Coal Industry Context
Since April 2014, coal miners Alpha Natural Resources Inc., Arch Coal Inc., Patriot Coal Corp. and Walter Energy Inc. have all sought bankruptcy protection. Global coal inventories continue to climb and the coal price remains depressed (see Figure 1). The obvious question for investors is "what will be the next shoe to drop"?
Figure 1: Historical Coal Prices: US and Australia
Joy Global (NYSE:JOY) is a potential short candidate with its reliance on sales of capital equipment to miners in the depressed coal, copper, crude oil, gold and iron ore sectors. Historically and for 2015, most of JOY's revenues are from miners in the coal sector. The JOY stock price is down almost 90% since its peak in 2011 and has consistently underperformed its capital good peers over that timeframe (see Figure 2).
Figure 2: JOY Comparable Company Relative Performance: 2011 - present
JOY's senior unsecured bonds trade as if the common equity has no value and the bondholders will need to take a large haircut in any bankruptcy (see Figure 3). The 2021 bonds are quoted at a price of 71.75 for a yield of 12.1% and the 2036 bonds are quoted at 63. Part of the reason behind the drop in the bond prices is the recent decision by Moody's to lower the rating on these bonds from investment grade to high yield and the negative credit outlook from S&P. However, a one notch sub-investment grade rating can't explain a 37 point drop in bond prices.
Figure 3: JOY 6.625% 2036 Senior Unsecured Bonds
(Source: FINRA, Morningstar)
With the stock price down almost 90% since 2012 and its bonds trading as if the common equity is worthless, is it in fact safe to assume that the JOY share price is ultimately going to $0?
Putting aside some minor annual amortization of its term loan and revolving credit agreement over the next 3 years, JOY has a surprisingly "empty runway" of debt maturities until 2019 (see Figure 4). In late 2015, JOY paid the make whole premium and repurchased its outstanding 2016 maturities.
What is surprising about JOY's bond prices is that the 2019 senior unsecured bonds have a face value of $340 million. Yet, JOY's current annual Cash Flow From Operations (CFFO) exceeds $300 mm.
Figure 4: JOY Debt Maturities: 2016 to 2022
We do not have sufficient confidence in our commodity price forecasting abilities to make accurate long term projections of JOY's revenues until 2022. What we can do is back-solve a liquidity model to determine the quantum of CFFO declines JOY would need to experience each and every year from 2016 until 2021 for it be unable to repay its 2019 and/or 2021 debt maturities.
Figure 5: JOY Liquidity Projection: 20% Annual CFFO Reductions & 0% Annual Capex Increases: 2016 to 2021
(Note: CFFO excludes interest costs and includes post-interest cash taxes paid)
Fortunately, the liquidity analysis yields such an extreme CFFO scenario for bankruptcy to occur, that we can take comfort from the fact that the 2019 and 2021 bonds are not likely to default. For example, in Figure 5 we show that if we assume a 20% Compound Average Growth Rate (CAGR) reduction in CCFO combined with flat capex costs, every year between 2016 and 2022, results in no liquidity crisis before 2022. If JOY manages to improve on either of these metrics in any way (e.g. implements capex cuts and/or keeps the CFFO reduction to < 20% per year) then JOY can repay all of its maturities up to and including 2021. JOY does not currently face any other debt maturities until 2036.
The main reason we limit the CFFO CAGR to 20% declines when back-solving for 2022 liquidity is the leverage covenants in the revolving credit facility. As we discuss below, without that covenant, the company could have endured almost 30% CAGR declines in CFFO (combined with rising capex cost) and still have repaid the 2019 and 2021 debt maturities.
In Figure 6 we provide a wide range of different CFFO and capex CAGR assumptions. Keep in mind that these variables represent x% change each and every year from 2016 to 2022 (it is not a one-time % change) making most of these scenarios equivalent to an extreme "scorched earth" scenario.
Figure 6: JOY Liquidity Scenarios: 2021 Closing Liquidity
(Note: CFFO excludes interest costs and includes post-interest cash taxes paid. In most downside scenarios there are no cash taxes payable after utilization of existing NOL balances)
It should be obvious that if CFFO is declining by double-digit percentages every year, it is extremely unlikely that management would be keeping its capex spend flat for over 6 years. We think the more likely range of scenarios when you have 20+% annual CFFO declines for six consecutive years would be a declining annual capex spend. By way of comparison, in 2014 and 2015 global mining capex declined by 18% and 19%, respectively. In response, JOY reduced its own capex from $153 million in 2013 to $91 million in 2014 (down 41%) and $71 million in 2015 (down 28%).
