Alpha Natural Resources: The Ship Is Not Sinking

Aug. 8.14 | About: Alpha Natural (ANRZQ)

Summary

Alpha Natural Resources Q2 results were influenced by one-time items.

Cost improvements in company's Appalachia operations strengthen its position.

Alpha Natural Resources has enough liquidity to sustain the current market downturn.

Shares of Alpha Natural Resources (NYSE: ANR) have been under tremendous pressure this year. The company produces thermal coal and met coal, and both markets have been weak and showed no signs of a major rebound this year. However, while the market situation remains unfavorable for Alpha Natural Resources, the company showed continuous improvement which should translate into upside for its shares.

Q2 results are not that bad as it might seem at first glance

Alpha Natural Resources has recently reported a second quarter net loss of $513 million, which seems big given that the company continues reporting losses quarter after quarter. What's more, the company's operating cash flow was a negative $217 million, a huge drop compared to a negative $54 million in the first quarter of this year.

However, there are several things to consider. First, the company took a $309 million goodwill impairment charge. This is a pure bookkeeping issue, and the market has already factored this in Alpha Natural Resources' share price. The operating cash flow figures look scarier, as they represent an outflow of real cash. Here, the company had to pay $165 million to complete the funding of the previously shareholder class action litigation settlement. This is a one-time item, so, without it, the cash outflow was $52 million, in-line with the previous quarter.

Sure, cash burn remains a major problem for the company. Alpha Natural Resources paid $91 million of interest in the second quarter to service its large debt that was taken to finance an ill-timed acquisition of Massey Energy back in 2011. This debt burden will likely remain with the company for years.

Alpha Natural Resources also suffered from poor shipment performance in the Powder River Basin. This issue raised costs at the company's PRB segment from $10.23 per ton in the first quarter to $12.06 per ton in the second quarter. On the positive side, the company's operations in Appalachia showed improvement, and costs dropped from $65.73 per ton in the first quarter to $62.01 per ton in the second quarter. I believe that Alpha Natural Resources would be able to return to its previous cost performance in the PRB in 2015, as the situation with shipments normalizes. Thus, I expect better cost performance going forward.

Positive on met coal but cautious on thermal coal

Met coal and thermal coal are equally important for Alpha Natural Resources. I outlined why I think that met coal prices could have reached their bottom in my article on Alpha Natural Resources' met coal peer, Walter Energy (NYSE: WLT). In short, I believe that met coal production cuts together with lower production growth from diversified mining giants would lead to improvements in the second half of 2015.

I'm not that enthusiastic on thermal coal. The problem for thermal coal is that it has a substitute - natural gas. The thermal coal optimism that Alpha Natural Resources expressed during the first quarter earnings call was due a bump in natural gas prices during the winter. Since then, natural gas prices have moved lower and put additional pressure on coal prices. Importantly, natural gas price differentials could be huge, leading to a heavy discount to benchmark prices.

For example, recent quarterly report of Chesapeake Energy (NYSE: CHK) showed that the company's average sales price excluding gains on derivatives was just $2.76 per mcf. One should not forget recent EPA proposals, which are bearish for thermal coal in the long term. Thus, I think that Alpha Natural Resources is poised to benefit from its met coal operations in the future while the company's thermal coal operations do not have much upside.

Liquidity position is solid

In my view, Alpha Natural Resources possesses sufficient liquidity that provides it the necessary time to wait for improvement in the met coal markets. The company has finished the second quarter with $1139 million in cash and short-term investments. If we assume a negative operating cash flow of $50 million per quarter and capital spending run rate of $250 million per year, the company has more than 6 quarters before its cash depletes to $400 million. I believe that met coal markets would improve within this timeframe, and Alpha Natural Resources would be able to return to positive operating cash flow. In turn, this will allow the company to refinance part of its debt at better terms and lower its interest payments.

Bottom line

Based on the current Alpha Natural Resources' share price, the market has factored an almost catastrophic scenario for the company. However, Alpha Natural Resources has shown decent improvements on the cost front, and its liquidity position is solid. While I'm cautious on the thermal coal side, I think that met coal market is at its bottom. Thus, Alpha Natural Resources' shares have upside from current levels.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in ANR over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.