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Walter Energy, Inc. (NYSE:WLT)

Q2 2010 Earnings Call Transcript

July 29, 2010 9:00 am ET

Executives

Mark Tubb – VP, IR and Strategic Planning

Joe Leonard – Interim CEO

Lisa Honnold – Interim CFO, SVP and Controller

George Richmond – President and COO, Walter Energy, Inc.; CEO of Jim Walter Resources, Inc.

Walt Scheller – President and COO, Jim Walter Resources

Analysts

Jim Rollyson – Raymond James

Curt Woodworth – Macquarie

Shneur Gershuni – UBS

Jeremy Sussman – Brean Murray, Carret & Co.

Dan Mannes – Avondale Partners

Mark Liinamaa – Morgan Stanley

Daniel Scott – Dahlman Rose

Mark Parr – KeyBanc Capital Markets

Meredith Bandy – BMO Capital Markets

Garrett Nelson – Davenport & Company

Peter Epstein – PWP

Mark Caruso – Millennium Partners

Brian Gamble – Simmons

Operator

Welcome to the Walter Energy’s second quarter 2010 earnings call. All participants are in a listen-only mode. (Operator instructions) Now, I would like to turn the meeting over to Mr. Mark Tubb, Vice President of Investor Relations. Sir you may begin.

Mark Tubb

Thank you, Tania. Good morning and thanks for joining us for Walter Energy's second quarter 2010 earnings conference call. Today’s call is being webcast live over the Internet, and a recording will be archived on our website for up to 30 days.

Joining me today are Walter Energy’s Interim CEO, Joe Leonard; President and COO, George Richmond; our new Chief Operating Officer, for Jim Walter Resources, Walt Scheller; and our Interim CFO, Lisa Honnold. Today we will discuss earnings for the second quarter, our views on the market, and our updated business outlook. Following our prepared remarks, we will open the call to questions.

We may refer to forward-looking statements made in yesterday's press release and may make those and other forward-looking statements on today’s call. For more information regarding risks associated with forward-looking statements, please refer to the company’s SEC filings.

At this time, I will turn the call over to Joe.

Joe Leonard

Thank you, Mark and good morning everyone. I would like to start by recapping some of the highlights of the quarter. As you know, we reported an outstanding earnings of $2.16 per share for the second quarter, driven by significant volume and price increases at our coking coal and metallurgical coke businesses. We completed the HighMount acquisition, which more than doubles our annual coal bed methane production, and is expected to be a stable generator of earnings and cash flows into the future.

More importantly, this acquisition helps ensure that future coal production areas will be properly degasified, improving the safety and operational efficiency of our mining operations into the future. We spent $48.8 million buying back nearly 668,000 shares of our own stock during the quarter under our share repurchase program.

Finally, we continue to move forward in positioning the company for the future. Specifically, we are making very good progress in our search for a new CEO, and expect to have an announcement in the near future. We continue to work on a plan to acquire and develop 170 million tons of Blue Creek metallurgical coal reserves to the north-west of our existing underground operations, which will more than double our coal coking reserve base.

We have signed a coal lease for 22 million tons with a third party and continue to pursue acquisition of other reserves in the area. Finally, we completed the buildout of our headquarters building in Atlanta, and expect to open that up in August. Now I will turn the call over to Lisa to discuss our financial results for the quarter. Lisa.

Lisa Honnold

Thanks Joe, and good morning everyone. Yesterday, we reported second-quarter 2010 results from continuing operations of $116.1 million, or $2.16 per diluted share. Second-quarter operating income was $170.2 million on revenues of $410.6 million. Revenue and operating income in the quarter improved on higher selling prices and volumes from each of our operating segments, especially from increased average selling prices of our coking coal at our underground mining segment.

The improvement to operating income from pricing and volume growth was partially offset by increased cost of sales and SG&A expenses, as compared to the prior-year second quarter. Increased coking coal cost of sales on a per ton basis resulted from higher inventory royalty and freight cost as compared to the prior-year period. Furthermore, selling, general and administrative expenses increased primarily due to cost of two strategic initiatives, including the HighMount acquisition, our corporate relocation to Birmingham, and other growth opportunities.

Our second quarter effective tax rate was 30.2%, and we continue to expect our full year 2010 effective tax rate to be approximately 31%. Our favorable tax rate reflects the benefit of percentage depletion deductions. Cash at June 30, 2010 was $95.7 million compared to $214.4 million at March 31.

Favourable cash flow from operations allowed us to rebuild cash in the second quarter after spending $210 million for the HighMount natural gas acquisition, $48.8 million on share repurchases, and $30.7 million for capital expenditures. Available liquidity was $335.5 million at June 30 compared to $452.6 million at the end of the first quarter.

I will now turn the call over to George to discuss our operational results for the quarter.

George Richmond

Thanks Lisa and good morning. I would like to take a moment to cover our safety performance before moving into our operational results for the quarter. Sadly, we had an accident in June, which resulted in a fatality to tapped [ph] surface operations, and our condolences go out to the family. In conjunction with MSHA and the State of Alabama, we are conducting a full investigation into the incident.

