Peabody Energy (NYSE:BTU) shares have taken quite a pounding in recent days due to fear instilled as a result of the Arch Coal (NYSE:ACI) bankruptcy. This article is not going to discuss it in detail except to say it certainly appears that such fear is justified given the press release made by Arch, which indicated that the payout to secured creditors would be roughly $518 million. Such a settlement would mean the assets were indeed worth quite a bit less the $6.8 billion reported in the company's last 10-Q.
Normally with a natural resource company, one would expect the GAAP financials valuing the assets to be a bit suspect, but in Arch's case, management had just performed a review of the carrying value of the Appalachian assets (see note 5 in the 10-Q) literally within the last three months and written them down to fair value, so the shock realized by market participants is understandable.
Assuming the author's reading of the regulatory filings is correct, the subject of this article has become quite unimportant in the overall scheme of things, as Peabody is not only insolvent, as is generally acknowledged by its bond prices, but in fact, so insolvent that it becomes doubtful that any recovery by unsecured creditors is likely.
Nevertheless, this article will assume that coal assets have not suddenly became worthless. Instead, it will focus on the very difficult tax situation faced by Peabody that makes piecemeal restructuring of its debt outside of bankruptcy difficult. Those problems include:
- Its U.S. assets remain profitable, and Peabody continues to pay income taxes to the U.S. government.
- Massive losses in Australia do not result in reduced U.S. taxes, and merely result in loss carryforwards reported to the Australian Tax Office.
Both of the above statements are based on a review of Note 10 in its most recent 10-K .
If Peabody were to buy back debt at a discount to face value, it would trigger cancellation of indebtedness income (COD) for U.S. tax purposes, which would result in additional payments to the U.S Treasury unless one exception is met. That exception is: COD income is not taxable to the extent the company is insolvent.
So, how insolvent is Peabody? It is a question that I would find very difficult to answer, and if anyone other than an appellate court judge were to provide an answer, I would say it is subject to challenge. This lack of certainty is a reason for doing any restructuring as part of one large transaction, which, as much as I hate to say it, may have to be part of a bankruptcy proceeding.
Obviously, bankruptcy raises a whole host of other issues, and, as with marriage, is not to be entered into lightly. Assume the restructuring is either done outside of bankruptcy court or as part of a pre-packaged bankruptcy where all stakeholders agree on what the result will be, the question, as asked earlier, is how insolvent is Peabody?
One method would be to use the discount applicable to bond values, which, according to the last 10-Qs, were:
Obviously, values have declined since these regulatory filings were made, but the bond values plus market capitalization seem most appropriate. Two other values would be:
- GAAP financials. As equity is positive, there is no insolvency, and all COD income is going to result in tax liabilities. If $4 billion in COD income were recorded, it would likely result in a tax liability in excess of $1 billion.
- Arch Coal methodology. Granted it is extreme, but it appears as though management used roughly three times EBITDA, which would be favorable from a tax perspective, as it means little, if any, would be owed to the IRS.
Fortunately or unfortunately, as the case might be, Peabody is insolvent, and the tax will be less than a billion dollars, but the complexities faced are enormous, involving not only U.S. rules, but Australian issues as well. Management has to tread very carefully for many different reasons, but at some point in time, they will have to move.
Disclosure: I am/we are long BTU.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Long Peabody unsecured bonds and Arch second-lien bonds.
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