ANR Earnings: It Is All About Cost Control

|
 |  About: Alpha Natural Resources, Inc. (ANRZQ)
by: Research and Value

Summary

Alpha reported better than expected 2Q 2014 results driven by strong cost performance in the Eastern coal segment.

Analysis presented in this article shows that economic cash burn could decline meaningfully in 2015 driven by continued improving cost performance.

ANR senior bonds appear to be an attractive, though speculative investment opportunity with equity like potential return profile.

The purpose of this article is to analyze the future cash flow dynamic of the company in the context of the most recent earnings results. Alpha (ANR) reported stronger than expected 2Q 2014, driven by strong cost performance in Eastern coal segment. ANR's senior bonds appear to be still attractive even though they bounced off the bottom reached at about the beginning of this month. For example, these bonds include the 9.75% coupon senior bonds maturing in 2018, and currently trading between 85 to 88 cents on a dollar; or the 6.25% coupon senior bonds maturing in 2021 currently trading between 64 and 68 cents on a dollar.

With respect to ANR stock, I think at this stage it is too risky to buy given the large debt burden and continued estimated cash burn in 2015 despite being at a lower rate. On the other hand, it may also be too risky to be short this stock, because one never knows when the coal markets will turn, and if they do turn in 2015 then the short position could take a material beating. Furthermore, if the company continues cutting cash costs and achieves levels seen in 2009 or 2007, then the company could become cash flow positive even under the current dismal coal pricing environment. Before delving into estimating future cash flow dynamic, let's first briefly review the 2Q 2014 performance.

ANR Earnings Review

On August 6 ANR reported better than expected 2Q 2014 results, predominantly driven by strong cost control. Specifically, 2Q EPS came in at -$0.56 beating estimates by $0.19, driven by cost per ton in its Eastern mining segment falling to about $62 per ton. There seems to be an unmistakable trend of cost improvement, as costs in the segment declined from $65.73 per ton in 1Q 2014, and from whopping $74.42 per ton a year ago. See exhibit 1 on more operating and cost detail for the quarter.

Exhibit 1 - 2Q 2014 Operating Performance

Click to enlarge

Source: ANR earnings release

The cost improvement this quarter looks even more impressive if compared to 2011 figure of about $80 per ton, representing over 22% decline from the peak. The importance of cost performance cannot be overstated. For example, adjusted cash margin per ton for Eastern coal (met and steam combined margin) actually increased both sequentially and year-on-year. The margin improvement occurred despite significant reduction in realized pricing, see exhibit 1 above.

Despite strong cost performance, the company may have more space to continue cost cuts. This makes logical sense based on the past cost performance history of ANR's and its acquired businesses. For example, Eastern costs per ton in 2009, 2007, and 2006 stood at about $54.63, $47.45 and $46.51, respectively. Massey Energy, the company acquired by Alpha, had even lower costs per ton at $50.48, $41.2 and $40.95 for those years respectively. Clearly, if the company can drive further cost improvements it can improve its cash flow without the recovery in the coal markets. Next sub-section explores the cash flow dynamic of the company in 2015.

Cash Flow Burn Dynamic

Based on the guidance updated by the company, economic cash flow burn can be estimated for 2014, see exhibit 2 below.

Exhibit 2 - Estimated Economic Cash Burn for 2014

Click to enlarge

Source: analysis by the author

The cash flow metrics for 2014 look quite awful, with economic cash burn of $307MM, and including non-cash interest a burn of $380MM. While a dreadful operating picture, the company has ample liquidity to get through this year. The question then is, how could the operating picture look like in 2015? By making certain assumptions on coal production, realized pricing, operating expenses, and capital expenditures 2015 economic cash flow can be estimated to a certain degree, see exhibit 3.

Exhibit 3 - Estimated Economic Cash Burn in 2015

Click to enlarge

Source: analysis by the author

Based on the analysis above, economic cash burn should decline meaningfully in 2015. Specifically, cash burn may decline from about $307MM in 2014 to about $165MM in 2015. I think the assumptions underlying the 2015 cash burn estimates are reasonable. For example, production estimate for Eastern coal assumes further decline in production by another 4.5MM tons, while costs per tone are assumed to decline by $1 per ton from the levels observed in 2Q 2014 of $62 per ton. With respect to PRB, both production and costs are assumed to normalize as PRB rail issues are resolved. SG&A and Capex are estimated to stay the same as the guidance for 2014.

Interestingly, if ANR at some point in the future were to achieve similar Eastern segment cash cost metrics as it did in 2009, 2007 or 2006 (about $55, $47 and $46 respectively), the cash flow burn could become a meaningful free cash flow even under the current challenging coal industry conditions.

Conclusion

In conclusion, the company demonstrated strong performance on cost control in its Eastern coal segment, allowing the combined Eastern coal margin per ton to actually expand both on a year-on-year and sequential basis. Based on continued strong cost performance and conservatively assuming effectively no recovery in the coal markets, the analysis presented in this article shows that cash burn could decline significantly in 2015 from 2014 levels. ANR's senior bonds appear an attractive though still speculative investment opportunity against this backdrop of improving operating performance.

With respect to ANR stock, I think at this stage it is too risky to buy given the large debt burden and continued estimated cash burn in 2015 despite being at a lower rate. On the other hand, it may also be too risky to be short this stock, because one never knows when the coal markets will turn, and if they do turn in 2015 then the short position could take a material beating.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within 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.

Additional disclosure: The author is long ANR 9.75% senior bonds. For additional disclaimer please see my profile.