Prior to that accident, (inaudible) went nearly 3 years without a lost time accident, and had the best safety record in the company. The rest of the operations improved their incident rates for the first six months of 2010, with Jim Walter Resources improving its lost time incident rate 37% compared to the same period last year. Our goal remains to ensure every employee returns home safely at the end of every day, a goal we strive for constantly.

Turning now to our operational results for the quarter, coking coal sales in the quarter totaled 1.8 million tons. Demand in pricing for high-quality hard coking coal remained strong in our coal markets of South America and Europe. There has been a number of reports of a slowdown in the global steel market. However, we have not been asked to delay or defer any shipments. In fact, some customers have asked for increased tons.

As we have said in the past, this is due to our premium coking coal product, as well as our customer base with the primary focus on selling directly to the end user in our coal markets. Steel production in South America is up 35% both for the second quarter and the year-to-date versus 2009. In Europe, production is up 50% in the second quarter and 44% year-to-date versus the prior year.

Production in the quarter totaled nearly 1.7 million tons, which was at the lower end of the guidance. Production was impacted by several continuous mining sections encountering difficult geological conditions. We are working through these issues and have seen an improvement. However, it will delay the long haul move in the fourth quarter.

Production cost averaged $59.82 per ton compared to $69.38 in the prior-year period due to higher volumes. Our surface mining operations sold 387,000 tons of coal in the second quarter and average selling prices improved by $6.42 per ton versus the second quarter of 2009. Production totaled 369,000 tons in the quarter. At Walter Coke, our strong results were driven by a rebound in the domestic steel market, selling 96,000 tons in the second quarter 2010, compared to 28,000 in the prior-year period, with income increasing more than $15 million.

I would now like to turn the call over to Walt Scheller, the new President and Chief Operating Officer of Jim Walter Resources. Walt has more than 25 years of hands on mining experience with Peabody and Consol, and we welcome him to the Walter Energy team. Walt.

Walt Scheller

Thanks George. I joined the company about a month ago, and have been very impressed by the quality of the team here, the quality of our products, and our outlook for the future. Turning to our third quarter outlook, coking coal sales are estimated to be between 1.8 million tons and 2 million tons with operating margins per ton expanding 15% to 20% on higher realized prices and lower expected costs.

We have priced approximately 1.7 million metric tons of coking coal for the second half of the year averaging $237 per metric ton, which equates to an expected realized price of more than $215 per short ton. We are satisfied with this pricing, and this premium over other settlements in the market illustrate our competitive advantages.

Third quarter coking coal production is expected to total 1.9 million tons to 2.1 million tons with costs averaging $50 to $55 per ton. For the full year, we have modified our sales guidance from 8 million tons to a range of 7.7 million tons to 7.9 million tons. Continuous minor shortfalls in the second quarter resulted in approximately 100,000 tons of reduced production. The slower advance rates are needed to developing the replacement longwall in mine No. 7 and 8 are expected to delay the longwall move, resulting in 100,000 ton reduction for the fourth quarter.

We expect transportation and handling costs to continue to remain approximately $15 to $16 per ton for the remainder of the year. As you know, all of our export sales are shipped to the Port of Mobile. We have been in nearly daily contact with the officials at the port, and have not seen any adverse shipping impact from the Gulf oil spill. Port officials remain confident that the port will remain open in almost any scenario related to the spill. Separately, the loss [ph] on the Black Warrior River have been closed since the first week of July for planned maintenance, limiting our shipping to rail only during this period.

We expect the river to be closed until the first week of August. With slower coking coal shipments expected in July and part of August, we see a heavy loading schedule for September. Even with strong deliveries in September, we will likely build inventory over the next several weeks, but expect it to be reduced as we move into October and November.

In closing, my two biggest priorities are to get repeatable production volumes above 2 million tons per quarter, and to drive accidents out of the system. Safety is not only a core value of this company, but one of mine as well. I will now turn the call back over to Joe to conclude today’s call.

Joe Leonard

Thank you all. On the strategic front, we expect to leverage our strong liquidity position and cash generation to invest and grow initiatives in the future. The balance that, however, with our desire to return cash to our shareholders through dividends and share repurchases.

Before I open the call to questions, I would like to echo George’s comments and welcoming Walt to Walter Energy. We appreciate your commitment to safety and production, and I’m sure that every person on this call has the same appreciation. We look forward to many years of your great contributions. And George, from a personal standpoint I would like to thank you for your more than 32 years of service, your significant contributions to this company, and for building a culture of respect and accountability.

Your team built the Blue Creek coal name into a brand that is known as one of the finest coking coals in the world. Your leadership and guidance has helped position us as a leader in our industry, and leaves us well positioned for the future. Congratulations to you on a well-deserved retirement. We wish you and your wife Linda all the best for the future.

George Richmond

Thanks Joe for the kind words. I just like to take the moment to thank all of you for being part of what has been a memorable journey to me for the last three decades with the company. I have had the opportunity to meet many of you and share our compelling story. I like to thank my family, I like to thank my friends, and more importantly, I want to thank the men and women of Walter Energy. These are the people who truly make this a special company.

You should know that your investment is in good hands with them. Joe.

Joe Leonard

Thank you George. And with that we will open the conference for questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question Jim Rollyson with Raymond James. You may ask your question.

