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Summary:

Investing in coal miners can be risky. The coal mining index has dropped 40% this year and several companies' valuations are at multi-year low levels. The industry faces various challenges including deteriorating coal prices and increasing regulatory requirements. Even worse, most mining companies are highly levered due to the intense capital requirements. On 6/14/2013, it was reported that Walter Energy (NYSE:WLT) pulled a planned $1.55 billion credit refinancing due to market conditions. WLT's price fell 17% after the news and other coal mining companies fell 3-7% as well.

The decreasing coal price will force miners to shut production and the coal mining industry will eventually recover after the supply and demand reach a new balance. But it may take several months or years before this recovery can happen. Until then, the industry will continue to face challenges and there could be more bankruptcies or consolidations. If you want to take advantage of the recent price drop and invest in the coal mining industry, it is crucial to conduct a thorough credit analysis and search companies with lower default risk in the industry. In this article, I provide this analysis and compare the default risk of several large US coal miners. My analysis focuses on four aspects: credit ratings, Altman Z-score, risk factors and debt structure.

I picked the seven largest US coal mining companies to conduct my credit analysis. I chose US companies so that I can exclude the sovereign risk. These seven companies are:

  1. Peabody Energy Corporation (NYSE:BTU)
  2. Alliance Resource Partners (NASDAQ:ARLP)
  3. Alpha Natural Resources (NYSE:ANR)
  4. Arch Coal Inc (NYSE:ACI)
  5. Walter Energy
  6. Westmoreland Coal Company (NASDAQ:WLB)
  7. James River Coal Company (JRCC)

Figure 1 shows the price movements of these seven companies over the last 6 months. Table 1 shows several key statistics of these companies as of Q1 2013.

Figure 1. Six Months Stock Performance (click to enlarge)

Table 1. Key Financial Statistics

$ Millions

BTU

ARLP

ANR

ACI

WLT

WLB

JRCC

Market Cap

4,597

2,596

1,360

940

878

168

86

Cash & Equivalents

630

29

610

979

236

41

98

Preferred & Other

36

-

-

-

-

(16)

-

Total Debt

6,146

805

3,382

5,111

2,611

356

550

Enterprise Value

10,149

3,373

4,132

5,072

3,253

468

538

Revenue

7,822

2,139

6,374

3,945

2,260

616

991

Growth %, YoY

(5)

15

(19)

(11)

(19)

18

(25)

Gross Profit

1,207

474

340

284

225

72

(54)

Margin %

15

22

5

7

10

12

(5)

EBITDA

1,632

653

843

559

291

86

18

Margin %

21

31

13

14

13

14

2

Net Income Before XO

(663)

356

(2,519)

(755)

(1,156)

(16)

(165)

Margin %

(8)

17

(40)

(19)

(51)

(3)

(17)

Adjusted EPS

1

7

(1)

(1)

(1)

(4)

Cash from Operations

1,391

641

417

321

240

65

19

Capital Expenditures

(1,168)

(436)

(321)

(356)

(305)

(22)

(66)

Free Cash Flow

224

204

96

(35)

(65)

43

(48)

Credit Rating:

Table 2 shows credit ratings from the big three rating agencies for each of the seven companies. The best rated company is BTU with a BB rating grade, the second best rated company is ANR with a B+ rating. The worst rated company is JRCC with a CCC rating grade, followed by WLB, WLT and ACI. ARLP is not rated by any of the three rating agencies.

Table 2. Public Credit Ratings

Moody's

S&P

Fitch

BTU

Ba1

BB+

BB+

ARLP

NR

NR

NR

ANR

B1

B+

NR

ACI

B2

B+

B-

WLT

B2

B

NR

WLB

Caa1

B-

NR

JRCC

Caa2

CCC

NR

Altman Z-score:

The Altman Z-score was created by Edward Altman in 1968 as a measure to predict bankruptcy for publicly traded corporations. As the name suggests, the Altman Z-score is a linear combination of five financial ratios that can be calculated from data found on a company's financial statements. The five financial ratios reflect a company's liquidity, earnings power and balance sheet strength. Z-scores above 3.0 indicate that bankruptcy is unlikely in two years, scores between 1.8 and 3.0 are inconclusive, and scores below 1.8 indicate an increased risk of business failure.

Table 3 shows historical Altman Z-scores for each of the seven companies. The only company that has a Z-score in the safe zone is ARLP. And BTU is the only other company that has a Z-score more than 1. The default risk can be ranked by Z-score as: WLB > JRCC > WLT > ACI > ANR > BTU > ARLP.

Table 3. Altman Z-score

Z SCORE

2013 Q1

2012 Q4

2012 Q3

2012 Q2

2012 Q1

BTU

1.32

1.46

1.47

1.52

1.63

ARLP

2.69

2.55

2.60

2.59

2.90

ANR

0.68

0.96

0.88

1.09

1.74

ACI

0.65

0.75

0.80

0.82

0.95

WLT

0.50

0.66

0.84

1.27

1.47

WLB

0.17

0.15

0.14

0.05

0.09

JRCC

0.32

0.89

0.99

1.19

Risk Factor Analysis

Although the Altman Z-score was widely accepted by the financial industry as a predictor of bankruptcy, it has its limitations (see this paper). The main problem is that Z-score works best for the manufacturing industry, but its accuracy decreases for other industries. Furthermore, because of its popularity, more and more companies start to manipulate their financial statements to get a better Z-score, which limits the effectiveness of a Z-score. Instead of splitting hairs on more sophisticated math models, I explored several risk factors that affect a company's credit profile.

