Walter Energy: A Look At Its Liquidity And Cash Flow Situation

Aug.24.14 | About: Walter Energy, (WLT)

Summary

Walter Energy requires metallurgical coal prices to go up approximately 35% to 40% to reach free cash flow breakeven.

However, Walter Energy appears to have sufficient liquidity to last until at least 2016 without additional asset sales or additional financing.

The Australian dollar hasn't fallen with coal prices during the two most recent quarters, increasing the chance of Australian supply cutbacks.

Demand growth is more likely than supply cutbacks to affect Walter Energy's future.

Walter Energy (NYSE:WLT) is a company that I'd previously believed could handle a prolonged slump in the metallurgical coal market. However, the metallurgical coal market has fallen more than anyone expected in mid-2013, with the current benchmark price of $120 per metric ton well below the lowest 2014 forecast of $135 per metric ton.

Walter Energy has done a solid job of reducing costs and shoring up its liquidity situation. However, its future prospects are largely out of its hands now, as it is reliant on a significant metallurgical coal market recovery to reach positive free cash flow. I estimate that a benchmark price of around $165 per metric ton would result in realized pricing that would allow Walter Energy to reach breakeven free cash flow. This is 37.5% above the current benchmark price. On the other hand, Walter Energy does still have some time to wait things out, as it can likely last until mid-2016 without additional asset sales or financing at current metallurgical coal prices.

A Look At Annual Costs

Based on the data from the latest conference call, Walter Energy has approximately $285 million per year in cash interest expenses. Walter Energy is targeting $70 million in SG&A expenses, and maintenance capital expenditures are expected to be around $120 million. Idling costs for the Canadian operations are expected to be at least $20 million per year (if it can avoid take or pay charges). Therefore, we are looking at around $495 million in annual cash costs (outside of cost of sales) with the Canadian operations idled.

In $ Million

Annual Costs

SG&A

$70

Cash Interest

$285

Capital Expenditures

$120

Idling Costs

$20

Total

$495

Click to enlarge

Metallurgical Coal Gross Margins

Based on past history, it seems reasonable to assume that Walter Energy will receive an average of 91% of the benchmark pricing for its U.S. metallurgical coal. This has ranged from 89% to 95% over the last six quarters. The cost of sales is pegged at $100 per metric ton as per management's comments, while production is around 8 million metric tons per year.

Therefore at a benchmark price of $110 per metric ton, the U.S. metallurgical coal operations have cost of sales essentially equal to its realized price. At $130 per metric ton, gross margin goes up to $146 million per year.

Benchmark Price ($ Per Metric Ton)

$110

$120

$130

$140

$150

$160

$170

Realized Price - US Met Operations ($ Per Metric Ton)

$100.10

$109.20

$118.30

$127.40

$136.50

$145.60

$154.70

Cost of Sales - US Met Operations ($ Per Metric Ton)

$100

$100

$100

$100

$100

$100

$100

Gross Margin @ 8 Million Tons Per Year ($ Million)

$1

$74

$146

$219

$292

$365

$438

Click to enlarge

For the Canadian metallurgical coal operations, the assumption is that Walter Energy will receive an average of 85.5% of the benchmark price for its metallurgical coal. This is a bit lower than the U.S. operations since slightly over half of its Canadian production is low-vol PCI, which fetches a lower price. The cost of sales is roughly pegged at $120 per metric ton, while production is roughly 3.5 million metric tons per year. Only the Wolverine and Brule mines are included in this assessment, as the benchmark price would likely need to rise above $170 per metric ton for Willow Creek to start producing metallurgical coal again.

At a benchmark price of $140 per metric ton, the Canadian metallurgical coal operations have cost of sales essentially equal to its realized price. As this is a better result than the $20 million per year in idling costs, it may make sense to restart operations at that price point. However, the decision to restart operations will also depend on other factors such as expectations for future metallurgical coal price trends and the strength/weakness of the Canadian dollar.

Benchmark Price ($ Per Ton)

$140

$150

$160

$170

Realized Price - Canadian Met Operations ($ Per Ton)

$119.76

$128.31

$136.86

$145.42

Cost of Sales - Canadian Met Operations ($ Per Ton)

$120

$120

$120

$120

Gross Margin @ 3.5 Million Tons Per Year ($ Millions)

-$1

$29

$59

$89

Click to enlarge

It appears that the contributions from Walter Energy's other operations (such as natural gas, thermal coal, its coke plant and Welsh mine) are generally offset by dividend payments and pension and postretirement benefit contributions, so I'm going to assume that the net impact of all those items is zero.