Jim Rollyson – Raymond James

Good morning everyone. Good luck on the retirement George, and I guess welcome Walt.

George Richmond

Thank you.

Walt Scheller

Thank you.

Jim Rollyson – Raymond James

George or Walt, whoever, by my math with your guidance range for the year, you still have about 1.7 million tons to 1.9 million tons yet to be priced on the met side, any thoughts on pricing there, maybe kind of thinking that is going to be in line what you have priced so for this year, or just any color you can add?

George Richmond

Yes, obviously, on the quarter I can’t give you what the exact numbers were with – I think we will finish the fourth quarter, but at least let me give you a little color on it. As you remember, we settled a six-month deal into Europe around 235 [ph], which spanned into the third quarter. We have obviously just put numbers out, that is now saying that the third quarter is 237. So, the business we have just concluded, I mean, just in the last few weeks into South America were clearly above the 235. So we got a better price in the third quarter than the second quarter even with the bloom and doom.

So, again, our is basically built. We have pricing still to negotiate. We are still very, very bullish with our particular coal into our particular markets.

Jim Rollyson – Raymond James

All right. As a follow-up to that, you have got the Reid School Mine starting production in the second half. Number one, can you remind us kind of where that falls on the grades of highwall, and number two what kind of pricing you see in the market for that today?

George Richmond

Yes, and let me just say that. Obviously, we have just started, so that is going to change a little bit as we get into next year. But it is a grade A coal [ph] with ash in the 4% range. It is an extremely attractive product. What we are doing with it now, we’re blending some of it with some of the purchased coal to lift the quality, and we use some of it into the – we will use some of it into our coke operations.

But as we go forward, and by the way we are putting a price value on it right now of approximately 40 bucks. But as we go forward into next year’s business, we will probably switch that coal as a standalone. It is a very, very good product and I think it will command you know the same type of prices, the very, very high quality, high volume coals and then back of the mind, we will obviously get the transportation advantage we get on that product versus the Appalachian people.

Jim Rollyson – Raymond James

Got you. That is very helpful, and then last question from me, surface production guidance for 3Q is not a whole lot changed from where you were in the second quarter. Can you remind me, when you start to benefit from the North River mine, which if I recall correctly was about 2.4 million tons a year. So is that start-up in 3Q or is that not until 4Q?

Joe Leonard

Well, still – regarding that mine, we are still under a non-binding letter of intent, and we still actually in due diligence. So, when we will include that. I don’t know. I mean, obviously we are working on it as we go forward.

Jim Rollyson – Raymond James

Okay. Thank you guys.

Joe Leonard

Thanks Jim.

Operator

Our next question Curt Woodworth with Macquarie. Your line is open.

Curt Woodworth – Macquarie

Yes, hi, good morning everyone.

Joe Leonard

Good morning.

Curt Woodworth – Macquarie

I guess, sort of follow up to Jim’s question on the tonnage your priced, the 1.7 this quarter, was that for a two quarter deal into South America?

Joe Leonard

No, the 237 at 1.7 million that is a blended price of new business in South America we have just concluded, plus the second quarter of the six-month deal into Europe, the second quarter of that business. So it is both of them together.

Curt Woodworth – Macquarie

And how much was price in the quarter in South America, and what price did you get for that?

Joe Leonard

I am simply not going to break it down. Obviously, it is a 237 blended price. It was higher than the 237 booked. I really don’t break it down, obviously price is sometimes vary customer to customer.

Curt Woodworth – Macquarie

Okay. And that would include the small portion you did at 245, right?

Joe Leonard

Yes, that was a small portion at the time.

Curt Woodworth – Macquarie

Okay. And then in terms of the remaining administered price for the third quarter, it looks like it is about 300,000 or 400,000 tons, what is the timing on when you expect to price those?

Joe Leonard

The third quarter.

Curt Woodworth – Macquarie

Yes, if you just add up the…

Joe Leonard

Some of that is the purchased coal. It does not really – it is about 200,000 still to price. And I would imagine over the next three or four weeks. We’re actually shipping some of that tonnage. We just haven’t quite got there yet.

Curt Woodworth – Macquarie

Okay.

Joe Leonard

I do not expect that remaining couple of hundred thousand to vary from – to change the 237 very much.

Curt Woodworth – Macquarie

Yes, okay. And then on the carryover, the 208 tons, are those exhausted by the end of this year, or do you have some of that go into ’11?

George Richmond

I think we have to get better vision [ph] on that. Regionally that was one shipment into the first quarter, one shipment in the first quarter of next year, but I think right now that probably is going to be brought forward. So, I think in general it is going to be minimal into next year, and that will probably level it off this year.

Curt Woodworth – Macquarie

Okay. And then just in terms of, I guess, sentiment from your customer base, you talked that some companies were accelerating scheduling above all the others. Do you get the sense that the strength is mainly in South America, or you are seeing it embraced in Europe as well, and then is there any seasonality involved where, you know, the vessel scheduling picked up a little bit in the fourth quarter or is that typically more evenly spread throughout the year.

Joe Leonard

That is not really – you know, our contracts tend to be evenly spaced. The only way that we get a heavier quarter is if we don’t think, we don’t want the bows to be stopped there on [ph] demurrage. So, if we don’t think we can line the boats. For example, I know there is a few boats that are in the first week or so of the next quarter that they really want to take on his quarter, and we just deferred them a little bit.

