walter Energy also mentioned that it has no material debt principal payments due until 2015. That loan was at a favorable interest rate (4.80%) compared with more recent loans, but Walter Energy potentially has a couple years before needing to deal with refinancing and higher interest costs. KeyBanc mentioned in March that Walter Energy has been encouraged by its banking group to repay part of the lower interest term loans with higher interest unsecured notes, which explains its recent refinancing actions as well as leading to interest expenses potentially rising above $175 million per year before 2015.

Here are its long-term debt components as of Q1 FY13:

Debt Type

Amount

Weighted Average Stated Interest Rate

Final Maturity

2011 Term Loan A

$656.6 Million

4.80%

April 2016

2011 Term Loan B

$978.2 Million

5.75%

April 2018

9.875% Senior Notes ($500 Million Face Value)

$496.6 Million

9.88%

December 2020

8.500% Senior Notes

$450.0 Million

8.50%

April 2021

Other

$29.7 Million

Various

Various

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Current liquidity at the end of Q1 FY13 was $560 million, including $236 million in cash and cash equivalents, and $324 million available under its revolving credit facility.

The table below outlines annual expectations for cash outflows. We'd expect approximately $561 million to be spent on interest, capital expenditures, dividend payments and operating expenses over the next year.

Type

Amount

Interest Expense

$175 Million

Capital Expenditures

$170 Million

Selling, General, and Administrative

$125 Million

Post Retirement Benefits

$60 Million

Dividends

$31 Million

Total

$561 Million

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Based on guidance, it is expecting annual production of 11 million tons of metallurgical coal, with cost of sales decreasing 15% by year end. Cost of sales was $124 per ton during Q4 FY12, so a 15% decrease would bring this to $105 per ton. We are using $113 per ton as the average over the next year assuming that the cost of sales per ton is $115 per ton in Q2 FY13, $110 per ton in Q3 FY13, and $105 per ton in Q4 FY13 and Q1 FY14.

The numbers for revenue per ton are based on Q1 FY13 averages.

Type

Tons

Revenue Per Ton

Cost of Sales Per Ton

Gross Margin

Metallurgical Coal

11,000,000

$152

$109

$473 Million

Thermal Coal

1,000,000

$64

$81

($17 Million)

Total

12,000,000

$456 Million

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Based on these calculations, under current market conditions Walter Energy will use approximately $105 million in cash over the next four quarters. Its liquidity at the end of Q1 FY14 is projected to be $455 million under current market conditions. Even with possible increases in capital expenditures, it appears that Walter Energy should be able to weather current market conditions until its 2016 debt payments without needing additional financing. April 2016 is when it needs to refinance $656.6 million in maturing debt, so that represents its most immediate major financial issue assuming that market conditions remain in this weak state, but do not deteriorate further.

If prices drop an additional 10% for metallurgical coal, then it will use approximately $270 million in cash over the next four quarters, leaving it with $290 million in liquidity at the end of Q1 FY14. That situation is more serious, but does indicate that the company will likely survive for a significant period of time even with a prolonged price drop from already weak market conditions.

Walter Energy's Future

Here is a look at what Walter Energy's gross margins on coal sales will look like under various scenarios. The thermal coal mines are forecast to be permanently shutdown at the end of 2013, so they are not factored into these calculations. The cost of sales per ton is pegged at the same level as at the end of FY13 with one exception. With a 30% increase in metallurgical coal prices, it is assumed that Walter Energy will bring its idled metallurgical mines online. We have estimated that cost of sales per ton increases to $120 per ton in this case due to the inclusion of higher cost mines.

The gross margins from the sale of metallurgical coal are estimated to range from $352 million (with a 10% price drop) to $1.17 billion (with a 30% price increase).