Finally, we derive a large degree of comfort from the fact that JOY has net working capital with a book value in excess of $1 billion. The net working capital is equal to all of JOY's external indebtedness. The company has not disclosed any potential impairments of its debtors or its inventory. JOY's accountants apply the lowest of cost or fair value when valuing its inventory. Over 80% of the inventory is represented by finished goods. The trade receivables (net of allowance for doubtful debts) comprise over 80% of total accounts receivable. Management estimates that of the $873 million revenue backlog, only $184 million is due after fiscal year 2016. This net working capital position is a true source of liquidity and it is not included in our projections.
In a distressed liquidation "fire sale" scenario it is conceivable that these current assets would be worth only a portion of their book values. However, the significance of these current assets is not their value in liquidation (although they would have a high degree of value in such a scenario). These current assets are important because they provide prospective bank lenders with a high degree of confidence that JOY can meet its external commitments with relatively liquid assets. Compare this to the situation of a borrower who has most of their balance sheet value locked up in long-term fixed assets such as property and goodwill. Also, remember that our liquidity analysis is based on a scenario where CFFO declines to a point where the company does not need to file for bankruptcy (i.e. there should be no distressed liquidation of the net working capital).
Risks to Our Liquidity Analysis
To get comfortable with these long range liquidity projections we needed to address a number of risks and uncertainties with JOY's operations and financial position. We address some of those concerns below:
- Counterparty risk - the top 10 customers in 2015 accounted for 37% of net sales. Only one customer accounted for more than 10% of consolidated revenues (11% in FY15). To date, there are no disclosed impairment reviews related to counterparty risk. As an aside, a lot of commentators have commented on MLP counterparty risk. However, when customers go bankrupt they will often continue to operate under the management of the existing lenders and/or raise debtor-in-possession financing. It is usually not the case that bankrupt firms cease production and shut up shop. The real risk is that off-market contracts (such as legacy pipeline transportation contracts) are repriced during bankruptcy. This is less of a risk for a capital goods supplier;
- Common share dividend - we have assumed that management eliminates the dividend. It only costs around $4 million which is not material to overall liquidity but it seems a more realistic assumption in a world of multi-year 20+% CFFO declines. However, if management repeats its decision in 2014 to raise the dividend, that could drain important liquidity from our projections. The amended credit agreement only caps dividend payments at $25 million per year. It would be theoretically possible to increase the dividend from current levels, albeit very unlikely;
- Interest rate risk - higher interest rates would generally be inconsistent with a scenario of 20% CFFO reductions (unless the CFFO declines are company specific). Moreover, the outstanding bonds are fixed rate instruments and even sizeable interest rate movements on the amortizing term loan would not move the needle in our liquidity projections;
- Acquisition risk - we can't rule out the risk of management undertaking dilutive acquisitions in the future. However, JOY management appear very alive to industry challenges and we don't expect any dilutive acquisitions if the market continues to decline;
- Pension costs - as of Q4 2015 the pension liability is 90% funded. The recent change to mark-to-market accounting for the pension expense might impact the EPS performance but on a cash basis we don't anticipate any liquidity issues related to pension costs;
- Forex exposure - the strong US dollar in 2015 - especially against the Australian Dollar and the South African Rand - adversely impacted US dollar earnings in 2015. Historically, movements in the US dollar are much less important than commodity price volatility (see Figure 7) in terms of CFFO impact;
- Revolving credit renewal - we are assuming that the existing credit facility is rolled over. In our liquidity analysis we are assuming that CFFO declines year after year until 2021 before growing again in 2022. A lender might look at that liquidity profile and question if cash flows will ever start to grow again. It is inherent in the very nature of commercial lending to take industry and commodity cycle risks and this is the source of the CFFO declines in our analysis. We are not assuming ongoing CFFO declines related to poor management, cost blow outs, etc. In reality, the liquidity upsides we discussed previously should ensure that any credit rollover is achievable (especially the $1 billion in net working capital as well as the assumption that CFFO starts to stabilize and/or start growing again after 2021);
- Letter of Credit Utilization - any Letter of Credit (LOC) increase would mean triggering the EBITDA coverage ratios sooner than 2022. However, with the JOY business shrinking in our forecast period there should be no operational need to issue additional LOCs; and
- Debt covenants - the credit facility covenants were amended late 2015 to provide additional headroom. As mentioned previously, these amended covenants act as a constraint on our downside analysis but they are not breached in any forecast year.
