James River Coal's (JRCC) Q3 FY2013 earnings report was quite similar to what we expected. We estimated that James River Coal would post an adjusted EBITDA loss of over $5 million (actual adjusted EBITDA loss of $7 million), and that James River Coal would have between $85 million to $90 million in working capital (actual working capital of $89.9 million).
What will likely happen now is that James River Coal will draw down its inventory to fulfill its remaining 2013 contracts. CAPP thermal coal production has been reduced drastically as James River Coal has only signed fixed price contracts for 1.048 million tons of CAPP thermal coal for delivery in 2014, and current CAPP coal prices are below its production costs. At the same time last year, James River Coal had signed fixed price contracts for 3.405 million tons of CAPP thermal coal for delivery in 2013.
Drawing down its inventory will preserve liquidity until 2014, but a major rebound in the metallurgical coal market will likely be necessary to avoid dangerously low liquidity levels in the first half of 2014.
Coal Inventory Levels
James River Coal's coal inventory levels are significantly higher than typical and appear to have reached an all time high. The coal inventory appears to be primarily CAPP coal. Since the low inventory levels of Q4 FY2012, James River Coal has produced 1.775 million tons of Midwest coal and shipped 1.765 million tons, resulting in an inventory gain of 10,000 tons. On the other hand, James River Coal has produced and purchased 5.333 million tons of CAPP coal, but only has shipped 4.898 million tons of CAPP coal. There has been an inventory increase of 435,000 tons of CAPP coal during 2013.
James River Coal Inventory - Coal
At an average of $75 per ton (due to inventory being heavily weighted towards higher cost CAPP coal), this would would indicate that James River Coal has around 830,000 tons of coal in inventory.
The main reason for these high inventory levels is that James River Coal is attempting to avoid selling its coal at a loss. Recent contract prices for CAPP thermal coal (which likely makes up the majority of the CAPP coal inventory) are substantially below the cost of production for many of James River Coal's mines. James River Coal already had contracts for the majority of its 2013 production, but has signed little in the way of new contracts due to the poor prices.
As a result, James River Coal has idled most of its CAPP thermal mines as it will fulfill its existing contracts through a combination of inventory and the remaining lower-cost CAPP thermal production. James River Coal appears to currently have only around 2 million annual tons of active CAPP thermal production based on its comments that current operating mines have a capacity of 6 to 7 million annual tons. Approximately 2.5 million of this is profitable Illinois Basin coal, with perhaps another 1.5 million tons of metallurgical coal production (not including purchased coal).
We expect the Q4 results for James River Coal to be fairly similar to its Q3 results. Metallurgical coal prices have rebounded somewhat, so that may improve its adjusted EBITDA loss to around $5 million from $7 million. Added to that is $5.8 million in severance related costs.
With an estimated additional $22 million in capital expenditures and cash interest costs during the quarter, we'd expect James River Coal's liquidity to decrease by around $33 million if other working capital items remained the same. However, with a major drawdown in inventory likely in Q4, liquidity levels are likely to be maintained above the $71 million level for this quarter. Working capital on the other hand is likely to decline to the $60 million to $65 million range.
Thermal Coal Pricing - Why A Cold Winter Will Not Help Much
One question we had for the Q3 results was around James River Coal's contracted thermal coal pricing. James River Coal has now priced 2014 Midwest coal in volumes equivalent to 80% of its 2012 production. The average of $44.86 per ton should lead to margins of around $7.50 per ton, which is close to the $8 per ton that we estimated before.
James River Coal has also priced 1.048 million tons of CAPP coal, which is likely thermal coal since metallurgical coal isn't usually sold on fixed price contracts far in advance. With its current CAPP thermal production levels estimated at 2 million tons per year, the contracts represent around 50% of its total CAPP thermal production.
CAPP thermal coal prices will probably need to increase by nearly 10% for James River Coal to consider restarting the mines that it idled in September. Even at those prices the margins on James River Coal's CAPP thermal coal will be very limited. We do not foresee James River Coal obtaining significant margins on its CAPP thermal coal even with a cold winter due to the high levels of current natural gas production and competition from other coal basins. There would need to be a significant increase in the price of natural gas (despite high production levels) as well as the price of Illinois Basin and PRB coal before CAPP thermal coal would start moving upward significantly.
As for James River Coal's Illinois Basin coal, only 20% of its Illinois Basin production is not committed, so it would only benefit partially from any improvement in Illinois Basin coal prices in 2014.
Liquidity, Liquidity, Liquidity
It appears that James River Coal's chances of avoiding a liquidity crisis are dependent on some combination of a rapid and major metallurgical coal price increase, selling assets, or acquiring additional funding.
The magnitude and speed of the required metallurgical coal price increase will likely need to involve some sort of supply shock (such as severe Queensland flooding) since increasing demand alone is unlikely to move prices quickly enough for James River Coal's needs.
Asset sales are likely to only delay the inevitable, as the idled CAPP thermal coal mines are unattractive to buyers due to their high cost structure. The metallurgical coal mines and Illinois Basin operations may attract interest, but sales of those mines would buy some time at the expense of further harming James River Coal's long term prospects.
That leaves the prospect of additional funding. James River Coal mentioned that it was working on liquidity initiatives, but nothing has been finalized yet. We believe it will be difficult for James River Coal to acquire significant amounts of additional funding given its current financial state and continued heavy losses. Even if it did secure additional funding, the cost may be very prohibitive. As well, any additional funding will be used up quickly unless there is that major increase in metallurgical coal prices.
So far, James River Coal's results and future outlook are progressing as we expected. Q4 results are likely to result in a negative adjusted EBITDA as well, along with $5.8 million in severance costs to be paid out. Despite that, we expect James River Coal's liquidity to likely remain around similar levels to Q3 in Q4. James River Coal will be drawing down its inventory significantly to fulfill its remaining 2013 CAPP coal obligations. That reduction in inventory may negate the impact of James River Coal's expected loss on cash burn. That will likely only be a temporary respite though, as James River Coal needs a quick and major increase in metallurgical coal prices to avoid severe liquidity issues in 2014. James River Coal is looking at options to enhance liquidity, but it seems unlikely that it would be able to raise the required levels of additional debt, and an asset sale would likely involve its Midwest operations, which has accounted for the majority of its gross margin this year.