Patriot Coal's Deteriorating Financial Prospects

Feb. 6.12 | About: Patriot Coal (PCXCQ)

Last Thursday (2/2/12) Patriot Coal (PCX) pulled off quite the head-scratcher after missing analyst consensus estimates for revenue and EPS by 6% and 40% respectively yet rallying on the day, at times reaching +14% territory. This pop was a welcome respite for shareholders who have seen the price of Patriot Coal fall 70% from a year ago.Click to enlarge
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Many analysts cite the earnings call announcement that PCX would be closing the Big Mountain complex as the bullish piece of information that sent the stock flying. The closure was cited as good news that Patriot was keeping a grip on output, and that by managing production they might improve operating margins and help shore up the price of thermal coal.

So is this closure the solution shareholders have been looking for? As Motely Fool's Travis Hoium notes, this move probably won't solve any of the long-term problems facing PCX or coal in general:

Since thermal coal usage is falling in the U.S., I highly doubt that the production cut will do anything but stall problems already forming in the thermal coal market. Unless China picks up demand from U.S. producers this isn't a space I would want to be invested in right now. This is a great time to exit if you agree with that analysis.

With the upside of the closure dubious in the context of rock bottom natural gas prices from the fracking fever that has swept the nation, shareholders are left with a disappointing quarter financially speaking.

To determine just how bad a spot Patriot Coal's earnings miss puts them in, I utilized the Altman Z-Score + Web App, developed by a mobile financial app start-up, Business Compass LLC, in collaboration with Professor Edward Altman. The Altman Z-score test is meant to gauge financial distress and likelihood of bankruptcy, with the lower the socre, the more likely the company is headed for bankruptcy or restructuring.

The web app generates a z score of 0.793 for Patriot coal as of the end of FY 2011. This corresponds to a bond rating equivalent of Caa1/CCC+, with a projected likelihood of default of 18% in one year and 40% in three years.

The trend is negative when PCX's 2009 and 2010 fiscal year results are also run through the tool. As we can see by the chart below, which shows PCX's bond-rating equivalent historically, Patriot's bond rating equivalent has a negative trajectory.

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It can't get any worse for Patriot Coal though, right? In the comments section of my previous article regarding Patriot Coal ("Is Patriot Coal Headed for Bankruptcy?") many commentors suggested that PCX had a great deal of legacy contracts written at much lower coal prices, and that as these contacts expired in 2011 and 2012 that Patriot Coal would be able to roll them over at much more attractive prices. Obviously if this was the case, one could make a compelling argument that today's losses were more about the mistakes of a previous management team and did not accurately reflect PCX's forward looking prospects.

To determine if this held any water, I took to Patriot Coal's most recent 10-K, released 2/25/11. I was looking for any commentary on expiring legacy contracts that would positively impact forward earnings. Surely if these contracts were what was holding PCX back, Patriot's management team would be crawling over each other to notify the prospective investor that their historical losses should be overlooked!

The only mention I found of below-market contracts were in connection with Patriot Coal's 2008 acquisition of Magnum Coal Company*. This acquisition was completed shortly after Patriot Coal's 2007 spinoff from Peabody Energy (BTU). Per the 10-K:

In connection with the Magnum acquisition, we recorded liabilities related to below market sales contracts. The below market supply contracts were recorded at their fair values when allocating the purchase price, resulting in a liability of $945.7 million, which is being accreted into earnings as the coal is shipped over a weighted average period of approximately three years.

This is accreted to the income statement under the line item "Sales contract accretion", which includes the liability mentioned above net of the asset of the above market contracts Magnum had at the time of acquisition. PCX realized a net gain of $121M in 2010, $299M in 2009 and $279M in 2008 from sales contract accretion. Without this line item, PCX profit would have been -$170M in 2010 (vs. -$48M reported), -$171M in 2009 (vs. $127M profit) and -$137M in 2008 (vs. $143M profit).

For the nine months ended 9/30/2011, if PCX wouldn't have had this line item, they would have lost -$123M (vs. -$77M reported). With this expiring likely sometime in 2012 per the three year statement above, one would expect Patriot Coal to be in a fair amount of trouble as the above market contracts expire.

Between the trend of their deteriorating bond rating equivalent, dim industry outlook and expiring above-market legacy contracts, unless the market dynamics turnaround quickly PCX may find itself in some trouble going forward.

Inputs** for Altman Z score test:

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* Please contact me if you have any additional information on Patriot Coal legacy contracts

** As a note, the Altman Z-score world divides companies as manufacturing or non-manufacturing. Patriot Coal is classified as a manufacturing company in this regard.

Disclosure: I am short PCX.