Patriot Coal (PCX) had a wild ride last week, ending it on a sour note. I like the stock, especially below $10 per share, and I'm long call options. My renewed faith in the company comes from the recent hiring of COO, Ben Hatfield. Ben was the CEO of International Coal until it was acquired by Arch Coal. In my dealings with Ben, I was impressed with his candor and his coal market intelligence. He's considered one of the best in the business. To say that Ben's decision to join Patriot Coal is a vote of confidence is a major understatement.
In the past few weeks I've spoken with equity analysts and industry people about the bloodbath in coal stocks. Most are as surprised as I am about the severity of the decline. Comparisons continue to be made to 2008-9, not necessarily because pundits think today's fundamentals are eerily similar to those back then, but because there's no other explanation to describe why this might be happening.
In a previous article I wrote about Alpha Natural Resources (NYSE:ANR). I stated that ANR was down 74% from its January, 2011 high. This compares to an 85% decline in ANR during the financial crisis. Clearly there's fear and even panic priced into the stock. But, it's not just ANR or coal stocks, it's a wide range of natural resources, cyclical and industrial stocks that have been hammered.
Assuming that these stocks and sectors will continue to be volatile, I'm looking for alternative ways to play the fundamental coal story without the crazy price swings in the stocks. One way I found was to sell put options on Walter Energy (NYSE:WLT). While this trade is very risky, there's a margin for error embedded in the trade, i.e. the difference between the strike price and the current price.
My bet on WLT is that the stock will not close at $40 or lower by March 17, 2012. The current price is $61. Importantly, my bet is also that stock market volatility will decline between now and March. These 2 bets go hand-in-hand and I like both bets.
Getting back to Patriot Coal, instead of buying PCX stock, or playing it through stock options, I'm looking at the Company's 8.25% coupon bonds at a price of $87,yielding 11% with a 9.5% current yield. PCX had $457mm of debt and $263mm of cash at 6/30/11, equating to net debt of $194mm. For 2012, recently revised consensus EBITDA is $414mm. Net debt divided by 2012e EBITDA is therefore $194mm/$414mm = 0.5x.
But wait, there's a big complicating factor. PCX has $1.9 billion of legacy liabilities. In order to account for this, I conduct an analytical exercise. I add the $1.9 billion to gross debt of $457mm for an adjusted debt figure of $2.36 billion. Subtracting cash, net adjusted debt is about $2.1 billion. Since I'm adding the legacy liabilities to gross debt in this exercise, I also add the annual payments made to service the legacy liabilities to EBITDA. The adjusted net debt/ EBITDA is therefore approximately 3.0x.
The adjusted net leverage of ~3.0x is not alarmingly high, nor is it especially low. But adjusting the debt leverage ratio by adding 100% of the legacy liabilities may be an overly harsh way of looking at the situation. Since there's no fixed maturity on the legacy liabilities, the immediate repayment of the $1.9 billion would only become due if PCX were to file for bankruptcy. Unless one believes that Patriot Coal is headed for bankruptcy, then these bonds offer an intriguing opportunity.
The kicker comes from a potential takeover of the company. Assuming that a larger company with a strong balance sheet and investment grade ratings were to acquire PCX, the 8.25% bonds would trade up as much as 25 pts. How is this possible? If for example BHP Billiton Limited (NYSE:BHP) was the acquirer, PCX bonds would trade at almost the same yield spread over treasuries as BHP bonds because BHP would assume the debt obligations of PCX.
BHP bonds that mature in the same year as the PCX bonds trade at a yield spread over treasuries of about 325 bps. PCX bonds are trading at about 1,000 bps over treasuries. If PCX bonds became the obligation of BHP, they too would trade at a yield spread of close to 325 bps. A yield spread of 325 bps on the PCX bonds would equate to a bond price of $112, or 25 bond points higher than the current price of $87. In that takeover scenario, the all-in return on the bonds if held for 1 year would be about 36%.