So, unless it is – whether it is availability of coal or the shipping schedule, ignoring that generally it is evenly spaced for our product.

Curt Woodworth – Macquarie

And then on the accelerated scheduling, is that broad-based or more specific to…

Joe Leonard

That – yes, the 315 tons that we brought forward, I think was brought across the board.

Curt Woodworth – Macquarie

Yes, okay. Okay, thank you.

Joe Leonard

Thank you Curt.

Operator

(Operator instructions) Shneur Gershuni, UBS, your line is open.

Shneur Gershuni – UBS

Hi, good morning.

Joe Leonard

Good morning.

George Richmond

Good morning.

Shneur Gershuni – UBS

I guess, my first question is, if you had a couple of months operating the mines 7 and 8 and so forth, gotten a better feel for the job and so forth, I was wondering if you guys still stand by the initial production targets that you had for the mines as a lookout to 2011, 2012?

Joe Leonard

Yes.

Shneur Gershuni – UBS

Great, okay. So, really nothing has changed despite the production changes this year, everything is fine on a go forward base?

George Richmond

I mean, we will give a little color on it. I’m the coal is bigger coal then we’re traditionally used to putting on the longwall and it mines very, very well. We just don’t have a lot of big hard rock to coat. As we move away from the initial course, the coal gets thicker, and the longwall will do well. We have added a couple of recoups on the continuous mined section over the last couple of months, but when we get through that, we’re actually improving significantly right now, and I think will recover. Yes, we are very, very positive on the east side, and it is clearly our best mining conditions.

Joe Leonard

I think oil production is up significantly over what it was in the first half of the year.

Shneur Gershuni – UBS

Okay, great. And then secondly, you now just I got the follow up the Jim’s question as well, but you talked about your closing remarks with respect to share buyback and so forth and deployment of capital. Is it fair to say that you know the trend that we saw this quarter with respect to buyback likely to continue throughout the year, unless you actually keep counting the perspective share or find a very juicy acquisition that you are interested in?

Joe Leonard

Yes, we still have some money left that has been approved by the board. Generally speaking, you know, our board and this company has always worked to return our prosperity to our shareholders either through share buyback or dividend increases, and so we will continue to take a look at that. We review share buybacks on a very regular basis. We have been very aggressive in the marketplace. I don’t want to predict what we will do in the future, but we do have about 11.9 million already approved, and when there are opportunities to the buyback at good prices we will do that.

Shneur Gershuni – UBS

Great. Thank you very much and George congratulations on a great career and good luck for retirement.

George Richmond

Thank you very much.

Shneur Gershuni – UBS

Thank you.

Shneur Gershuni – UBS

Thanks.

Operator

Our next question Jeremy Sussman with Brean Murray. Your line is open.

Jeremy Sussman – Brean Murray, Carret & Co.

Hi, good morning.

Joe Leonard

Hi Jeremy.

George Richmond

Good morning.

Jeremy Sussman – Brean Murray, Carret & Co.

The stuff that you just booked over the last few weeks, is that quarterly, semiannually, if you don’t want to get into that, you know, how much of your coal ultimately do you think is going to be annual versus shorter term these days?

Joe Leonard

Well, the latest piece was quarterly. So basically everything we got scheduled runs off at the end of – what was contracted runs off at the end of the third quarter. The tonnage that you see in the chart that is booked into the fourth quarter is really third quarter tonnage which was scheduled, and it rolls off a little bit.

I mean, we as a company, and I think our customers would much prefer the annual pricing. And it gives consistency of product, it allows the customers to book their input cost charges, which helps them to price the steel, et cetera, et cetera. So we would most prefer to be annual. However, when we get such a change in the market when the Australians switch to quarterly, it is very, very difficult for anybody to just jump out of that and do annual.

So, I’m not really sure which way it is going to switch. In the future, if it is a stable pricing environment, obviously we could do annual even in a quarterly environment. Or if you believe the strength of this product, and you leave the shortages going forward, booking annual and increasing price can certainly leave a lot of dollars on the table.

So, we have got a lot of thinking to do with deferred annual booked, we may end up being quarterly.

Jeremy Sussman – Brean Murray, Carret & Co.

No, I appreciate that. And just, as a quick follow up, to talk about the continuous miners seeing some tough geology, and so obviously you tweaked your production numbers, does that affect your longwall production ultimately in any way, any of this geology or I guess how should we – are they kind of mutually exclusive.

Joe Leonard

Yes, well, we had – In just one section we had a bunch of them. At no. 4 mine, we who would develop into the longwall. We have just started and there was a weak, and that vendor group went through the sections and slowed us down in both the sections driving the head gates and the tail gates. And that was when we were driving the baseline, we had a fall. And that is a slower entry drive, so we had to jump back and drive into the finish line.

We got all that drilled without affecting the longwall’s move et cetera, et cetera. But it cost us quite a lot of section tonnage. The no. 7 mine, we’ve had a period on the next replacement panel for the E2 longwall, which will have an effect and that is the 100,000 tons Walt talked about for the fourth quarter. He’s going to delay that longwall a couple of more weeks then we originally planned.