Type

Tons

Revenue Per Ton

Cost of Sales Per Ton

Gross Margin

Metallurgical Coal - 10% Price Drop

11,000,000

$137

$105

$352 Million

Metallurgical Coal - Current Conditions

11,000,000

$152

$105

$517 Million

Metallurgical Coal - 10% Price Increase

11,000,000

$167

$105

$682 Million

Metallurgical Coal - 20% Price Increase

11,000,000

$182

$105

$847 Million

Metallurgical Coal - 30% Price Increase

15,000,000

$198

$120

$1,170 Million

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Using the figures from above, we can calculate EBITDA under the various scenarios. Operating expenses are estimated at $185 million, including $125 million of SG&A expenses, and $60 million related to post-retirement benefits.

Type

Gross Margin

Operating Expenses

EBITDA

Metallurgical Coal - 10% Price Drop

$352 Million

$185 Million

$167 Million

Metallurgical Coal - Current Conditions

$517 Million

$185 Million

$332 Million

Metallurgical Coal - 10% Price Increase

$682 Million

$185 Million

$497 Million

Metallurgical Coal - 20% Price Increase

$847 Million

$185 Million

$662 Million

Metallurgical Coal - 30% Price Increase

$1,170 Million

$220 Million

$950 Million

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Valuing Walter Energy becomes quite interesting due to its high leverage and the potential for large margins on metallurgical coal sales. Using a 6x EBITDA valuation would value Walter Energy at around $1 billion with a 10% price drop and $2 billion under current conditions. Both of these values are below the net debt of the company. If you thought that metallurgical coal prices would remain at or below current prices long term, then Walter Energy would definitely not be a good investment.

However, with an increase in metallurgical coal prices Walter Energy could be worth substantially more. A 20% price increase would give Walter Energy around a $4 billion value, which would be around $25 per share after factoring in net debt. A 30% price increase would give Walter Energy a $5.7 billion value, making it worth approximately $50 per share.

While a 30% increase in metallurgical coal prices seems like a large increase, the metallurgical coal market has been fairly volatile in the past. A 30% increase means $198 per ton for Walter Energy's metallurgical coal, which is slightly above the prices it received in Q2 FY12 ($193) and Q3 FY12 ($191). That price is also nearly 10% below the $218 per ton it received in Q1 FY12 and 18% below the $242 per ton it received in Q4 FY11.

Conclusion

Despite the recent sell-off due to concerns about Walter Energy's financial health, a look at its cash flow and debt situation shows that it is likely to be able to handle depressed metallurgical coal market conditions for a couple years assuming it can continue to manage and negotiate its debt covenants. Walter Energy is a risky investment due to its heavy debt loads and uncertainty about when the metallurgical coal markets might recover.

However, at the current price of $12.13 per share, Walter Energy appears to be a very attractive vehicle for a bet on a metallurgical coal recovery. As noted above, a return of prices to levels seen nine months ago (which is still well below peak levels) would allow Walter Energy to generate nearly $1 billion in annual EBITDA, which would make its stock worth several times what it is right now. A significant amount of metallurgical coal production is estimated to be under water at current prices, so production cuts should stabilize the market and perhaps start a recovery in the latter half of 2013.

Though Walter Energy has faced some difficult market conditions recently, those trials should make Walter Energy a stronger company in the long term. The projected reduction in cost of sales per ton by 15% will make operations much more efficient, and represents an annual savings of $200 to $300 million compared with when prices were high and there was less incentive to be lean.

It also appears that some insiders feel that Walter Energy is significantly undervalued and are also betting on a metallurgical coal recovery at some point within the next couple years. As noted in this Seeking Alpha article, there were multiple insider purchases in May. Since then there have been additional insider purchases, for a combined total of over $2 million at an average price of nearly $18 per share.

It is uncertain whether Walter Energy has bottomed yet, but current prices are significantly below the prices that the insiders were recently purchasing shares at. Though there is potential for future downside, Walter Energy looks capable of surviving a continued weak metallurgical coal market, and has very significant upside if the market starts to recover.

Disclosure: I am long WLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.