Seeking Alpha
Deep value, long only
Profile| Send Message| ()  

Last week I sold March, 2012 $40 Put options on Walter Energy (WLT) for a $5 premium. I made the same trade a few weeks ago, and it paid off handsomely in a short period of time. When I entered the trade last time I did not expect for it to be profitable so quickly, but speculation emerged on September 7th that Anglo American was considering making a bid for WLT. That news drove the stock up to about $91 per share, and I closed my trade the next day.

I don't think that WLT is a buy at $60 per share because of sketchy management and recurring operational issues. However, enough suitors have looked at the company and continue to follow it that if the stock remains at $60 or lower, there will be another round of tire kicking, and investors will jump in anticipating a possible takeout attempt. Recall that it was less than a month ago that the shares spiked from $75 to $91. By selling $40 puts for $5, my breakeven price is $35, or 42% below the current price of $60. The annualized return on the investment will be 25% if the stock closes at $40 or above on March 17, 2012. The 7 analysts who have updated or reiterated price targets subsequent to WLT's earnings warning have an average target of $101.

Walter stock will continue to be volatile. The CEO suite has changed owners 4 times in the past 2 years. The most recent CEO was not hired from outside, he was promoted from COO. A common concern among stockholders is that no one outside the firm was willing to take the job. The other big concern is that WLT cut 3Q production guidance dramatically due to poor mining conditions. While it's important to understand that difficult mining conditions have plagued the company for years, it's equally important to understand the quality of the coal coming out of the company's Alabama mine-- it's as good as it gets. WLT's premium low-vol coking coal consistently sells at or slightly above benchmark Bowen Basin coals.

Recurring mining problems have caused the company to be stuck at producing roughly 7mm tons per year from its Alabama operations. Although it's disappointing that WLT hasn't been able to achieve higher production rates, 7mm tons of premium low-vol coking coal is a very significant amount. Canada's Teck Resources (TCK), the 2nd largest exporter in the world, produces about 22mm tons of similar quality coking coal. WLT's Alabama coking coal output is approximately one third of Teck's. This may not sound like a lot, but the global seaborne trade in the highest quality coals is approximately 250mm tons. Walter's 7mm tons makes it a top 10 producer in the world. Including Walter's newly acquired Canadian operations, WLT may become a top 5 producer of the highest quality coking coal in 3-4 years.

Walter ships out of Mobile, Alabama. This gives the company a distinct and sustainable transportation advantage to Brazil. This location is unique, all other U.S. coking coal production comes from Central and Northern Appalachia. Shipping lanes, railroads and port capacity are becoming bottlenecks off the east coast due to the resurgence in coal exports that began last year. It would make a great deal of sense for Brazilian iron ore giant Vale (VALE) to acquire Walter Energy. Vale has some coking coal assets, including 1 of the 2 dominant coking coal plays in Mozambique, but it would greatly benefit from Walter's 7mm tons of premium low-vol coking coal. The increased exposure to coking coal would diversify Vale's huge dependence on iron ore.

Other potential interested parties in WLT could include Brazilian and European Steel producers. Brazil does not have any indigenous coking coal, yet the country's needs are growing rapidly. Steel giant CSN could acquire WLT and sell the excess production to other steel makers in Brazil or elsewhere. ArcelorMittal (MT) is probably looking at Walter as well. Finally, global commodities trader Glencore could make hay trading Walter's coking coal.

Investors worry about WLT because so much of its earnings are tied to one mining complex-- a very valid concern. However, I think that risk is somewhat-- if not largely-- priced into the stock. Importantly, WLT's Alabama coal assets are worth more to a major like Anglo American (AAUKF.PK), Rio Tinto (RIO), BHP, Xstrata (OTC:XSRAF) or Teck Resources as part of a diversified portfolio of mining assets. A major could deploy better management and a lower cost of capital.

I did this trade in small size because this is a risky investment. Even if WLT never gets near $40 per share between now and March 17, 2012, if the stock trades down to say $50, the mark-to-market unrealized loss on the short Put position would be painful. However, I find that selling options offers nice diversification to a mostly long stock portfolio when stock market volatility is high. In addition to betting that WLT stock will not fall precipitously, I'm also betting that elevated market volatility will subside over time.

Source: Walter Energy: Selling March 2012 $40 Puts

Additional disclosure: I am effectively "long" WLT because I sold a Put.