Jeremy Sussman – Brean Murray, Carret & Co.

Okay, that makes sense, and George congratulations on a great career.

George Richmond

Thank you very much.

Joe Leonard

Thanks Jeremy.

Operator

Our next question Dan Mannes with Avondale. Your line is open.

Dan Mannes – Avondale Partners

Good morning everybody.

Joe Leonard

Good morning Dan.

George Richmond

Good morning.

Dan Mannes – Avondale Partners

One quick clarification for Joe, in your opening comments, you mentioned a new headquarters in Atlanta, and I think Lisa said Birmingham. Was that – did I mishear or…

Joe Leonard

It is Birmingham.

Dan Mannes – Avondale Partners

Got it. Thanks for that clarification. And then just briefly on – to follow up on Jim’s question is that embedded in the surface mining expectations for Q3 the start of Reid School?

Joe Leonard

It is in the surface, yes.

Dan Mannes – Avondale Partners

Okay, but I was going to say given the much higher pricing of the product, you margins aren’t expanding that much.

Joe Leonard

Yes, I mean, first of all some of the tonnage, nearly half the tonnage is going to Walter Coal, which is replacing other coal. So, we’re blending – so if you actually does make some of the surface products, you know, we are really cranking that thing. We only did 20 odd thousand tons in the quarter. We will pick it up, but then we will take a full look at that product going into next year.

My gut feeling is that it is going to be a stand-alone product, and that will maximize value I think to us.

Dan Mannes – Avondale Partners

And remind me, that is a fairly short life, I don’t know about how much coal is there, and how long do you think you can run that mine?

Joe Leonard

The existing lease was about three years, but the Black Creek [ph] thermal coal is about 0.5 million tons maybe that is a better way putting it. But the Black Creek thermal coal is a really good, and certainly I can’t guarantee it. But we’re going to certainly search around and see if we can pick any more of that stuff.

Dan Mannes – Avondale Partners

Got it. And then one last quick one, just on the cost side, and you know, you guys were well within your guidance range in spite of maybe even being a little bit below in production. You know, we’ve certainly heard different – some other coal companies, are you seeing any significant cost pressure from a regulatory front, or is that already well within your expectation.

Joe Leonard

Yes. I mean it obviously varies across the country, but I think you got to look at where we were to start with. I will give you an example. Last year, we had 1100 MSHA inspection shifts in the two mines. Last quarter, we had 270, 280. So, we haven’t seen an increase. It is hard to get more than 11,000. The deep underground coal mines pretty much always have a lot of attention.

So, obviously there is a lot of regulation going through its head, but from an inspection point of view, we still have four or five resident inspectors, MSHA inspectors, not including the stay, who turn up to the mines every single day.

Dan Mannes – Avondale Partners

Great, thanks. And George congratulations.

George Richmond

Thank you.

Joe Leonard

Thank you Dan.

Operator

Our next question Mark Liinamaa with Morgan Stanley. Your line is open.

Mark Liinamaa – Morgan Stanley

Hi, relative to some of the pricing that you gave recently, some of the hard coking coal index is a tip below 200, is that an adequate reflection of which you could do business today at?

Joe Leonard

Well, I could say we have just done business at 237 plus in the last few weeks.

Mark Liinamaa – Morgan Stanley

And today that would be a relevant – you would expect to do it as well?

Joe Leonard

(inaudible) we saw numbers down to 200. I mean there is no guarantee, what we are going to do with the quarter. But that seems low to me for these types of projects. I just can’t believe it.

Mark Liinamaa – Morgan Stanley

Okay, thanks. And given customers would prefer annuals – you said you would prefer annuals as a shift to quarterly, are you seeing customers look at other ways or want to discuss other ways that they can make their access to the coal more permanent?

Joe Leonard

Yes, I mean, with most of our customers, we have agreements with them on volumes going forward. Some of them are three years. So, they have got the volume scheduled. So we know where the goal is going to go. We still object, we cannot agree on a price, and one side or the other is a long way away from the market price, and the volumes can disappear.

So they have got some assurance. We have got some assurance, but I think what we would prefer an annual pricing. So, we all know where we are, they know where they are, but you know, I’m not sure I will get there from here unless something changes.

George Richmond

I think it is important to know Mark that our steel producers in South America are up 35% year-over-year and year-to-date. And our European customers are up 50% quarter-over-quarter and 44% year-to-date. So, there is strong demand for our product, for our particular customer.

Mark Liinamaa – Morgan Stanley

And just – I know you can’t talk about M&A, but that something comes up, and you have seen lesser quality properties get interest in that market, stock is off from where it was. Philosophically any thought?

Joe Leonard

Well, we think we have got some great growth opportunities. We look at M&A opportunities on a regular basis. We have our screening process that we go through. One thing we are not willing to do is do bad deals, and overpay for properties. So, we’re pretty careful about that.

Mark Liinamaa – Morgan Stanley

And on the other hand, I guess a receiver?

Joe Leonard

Pardon?

Mark Liinamaa – Morgan Stanley

As a receiver of an offer, maybe?

