- Walter Energy's decision to idle cash-negative Canadian operations will improve its performance.
- The company was able to refinance its debt, and the first debt maturity is in 2018.
- Met coal market is probably at its bottom, and could start rebounding next year.
- The company has enough resources to last through a year of weak met coal prices, and will capture the met coal price rebound.
Met coal price fallout has caught most miners off guard, and Walter Energy (NYSE: WLT) is not an exception. Walter Energy has recently posted another adjusted quarterly loss of $128.3 million, missing analysts' estimates. The company's stock was out of investors' favor for several years, but I believe there is a significant possibility that current price levels are the bottom for Walter Energy's shares.
How did it get that bad?
When Walter Energy announced the acquisition of Western Coal back in late 2010, coal market was booming. Coal miners raced to grow their portfolios and did not care for prices they had to pay for that growth. In a Bloomberg article of that time, you could see analysts' quotes like "We do love coking coal" and "The outlook for coking coal is good". Ironically, the completion of Western Coal acquisition marked the all-time high for Walter Energy's shares. The company's stock traded above $140 for a while, and has been in a race to the bottom since then.
This acquisition was financed with debt. Back then, this might have looked like a smart move. Now, this debt and related interest payments are a major source of Walter Energy's problems. The main asset of Western Coal was its Canadian met coal mines. In April 2014, Walter Energy decided to idle its Canadian operations due to unsustainable costs.
Just like many other miners, Walter Energy was slow in idling cash-negative operations, which made things even worse. Probably, the management was hoping that coal prices would ultimately rise. In reality, the opposite happened, and met coal prices dipped quarter after quarter fueled by growing production from Australia and a relative cool down in China.
So, what is the result of the ill-timed acquisition of Western Coal? Big debt, big interest payments and, currently, no production from Canadian mines because of high costs. This is the current starting point for Walter Energy.
What must happen to justify upside in Walter Energy's shares?
Now that underperforming Canadian operations are idled, there's little that Walter Energy could do. The company has refinanced part of its debt, cut capital spending to sustaining levels and reduced its SG&A. During the second-quarter earnings call question & answer session, Walter Energy stated that it was not expecting significant improvements in productivity on its operating mines. The company could squeeze some additional dollars out of its mines, but it won't change the big picture.
Thus, Walter Energy needs a rebound in met coal prices. Next, the company must be a going concern when this rebound happens. Last, the company must be able to refinance $1 billion of debt that is due 2018. If these three criteria are met, Walter Energy's shares have significant upside.
Met coal prices: probably, this is the bottom
Third-quarter met coal benchmark prices settled at $120 per ton, in line with second-quarter prices. This is an unsustainable level for many producers, and it forces production cuts. The latest move on this front came from Alpha Natural Resources (NYSE: ANR), which decided to downsize its West Virginia mining operations. We'll probably hear about more production cuts from different players in the future.
The growth of production from Australia will be of less concern going forward. Both Rio Tinto (NYSE: RIO) and BHP Billiton (NYSE: BHP) are mostly done with current met coal expansions. It looks unlikely that they will proceed with more met coal expansions as both companies actively pursue iron ore opportunities. For example, Rio Tinto has signed an agreement to develop South Simandou iron ore deposit in Guinea - a project that will demand huge investment.
It's important to notice that it will take time before production cuts will influence the demand/supply balance on the met coal market. First, it takes time to idle mines. Second, there's still inventory on the idled mines that has to be sold. Thus, a rebound in met coal prices is unlikely to happen until 2015.
In this light, it's important for Walter Energy to live through the period of low met coal prices. Standard & Poors has recently argued that Walter Energy's debt level is unsustainable because of weak met coal price environment. In turn, the company argued that it has enough liquidity during the second quarter earnings call.
In my view, the company was successful in refinancing its near term debt. The rates were high, but the most important part is that Walter Energy did actually refinance. It could have been worse, and the company could have seen closed doors in debt markets.
Sure, the interest burden is huge. Currently, the company expects that cash interest expense will be roughly $285 million this year. Thus, the company spends on average $71.25 million of cash on interest expense per quarter. Interest payments are unevenly divided between quarters with most of interest paid in the second and fourth quarters, but an average number is good to look at the big picture. Walter Energy expects to dedicate $120 million to capital spending this year, $30 million per quarter. There will be more capital expenses in the second half of the year, as Walter Energy spent just $44 million on capex in the first half.
There is also a cost of idling of Walter Energy's Canadian operations, which is projected to be between $5 million to $10 million per quarter. The company believes that this cost will be at the low end of its guidance, but for the sake of argument I'll stick to a rate of $7.5 million per quarter. Walter Energy also has to pay Canada transportation take or pay charges, which were $6.4 million in the second quarter. Walter Energy believes that it could try to mitigate those take or pay costs, but I would not count on that.
Thus, the remaining Walter Energy operating mines must deliver more than $115 million of cash flow to stop the company's cash burn. The average cash cost of sales at the company's U.S. met coal operations was $90.83 per ton in the second quarter, so U.S. mines have a chance to deliver solid cash flow in case of met coal price increase. On the positive side, the company had 2.2 million tons in inventory at the end of the second quarter. This inventory will transform into cash, although it won't happen soon, as the company's principal coal transportation provider at the Brule mine in Canada ceased operations in June. I believe that inventory sales will bolster Walter Energy's liquidity position and help the company navigate through another year of low met coal prices.
Walter Energy is highly unlikely to repay $1 billion in 2018 from its cash flows. The company needs a miracle for this. However, Walter Energy could refinance this debt if it is able to demonstrate positive cash flow from its U.S. mines. If met coal prices rebound, there will be no problem with that.
The restart of Canadian operations is trickier. Walter Energy needs to see sustaining improvement in met coal pricing, as costs at Canadian mines were high. However, it would be a mistake to sell these operations during the current market downturn, as it would wipe off shareholder value because of low met coal asset prices.
Risk and reward
The main risk is simple - bankruptcy. I do not believe that Walter Energy could attract more financing from the debt market if met coal prices drift towards the $100 per ton level. Second, the company could try to swap debt for equity, which will significantly dilute existing shareholders. During the earnings call, the company stated that it had no plans to do this, but the management's stance could change over time.
While the risk is great, the reward could be great as well. Walter Energy possesses significant resources that will rise in value if met coal pricing improves. If met coal prices rise back to the $160 level, the company's shares could easily get to $15 per share. Why? First, Walter Energy actually traded there when met coal prices were $160 per ton. Second, the rebound in met coal prices will open an option to sell Canadian operations at a decent price and reduce the debt burden.
I don't expect that Walter Energy's shares will have major upside in the near term. The company has too much problems, and met coal market is likely to remain weak in the next 3-4 quarters. However, they present an opportunity to bet on met coal revival for a risk-tolerant investor. The risk is great, but the reward might be great as well.