Walter Energy - A Massively Leveraged Option On A Recovery On Met Coal Prices

May.30.14 | About: Walter Energy, (WLT)


Met coal prices have plunged to multi-year lows.

WLT is the most operationally and financially leveraged way to play a met coal recovery.

This article will look at valuation for WLT under a variety of pricing scenarios.

Mining is a tough and cruel business. Rising price tides can make managements look very smart, falling prices do the opposite. In the case of WLT, management bought capacity at what proved to be the top in met coal and leveraged up to do it. The Company has struggled under the load of that debt ever since as prices have plunged from $350 per ton to $110 a ton over the last three years.

Metallurgical coal is used in the process of making steel. As you might guess, demand for met coal is tied to worldwide construction but particularly Chinese construction. As those projects have tapered off, so has pricing for met coal.

There are a wide variety of macro factors in addition to Chinese demand that drive met coal pricing, but that is a very quick overview. I do not claim to have a crystal ball as to what will drive a recovery of pricing and when, but think that at current levels much of the world's seaborne capacity is unprofitable and you are starting to see mine closures that are the key to getting supply and demand back in balance. You are also seeing the types of articles that tend to come at commodity bottoms, such as that met coal can never recover because lower cost substitutes are taking demand away and that Chinese demand is also permanently lower. In the case of Walter, their US mines are some of the lowest cost in the world. Unfortunately, their debt load makes it hard for them to turn a net profit. I estimate that WLT needs pricing to get back to at least $150-155 for them to begin to cover their fixed obligations. While that may sound like a long way from the current range of $110-120 a ton, met coal was at those levels only in September of last year. At current burn rates, WLT has about 2-3 years for prices to come back. At $5 a share, I view the stock as a leveraged option on that recovery. Without pricing back to at least spitting distance of the $150-160 range, WLT could face an in court restructuring. At $5, that is what the market seems to be pricing in.

The stock and bonds have taken a massive hit of both a decline in iron ore pricing and a UBS sell side piece, which states the obvious - WLT will have to restructure in a few years if met coal prices don't improve. That said, the core low cost US production (Canadian production was recently shuttered) of around 8mm tons is enormously sensitive to price. Every dollar of improved pricing drops to the bottom line. So while EBITDA is only about $75mm at $115 per ton (I am keeping met coal margins constant for this exercise as it doesn't really move the needle). At $125 per ton, EBITDA jacks up to $156mm. The Company has almost $700mm of cash and revolver availability and that is without selling non-core assets. After recent inventory and assets sales, along with a debt equity swap, I have net debt of around $2.3 billion. This is a moving target, but the key metric to watch is met pricing. As it moves back to the $130-140/ton levels, the cash burn drops dramatically to a range of $60-100mm and buys them 6-10 years with their current liquidity. So the way to look at the stock is as an option on met coal recoveries. From $115-140 a ton, you have about 2.5 to 4.75 years of runway, which is tight by still a fair amount of time by commodity standards. The $150-160 range is where the Company goes FCF positive and can bring on more tons in Canada (tons produced goes from 8-10mm). The value that accrues to common is dramatic as you can see below:

WLT: Sensitivity To Met Coal Pricing

Price Per Ton 160 165 170 175
EBITDA 565 616 666 715

EV @ 6x

3395 3694 3995 4295


3961 4311 4661 5011
8x 4527 4927 5326 5727
9x 5092 5542 5992 6442
Net Debt (2343) (2343) (2343) (2343)
Per Share @ 6x 15.98 20.54 25.10 29.66
7x 24.58 29.90 35.22 40.54
8x 33.18 39.26 45.34 51.42
9x 41.78 48.62 55.46 62.29
Click to enlarge

This table makes some simplifying assumptions that could affect valuation but it is directionally correct. The biggest assumption is that net debt doesn't increase as a result of burn over the next few years. Nor, however, does cash increase from a spike in prices either. $200-400mm of incremental burn would decrease values by $3-6 per share. The multiples appear reasonable to conservative. A few years ago when the Company was making $400-800mm of EBITDA, the trading multiple ranged from 7-11x EBITDA.

Given the massive burn, I started looking at WLT as an obvious candidate for Chapter 11, which is clearly, how the equity and debt market currently sees it. However, even under current dire pricing, they have 2-3 years of liquidity for the markets to turn which can be a lifetime in the coal markets. That estimate doesn't take into account further capital spending cuts or using the PIK toggle feature of their recent debt deal. It is worth noting that the Company was able to refinance their debt with no incremental equity raised (though they did do a debt equity swap at a discount to par). I view this step as very equity friendly. Management owns a lot of stock bought at much higher prices. They are fighting for equity. If pricing improves to more normalized levels, you could easily make 3-13x your money on the common. WLT is also constantly rumored to be a takeout, and I haven't even addressed those scenarios, as you don't need to down here.

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.

Additional disclosure: Positions can and do change at any time without warning or notice.