Joe Leonard

Well, we can’t help what other people do. What we do is focused on our growth plan, which we think is substantial from an inherent standpoint. As you know, we’re looking to move westward in the Yellow Creek [ph] area. And that is a good 10-year project with substantial growth internally, and then we look at M&A opportunities as they come along and what other people do we really have no control over.

Mark Liinamaa – Morgan Stanley

But it certainly sounds like your focus is just continuing to grow the company. So that is great. Thanks and good luck to everyone.

Joe Leonard

Thanks Mark.

Operator

Our next question Daniel scott with Dahlman Rose. Your line is open.

Daniel Scott – Dahlman Rose

Good morning guys. How are you doing?

Joe Leonard

Good morning.

Daniel Scott – Dahlman Rose

If we look at your guidance for third quarter production and then for full year sales, what it implies for the fourth quarter looks to be something around maybe 2.2 million tons and includes that 70s longwall move, how challenging do you think it is going to be to kind of hit that level, and is it going to take some of the inventory sales to get there do you think?

Joe Leonard

Yes, it will take inventory sales to get there. We will be dropping the inventory down in the fourth quarter. And there is also some what we call purchased coal product. So, volumes in the fourth quarter is I think round about 2 million, 1.92 million versus the number we just threw out.

Daniel Scott – Dahlman Rose

Okay, great. And then as a follow up, your cost guidance for the third quarter is the $50 to $55 a ton, which I think has historically been your target for roughly the full run rate cost you can do. Given that the fourth quarter and going forward will probably be even higher tonnage, do you think that that is the target that you could even exceed in the future?

Joe Leonard

Yes, if you, you know, obviously we talked about this before. It is a relatively fixed cost business. So, it could operate next year in the, you know, 8.5 million to 9 million ton range. The cost does go down below you know, when I say goes down below, I mean, if you say 50 to 55 it could be closer to the bottom end than the top end.

Daniel Scott – Dahlman Rose

Great, and finally if could you just remind us when your rail contract comes up for renewal and what is your mix is between rail and barge to kind of mitigate the risk of an increase there?

Joe Leonard

Yes, well, we – the original contract went out in March, and we extended it by the year, and the transportation rate just seems already built in until at least next March. We added a year with some increase for it, (inaudible) it’s a pretty good deal.

Daniel Scott – Dahlman Rose

And what’s the mix again between barge now?

Joe Leonard

It’s mainly rail. We’re doing – hope to a million tons right now but this is mainly rail.

Daniel Scott – Dahlman Rose

Great. Thanks and congratulations George.

Joe Leonard

Thank you.

George Richmond

Thanks Dan.

Operator

Our next question Mark Parr with KeyBanc Capital. Your line is open.

Mark Parr – KeyBanc Capital Markets

Hi. Thank you very much. Good morning.

Joe Leonard

Good morning.

George Richmond

Good morning.

Mark Parr – KeyBanc Capital Markets

Wondering, George, I know that you continue to be quite bullish about you know, the longer term supply demand situation for met coal in general and you’re clearly, the Walter product is a superior entry into the market. I just was wondering if you could give us your personal view, updated personal view, kind of on the coal supply situation. You know, anything that you might see unfolding in China over the next 6 months or 12 months that could perhaps you know, exacerbate a supply situation or you know, conversely you know, how you’d feel about the ability of the met coal market globally to handle the continuing recovery of steel production over the next couple of years?

George Richmond

Yes, well, I mean, there is talk about – there has been talk about that little bit of a slowdown in China, but I think, if I remember right, is that numbers for July – June was about 3.5 million tons of imported met coal, which is you know, 14 million tons annualized rate, which is 17%, 15% to 20% of the seaborne trade. So, in the higher quality coals with a total re-bond, you know, given the steel industries in South America and Europe, I still do not see where the – China be able to take that volumes, I do not see where the rest of the volume comes – yes, we can find some semi soft, and maybe some great beehive walls, the low and mid volume coals, they have always gone to the metallurgical market and, you know, that’s why I am so bullish.

I mean, I have, for a long time I have not understood, or I have not been able to figure out where the extra volume comes, if China picks up half a percentage after the market. So that is why generally we have been bullish. Regarding China, I mean, I guess lot of people’s thoughts are as good as mine. I mean, all the numbers we see and even though there is a little bit of slowdown and maybe a slight reduction in GDP, they’re still making a tremendous amount of steel. I think, if I see the numbers, steel production this year is estimated like 650 million out of China versus like 575. Those numbers might not be exactly right, but that’s right. I remember so. Again, they are still producing a lot of steel and it’s still increasing. I don’t – does that?

Mark Parr – KeyBanc Capital Markets

Is there anything coming out of Mongolia that may create significant incremental supply in the next couple of years?

George Richmond

I don’t think so in the next couple of years.

Mark Parr – KeyBanc Capital Markets

All right. Congratulations on a great career. My only regret is that I wish I hadn’t gotten to know you sooner. Good luck in your retirement George, thanks.

George Richmond

Thanks for the kind words.

Operator

Our next question Meredith Bandy with BMO Capital Markets. Your line is open.

Meredith Bandy – BMO Capital Markets

Hi good morning to everyone. Most of my questions have been answered, but first of all just add my congratulations to George and welcome to Walt. A small point, you did increase the CapEx guidance by $25 million. What was that related to?