Liquidity

Walter Energy noted in its Q2 2014 conference call that it had $646 million in liquidity after its latest round of financing, and that it had $110 million in inventory to draw down, plus that it was closing the sale of its Blue Creek terminal assets for $25 million. The combined value of those items is $781 million. Walter Energy was also looking to sell around $250 million total in non-core assets, although it wanted to avoid a fire sale of those assets.

At a benchmark price of $110 per ton, Walter Energy can likely last until early 2016 without selling additional assets or receiving additional financing. At $120 per ton, its runway extends until mid 2016, and $130 per ton extends it until late 2016. Average benchmark pricing of $140 per ton gives Walter Energy enough cash flow to last until mid-2017.

Benchmark Price ($ Per Ton)

$110

$120

$130

$140

$150

$160

$170

U.S. Gross Margins ($ Million)

$1

$74

$146

$219

$292

$365

$438

Canada Gross Margins ($ Million)

$0

$0

$0

$0

$29

$59

$89

Less Annual Cash Expenses ($ Million)

$495

$495

$495

$495

$475

$475

$475

Free Cash Flow ($ Million)

-$494

-$421

-$349

-$276

-$154

-$51

$52

Click to enlarge

Keep An Eye On Australia

As the quarterly metallurgical coal benchmark fell to $145 USD in Q3 2013 and $143 USD in Q1 2014, a weakening Australian dollar offset that decline for Australian producers. American producers faced a 13% decline in revenue per ton between Q1 2013 and Q1 2014 based on benchmark pricing. On the other hand, due to the weaker Australian dollar, revenue per ton remained the same in Australian dollars.

In Q2 2014 and Q3 2014, Australian producers finally experienced a significant hit. The benchmark price fell another 16%, but the Australian dollar also strengthened, leading to a 19% pricing decline in Australian dollars. This came as a bit of a surprise as the Australian dollar had largely moved in sync with coal before (lower coal prices, weaker Australian dollar).

Q1 2013

Q2 2013

Q3 2013

Q4 2013

Q1 2014

Q2 2014

Q3 2014

Benchmark in $USD per ton

$165

$172

$145

$152

$143

$120

$120

Benchmark in $AUS per ton

$159

$174

$158

$164

$159

$129

$128

Average AUS/USD Exchange Rate

$0.963

$1.010

$1.092

$1.079

$1.115

$1.072

$1.069

Click to enlarge

Many Australia metallurgical coal producers also are saddled with take-or-pay contracts that result in an average of $15 per metric ton in additional costs.

Between the relatively steady price (in Australian dollars) of metallurgical coal in 2013 and Q1 2014, and the take-or-pay contracts, there was limited reason for Australian producers to reduce metallurgical coal production. Instead, Australian producers focused on cutting costs, which often resulted in maximizing coal production to reduce the cost per ton. The continuing supply glut was a significant contributor to the downturn in prices this year.

The current lower prices for metallurgical coal (in Australian dollars) may prompt Australian producers to idle additional mines (Australian mine idling had been very limited until earlier this year. Successful challenges of the take-or-pay contracts could allow for additional supply cutbacks as well. However, Walter Energy's long-term future likely depends on a resurgence in demand, since Australian production will likely come back online at prices below what is needed to make Walter Energy cash flow positive. Still, any cutbacks in Australian production should result in improved prices that would reduce Walter Energy's cash burn and allow it to wait longer for a potential metallurgical coal market rebound.

Conclusion

Even under poor market conditions, it looks like Walter Energy can survive into 2016 without additional asset sales or additional financing. However, prices are currently nearly 30% below the level needed for Walter Energy to achieve breakeven free cash flow.

It is quite difficult to tell at this point whether the metallurgical coal markets will recover enough for Walter Energy to survive in the long run. It does have quite a bit of time to wait things out, but is also burning tons of cash at current pricing levels. I am currently treating Walter Energy as a swing trading opportunity, going long or short depending on whether I feel the market has overreacted or not. I am currently short having sold calls when Walter Energy was trading at over $6. Previously, I had initiated a long position in Walter Energy at under $5.

Disclosure: The author is short WLT.

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.