Figure 7: US Dollar Index and Commodity Price Index: 1999 to 2016
All-in-all, we do not see any material liquidity issues with these risk factors. We also feel that any potential risks are far outweighed by the potential upsides to our liquidity analysis discussed in the next section.
Upsides Not Reflected in the Liquidity Analysis
We believe that the liquidity analysis is, in fact, too pessimistic as it assumes no major changes to JOY's corporate finance policies or to its corporate strategy. This is a conservative assumption but there are too many alternatives which any reasonable management would implement long before 2022. As mentioned previously, there is over $1 billion in liquidity represented by net working capital which is not included in our forecasts. Some of the other sources of liquidity include:
- Cost reductions - management announced a target of $85 million in cost savings during 2016 ($45 million net of implementation costs). They also stated it was a reasonable assumption that they would exceed this target (for the 4th year in a row). Implicitly, our 20% CFFO reduction in 2016 consists of a 20% revenue reduction with no change in SG&A or an even larger % reduction in revenues combined with $45 million in SG&A reductions. Both alternatives are incredibly pessimistic;
- Capex reductions - as discussed above, you would expect that multi-year declines in CFFO would eventually result in major capex cuts. We are currently watching exactly that dynamic play out in the oil & gas E&P sector;
- Input costs - While JOY's revenues are adversely impact by the declining commodity prices (coal, copper, crude oil, gold & iron ore) it is also the case that JOY is a beneficiary of the low copper and steel prices which are raw materials used to produce their capital good products. They employ just-in-time inventory management processes so the input cost benefits should rapidly flow through to gross margins;
- Debt refinancing - we have assumed that JOY rolls over its existing credit revolver, however, we have not assumed any refinancing of its other maturities with longer-dated issues. Moody's has assigned to JOY a corporate family rating of Ba3 with a stable outlook while S&P still rates JOY's debt investment grade with a corporate credit rating of BBB- (following a 1 notch downgrade in January 2016 and a negative outlook). With a split rating, a long dated debt issuance at a reasonable coupon is feasible; subject to the new issuance debt markets being "open". Recent amendments to the credit facility would permit JOY to increase its consolidated leverage to 4.5 x EBITDA. The company could also look to replace the revolving credit facility with a form of debt that does not contain leverage covenants. In that case we could see CFFO decline by a 30% CAGR while retaining the ability to repay the debt maturities in 2019 and 2021 (see Figure 6);
- Asset sales - management has stated that it continues to evaluate non-core assets and operations for a potential sale. We have not included any sale proceeds in our liquidity analysis;
- Inventory management - JOY monetized around $100 million of inventory in 2015. We view benefit as a one-off cash flow benefit. The reality is that management will at least attempt to wring out additional working capital improvements in 2016 and beyond. As discussed above, the net working capital of circa $1 billion is strategically important when viewed alongside JOY's long term debt of the same amount;
- New customer segments - we have not incorporated any revenue benefits from entering new markets, products or customer segments. The recent acquisition of Montabert provided JOY with additional capabilities and customer growth opportunities in their hard rock product portfolio. The company also sees growth opportunities from entering the crushing & conveying capital products business. As we discuss below in the section on Carbon Capture & Storage (CC&S), regulatory change may also unlock additional realistic growth prospects for JOY;
- Debt buy-back - in late 2015 management bought back debt at a discount to its face value. Given the current trading prices for its 2021 and 2036 issues, JOY could adopt a similar strategy to reduce their future repayment obligations by purchasing the outstanding bond issuances at a discount to face value; and
- Equity issuance - any equity funding at current levels would be an expensive source of capital (< 5x EBITDA) but remains a possibility if JOY's liquidity becomes severely constrained.
Finally, it is instructive to examine JOY's actual financial performance in 2015. Despite major declines in several key commodity prices, JOY's Revenues and its CFFO increased in the last 3 quarters of the 2015 (see Figure 8). With the exception of Rocky Mountain coal (which increased approx 5%), most US coal basins experienced price declines of 20% to 30% in 2015. Iron ore prices declined around 40% and copper was down around 30%.
From 2014 to 2015 adjusted CFFO before pension contributions increased marginally from $363 million to $368 million while over the same time period global mining capex declined by almost 20% (see Figure 9, below).