Joe Leonard

It was really about $10 million versus new gas drilling in the HighMount business. We expect that to annualize to about $16 million in few gas wells and we plugged in $10 million for gas wells for the rest of this year.

Meredith Bandy – BMO Capital Markets

Okay, and then on the HighMount acquisition, I mean, would you have got that if you didn’t have the Chevron’s assets?

Joe Leonard

If it had been in Texas or Arkansas the answer is no. As a standalone business, it’s a pretty good business, but we consider it absolutely essential for our ability to extract coal efficiently and relatively cheap. And it’s not just the Chevron area or the recent leases we’ve signed. This also has got a lot of wells over the Metacity [ph] property as well. And if you remember Metacity property is the future mining, it won’t be a new mine but it’s the extension to the number four operations. So we think it’s an integral part of the operation, and it’s a pretty good deal anyway, but it’s really important to us.

Meredith Bandy – BMO Capital Markets

Okay, thank you. That’s helpful.

Joe Leonard

Thanks Meredith.

Operator

Our next question Garrett Nelson with Davenport & Company. Your line is open.

Garrett Nelson – Davenport & Company

Hi everyone. Congratulations George on everything you’ve accomplished.

George Richmond

I have a little trouble hearing you Garrett.

Garrett Nelson – Davenport & Company

Can you hear me now?

George Richmond

Little better.

Garrett Nelson – Davenport & Company

I said congratulations George on everything you’ve accomplished. Enjoy your retirement and hopefully some Alabama football games as well.

George Richmond

I will not.

Garrett Nelson – Davenport & Company

At the coke business, it looks like your quarterly realizations were record-high. I was wondering if you could provide some more color on that business. What does your commitment price position look for the balance of this year, where do you see coke prices currently, et cetera.

Joe Leonard

Yes, well, as you remember we are on quarterly pricing on the coke business and we are still discussing, so I can’t say too much about coke prices in particular because we are still in the negotiations for the third quarter. We are actually moving coke right now and supplying coke, but it’s on a provisional pricing, and hopefully we’ll get that result pretty quick, and we can give you. So, we’ve put an estimate in the margins going forward, margins are down (inaudible).

Joe Leonard

No, there is a lot of potential new builds floating around. It’s really out to – it seems none of them are really firm. It is hard to put any numbers on them right now. Regarding the inspections from MSHA, I mean, we have a lot of inspectors and they could increase – sometimes people forget that the law requires these deep mines to be inspected four times a year by MSHA. What they forget is that each inspection takes three months. So we pretty much got inspectors in the mine every single day, and if we are trying to do the business right and follow the laws and you know, whether an inspector is there or not it really shouldn’t affect the production I mean we should be doing those things right anyway.

George Richmond

I think in addition to that, our objective here is to always have safety first and we spend well beyond what is required by MSHA. So we go above and beyond in a number of areas and we think that will serve us well as we move forward.

Garrett Nelson – Davenport & Company

All right, sounds good. My other question was on the highwall like the Reid School coal pricing. How to think about pricing on your Reid School coal, you know, I know it’s a better margin than any of our other surface mining coal, but how should we think about it?the

Joe Leonard

Well, I mean, for the rest of this year, you know, I’d just leave it as the margin with putting that it’s in effect we’re using it to what coke plant, and we’re doing some blending with the purchased coal, but going forward and as we develop the business going into next year, it clearly will allow a significantly higher margin than the rest of the surface operations. Probably, I mean, right now, I guess, high quality coal is probably about 20 to 30 bucks below the low and mid coal. Sometimes they get close to parity depending up on the supply demand. Going forward, we’ll put a lot of value on that product.

Garrett Nelson – Davenport & Company

All right and my last question is anything that you’re seeing on China and you know, what is your view on the fourth quarter benchmark settlement?

Joe Leonard

I think we have been whereabouts, probably three or four weeks away from when the Australians would think will settle for the fourth quarter.

Garrett Nelson – Davenport & Company

Yes.

Joe Leonard

I hate to comment on what they may or may not do. I mean, if you look at our history, we’ve tended to at least go our own way anyway, and we’re still relatively bullish on the fourth quarter.

Garrett Nelson – Davenport & Company

Yes. No, I know you guys typically try to get the premium over that but you know, I just wanted to know your thoughts but thanks. This is great, helpful.

Joe Leonard

Thank you.

George Richmond

Thanks Garret.

Garrett Nelson – Davenport & Company

Yes.

Operator

Our next question Peter Epstein with PWP. Your line is open.

Peter Epstein – PWP

Hi, it is Perella Weinberg Partners, Xerion Fund. I was curious, you mentioned in the very beginning of the call $170 million reserves that you could pick up over the next year or two. Is that correct?

Joe Leonard

Yes.

George Richmond

Yes, that’s what we’re trying to do.

Peter Epstein – PWP

And what is your current reservation for coking coal only?

Joe Leonard

140 million tons.

Peter Epstein – PWP

140, and is that based on an assumed price?