Companies defaulted because they cannot repay debts that they owe to their creditors. This failure typically happened in two scenarios: in one scenario, the company failed to generate enough cash to pay the interest due on its debt; in the other scenario, the company failed to repay their debts when they matured. I presented three risk factors that can measure the probability of these two scenarios. These factors are widely used by credit rating agencies and banks in their own credit risk models to predict default probability.

  1. Debt/EBITDA (measures financial leverage): I choose total debt/EBITDA ratio to measure the degree to which a company has incurred obligations in anticipation of future earnings and cash flow that may be used for debt repayment. The metric has limitations in that EBITDA is not a measure of cash flow because it does not take into account other cash needs including working capital and capital spending. Despite these limitations, debt/EBITDA remains a key ratio used by lenders and regulators for evaluating a company's financial leverage. Any limitations to this metric are mitigated by the use of operating cash flow (FFO), which is described below. The lower the debt/EBITDA ratio, the greater the flexibility a company can manage through challenges in the economy or competitive environment.
  2. EBITDA/Interest (measures interest coverage): I choose the EBITDA/Interest ratio to measure a company's ability to meet the carrying costs of financial obligations from its operating results. The higher the ratio, the greater the flexibility to absorb an earnings decline before impairing the ability to make timely interest payments.
  3. FFO/Debt (measures debt coverage): I choose FFO/Debt to measure a company's ability to generate cash flow in relation to its existing debt. Strong and stable debt-to-cash flow ratios are very good indicators of a healthy credit profile and can also be a competitive advantage by providing greater strategic and financial flexibility during business downturns.

Table 4 shows trailing 12 months' risk factors for these seven coal mining companies. I also listed an industry average value for the ease of comparison. Table 5 shows the quarterly percentage change of these risk factors. I made the following conclusions from these two tables:

  1. All coal miners have high leverage, except ARLP. JRCC and WLT have the highest leverage. ARLP, BTU and ANR have lower than industry average leverage.
  2. Because of its low leverage, ARLP has very high interest coverage and debt coverage ratio. Among other companies, BTU is the only one that has both interest and debt coverage higher than industry average value. On the other hand, JRCC has the worst coverage ratio; ACI and WLT also have very weak coverage ratios.
  3. JRCC's interest coverage ratio is less than one, which means it cannot generate enough cash to pay its interest.
  4. From Q4 2012 to Q1 2013, JRCC and WLT's risk factors deteriorate the most, ARLP and WLB's risk factors deteriorate the least.

Table 4. Trailing 12 Months Risk Factor Values

Risk FactorIndustry AverageBTUARLPANRACIWLTWLBJRCC
Total Debt / EBITDA47.3826.447.4738.4249.8265.4956.73211.20
EBITDA/ Total Interest2.694.0322.223.971.661.782.000.35
FFO / Total Debt0.020.030.130.010.010.010.010.00

Table 5. Risk Factor Quarterly Percentage Change

Risk FactorBTUARLPANRACIWLTWLBJRCC
Total Debt / EBITDAR13%-3%11%19%45%3%156%
EBITDAR / Total Interest-12%4%-17%-19%-41%-3%-61%
FFO / Total Debt-7%12%-18%-5%-28%14%-42%

Debt Structure and Amortization Schedule:

In this section, we analyze the debt structure and amortization schedule for these companies. Typically, an evenly distributed amortization schedule is better than a concentrated schedule because it minimizes the refinance default risk.

Figure 2 shows the percentage of maturing debts of each company. We can learn the following things:

  1. WLB has the most concentrated debt amortization schedule (all debts mature in 2019). ARLP and JRCC also have concentrated debt amortization schedule (51% of ARLP debt matures in 2018, and 55% of JRCC debt matures in 2020)
  2. The chart shows that there are very few debts that will mature before 2016, therefore, there is very little refinance risk until at least 2016. It is also shown that BTU and ACI have the most evenly distributed amortization schedules among all seven companies.

Figure 2. Debt Amortization Schedule (click to enlarge)

Table 6 shows the weighted average coupon for these seven companies. A high coupon rate increases the debt servicing burden, reduces a company's income, and increases its default risk. Table 6 shows that WLB has the highest coupon rate, followed by JRCC and ACI. ARLP has the lowest coupon rate, followed by ANR and BTU.

Table 6. Coupon Rate

BTUARLPANRACIWLTWLBJRCC
Weighted Average Coupon Rate5.264.105.246.695.299.987.56

Conclusions:

In this article, I performed a credit analysis for seven US coal mining companies. My analysis can be summarized as the following conclusions:

  1. The immediate default risk due to refinancing is limited among these seven coal mining companies. There are very little debts that will mature before 2016.
  2. Six of all seven companies have very high financial leverage. Four of them have low interest coverage ratio and the ratio is dropping fast. Therefore, there is an increasing default risk due to missed interest payment if the coal market continues to deteriorate.
  3. I ranked the probability of default for these seven companies from high to low as: JRCC > WLT > ACI > WLB > ANR > BTU > ARLP

ARLP can be granted the safest coal miner among the seven companies. It has low leverage and high coverage ratio compared to its competitors. The companies that are closest to bankrupt are JRCC, ACI and WLT.

It should be noted that your investment decision should not purely based on a company's default probability. The "safe" firm such as ARLP has low leverage, which limits its upside potential when the industry recovers. The "dangerous" firms such as JRCC and ACI's price have already been heavily discounted due to their high default risk. However, firms such as BTU and ANR, which have relatively healthy balance sheets, but whose shares got hammered same as their more risky counterparties due to negative market sentiments, may present a good investment opportunity.

Source: A Credit Analysis For Coal Mining Companies