Last Friday, June 14, Walter Energy (WLT) announced that it would not go ahead with its planned refinancing of a portion of its existing debt. Before the announcement, shares reached highs of $15.16, but then closed at $11.76 -- a 17.43% decrease. This closing share price was the lowest since December 2008, when prices decreased to as low as $11.12. In our view, this announcement was a continuation of a bad year for WLT in that share prices are now seeing a year-over-year decrease of 73%. Has this stock bottomed after a tepid year, or can we continue to expect additional negatives?
As mentioned, before the announcement at the end of last week, WLT was already experiencing a terrible year. Recently, supply for metallurgical coal has by far outpaced demand, driving prices down to the point where some companies have stopped production in certain mines. Total demand for met coal has decreased as a result of lower demand in cash-strapped Europe and the slowing of economic activity in China. These factors do not seem to be going away in the near future, and forecasts indicate a continued drop in prices. This is not good news for WLT, which, as opposed to most of its competitors, mostly supplies met coal.
As a result of this decrease in price and therefore revenues, WLT announced that it had begun exploring ways to refinance its existing debt in order to improve its financial health. In the last quarter, debt stood at a whopping $2.6 billion with the majority of this debt being long term. Much of this debt was taken to finance the $3.3 billion purchase of Western Coal in 2010. In hindsight, this purchase was not as successful as expected as it increased production of met coal, and increased company debt while prices continued to fall. The only way we see WLT improving its financial situation is if cost of goods sold showed a continued decrease.
Last quarter, WLT reported relatively good results. Met coal sales volume increased by 17% and 9% for coking coal and low-volatility PCI, respectively. Coal prices increased by a low 2%, but the company is aware that this was a buck in the trend instead of the new norm. As mentioned, cost of goods sold is where WLT can try and make a difference in its current predicament, and last quarter the company saw a 2% decrease from the same quarter in the previous year. This company has done a good job of reducing these costs, mainly by changing mines from contractor-operated to owner-operated mines.
Individual mines have also increased their productivity and lowered spending. The Willow Creek mine, for example, reduced its cost of sales per ton by 51% compared to Q4 2012. WLT has to continue with these cost-cutting initiatives if it is going to be successful in getting past the predicament it is currently in as a result of low met coal prices. Although cost of goods sold have continued to decrease over several quarters, we believe that it has not been enough to counteract the effect that the decrease in coal prices has had -- and will continue to have -- on the company.
WLT currently has a forward P/E of 21.36, which is above our sub-15 threshold for undervalued companies. In our view, this valuation is correct as we believe that the share price will continue to decrease even after last week's announcement. The main issue with WLT is the decrease in coal prices. The only way these would increase if is a major coal left the market, which would shrink supply, or if the macroeconomic situation improved to the point where demand improves.
In our view, WLT has to diversify in order to include more of thermal coal in its production. Although thermal coal has seen a reduction in prices as well, in the short term, met coal prices have had more pressure. If WLT can get past this period of low prices, it would look attractive to us. But at the moment, the risk is too large to get involved as we believe the stock still has to bottom.
Recommendation: Short WLT.