Joe Leonard

Yes, yes. Obviously under the FCC report, what we tend to include is coal that is mineable by longwalls. So, if you restart – if you relook at it, a $200 price and then coal from continues miner sections becomes viable, and, you know, the reserve base can increase over that. There’s also a couple of more rules. For example, we have at least, that’s maybe about 10 years to go and then we’ll reopen it. But we won’t mine that coal for 15 years. We can’t include tonnage like that. So you know, we follow the guidelines very, very strictly of what we actually we include as reserves.

Peter Epstein – PWP

But that 140 million, might it be a lot higher with a higher coal price.

Joe Leonard

I wouldn’t say it’s a lot, however, I think it’s quite a bit though, either it could be a big number, but it’s tens of millions versus you know, a couple of million or $50 million.

Peter Epstein – PWP

Thank you and in South America what countries do you sell into besides Brazil?

Joe Leonard

Brazil, Argentina, and a small amount into Chile.

Peter Epstein – PWP

Is Argentina a material part of the business or is it mainly Brazil?

Joe Leonard

Yes, it’s a fair amount, yes.

Peter Epstein – PWP

And is Argentina growing?

Joe Leonard

It’s been pretty stable for at least the last 10 years.

Peter Epstein – PWP

Okay, and then finally in Brazil do you anticipate growing with Brazil or taking market share even?

Joe Leonard

Yes. I do expect to grow with Brazil. We used to be closer to 50-50 Europe and Europeans didn’t really grow, but they closed down a lot of their own steel, coal production. So we picked up in South America, that is, you know, subject to the expansion, for example, the big (inaudible) operation will open up, starting their coal in the latter part of this year and that will be a significant amount of volume for us going forward.

Peter Epstein – PWP

Okay, thanks very much.

Joe Leonard

Thanks Peter.

Operator

(Operator instructions). Mark Caruso with Millennium Partners, your line is open.

Mark Caruso – Millennium Partners

Hi guys, good morning. George, congratulations and Walter, welcome onboard. I guess one of the things I want to figure out going forward is you know, inventories in the past you said it’s 200 as we start ramping up with the longwall is it 300 inventory range if that if what you guys want to keep and how are you thinking about purchased coal at this point going forward?

George Richmond

Yes, one, 300 is a nice number. We’d probably drop below that at the end of this year. We can do sometimes, but it looks like we need to drop it below that in the well. Purchased coal, you know, that coal tends to be a secondary product. So we have the ability to produce quite a bit of it or it’s really market dependent. So right now, I still expect to do about a 400,000 but there is real potential going forward in a tight market in future years. We can do a lot more than that.

Mark Caruso – Millennium Partners

Okay and then as far as the longwall expansion, all you are saying it was delayed, when should we start to see the tonnage, is it more a fourth quarter when we start seeing the benefit of that?

Joe Leonard

No, we will be running all three longwalls in the third quarter, and then we’ll drop down to two longwalls for a period in the fourth quarter, and then go back to three longwalls hopefully, you know, a piece of December and most of next year are part of the standard moves.

Mark Caruso – Millennium Partners

Okay, perfect. Thanks so much.

Joe Leonard

Thank you Mark.

Operator

Our last question Brian Gamble with Simmons. Your line is open.

Brian Gamble – Simmons

Good morning guys.

Joe Leonard

Good morning.

George Richmond

Good morning Brian.

Brian Gamble – Simmons

I figure that comment about a land earlier was (inaudible). Just had one question George, kind of a funny question. You know, I know you guys have excellent relationships both in Europe and in South America with all of your customers and many of those are long-standing. Have you gotten at least, you know, this year or even over the last month or so despite the, despite kind of slowdown from the Chinese market. Do you ever get or have you gotten an increased push to ship coal to other markets, have you gotten people who have come in and say, do you, hey, I know you got these relationships, but we really want to kind of develop the same sort of thing. Is that something that people or the individual companies do, I am trying to get at it from a sense of exactly how valuable your coal is viewed outside of your current customer relationships?

Joe Leonard

Yes, the answer is yes. We got a lot of questions from Asia. Remember our coal is known very, very well in Japan. We used to actually supply 3 million tons into Japan, and I think all the mills know it. It has got a good reputation. Last year, we actually did ship some spot coal in Japan. We get questions, a lot of questions from India, lot of questions from China. The issue has always been though clearly in that part of the world, the Canadians and the Australians have a transportation advantage, whereas we haven’t in our traditional markets. So while we are able to move all the volume into our traditional market, we will realize the highest price back of the mining in my opinion. So unless we end up with additional volume or one of our traditional clients, are real problems, we feel very comfortable where we are today.

Brian Gamble – Simmons

That sounds great. George and Joe, we are all looking forward to working with you in the future.

George Richmond

Thank you.

Brian Gamble – Simmons

Thank you guys.

Joe Leonard

Thanks Brian.

Mark Tubb

We’re seeing there are no more questions. I think we’ll land up here. I’d like to say, I think you can tell very clearly that we’re very bullish on the third and fourth quarters. Production rates are improving. The market has remained strong. Pricing remains strong, and we look forward to a very, very strong second half of the year, and we look forward to talking to you at the end of the third quarter. Thank you very much.

Operator

Thank you. That concludes today’s conference call. All lines may disconnect. Once again that concludes today’s conference call. All lines may disconnect.

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Source: Walter Energy, Inc. Q2 2010 Earnings Call Transcript
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