Figure 8: JOY Quarterly Results 2015: CFFO & Revenues
Buy the Equity?
After deciding that the equity is not going to zero any time soon, we naturally need to address the question: is the JOY share price good value at current levels?
It is one thing to project sufficient liquidity for a debt repayment, it is another thing to decide the company will act in a way to provide the foundation for a higher share price. In the currently challenged, volatile market environment for miners and natural resource companies, we suspect that shareholders will be most rewarded by equity markets if management pursues strategic decisions that enhance liquidity and strengthen the balance sheet.
In 2014, JOY's management and the Board of Directors implemented a number of corporate finance and strategic decisions that could be perceived as not being entirely "defensive" in nature. In particular, the decisions to:
(1) increase the dividend for the first time in several years; and
(2) acquire another company (i.e. Montabert) for a purchase price requiring a 75% allocation purchase price to goodwill and intangibles ($90 million allocation out of a total purchase price of $121 million), might seem imprudent in the context of a generational bear market for its major customers and commodity prices.
On the other hand, management has exceeded its cost reduction targets for 3 years in a row. That includes 2015 where there was an additional, unbudgeted $7 million in SG&A associated with the integration of newly acquired Montabert.
Furthermore, a number of management actions taken in 2015 give us further reason to believe that they are fully aware of the challenges facing the industry. The most notable of these actions include:
(1) reducing the common equity dividend to 1 cent per share per quarter;
(2) announcing a $85 mm reduction in SG&A (and stating publicly that they expect to once again exceed this cost reduction target);
(3) announcing that 2016 capex would be flat on 2015 levels;
(4) re-negotiating their credit agreement to permit higher consolidated coverage ratios;
(5) paying the make whole premium and buying back the 2016 debt maturity; and
(6) inventory monetization of $100 million.
Finally, if you listen to the recent earnings call and read the 2015 annual report it is clear that management are sanguine about its future prospects and the seriousness of the current commodity price bear market. For example, they projected that coal-fired power generation will decline to 30% of US electricity production. And they see consolidated revenue in 2016 declining to a range of $2.4 to $2.6 billion.
Indeed, management see global mining industry capex declining another 20% in 2016 followed by a 5% decline in 2017, before stabilizing in 2018 and beyond (see figure 9).
Figure 9: Mining Industry Capital Expenditures
(Source: IMF, World Bank, Bloomberg, Factset, Wall St equity research consensus estimates, JOY research)
All of which, on balance, makes us think that management are "shareholder friendly" and will take the necessary steps to improve liquidity and the share price.
The current share buy-back authorization still has $500 million of unused capacity before it expires in August 2016. In this equity market environment, we believe that the company will be rewarded for strengthening its liquidity and reinforcing the balance sheet rather than boosting EPS with additional share buy-backs. As a result, we would like to see the share buy-back authorization expire with no further utilization between now and then. This is also the working assumption of Moody's when it recently assigned a stable credit outlook.
Our analysis suggests JOY can comfortably cover its liquidity needs even under a number of "scorched earth" scenarios. If and when the bonds recover in price it will remove the current overhang on the shares (i.e. the perception that the equity is worthless and that the debt will need to take a material haircut in any bankruptcy filing). Both of which should spark an impressive rally in the JOY share price.
25% of JOY's free float is currently short, representing a short ratio of 4.7 days. The share price should experience some dramatic short-covering rallies on any positive news.
However, we still need to examine a further risk associated with owning JOY shares.
Impact of COP21
We don't know exactly when commodity prices will turn. It is perhaps trite to suggest that the cycle will turn when there is an improved outlook for global GDP growth (with a particular emphasis on Chinese GDP growth) combined with further reductions in output by commodity miners. However, that assumes the commodity cycle is in a cyclical low. Many investors are viewing this as not a cyclical downturn but rather a structural change which will see carbon producing industries never recover in a meaningful way. Several advocacy groups around the world have declared that 80% of the world's known coal reserves must remain in the ground if we are to limit global warming to less than 2 degrees (e.g. CarbonTracker).
The December 2015 announcement at 2015 United Nations Conference on Climate Change (COP21) (also known as the "Paris Agreement") certainly point towards a possible future with much less economic reliance on carbon emitting industries and, in particular, less coal-fired electricity generation. But how much of a reduction in coal consumption are we talking?
The EIA analysis of COP21 demonstrates that coal is still a necessary part of the electricity generation industry - especially for emerging nations which need electricity to pull its citizens out of poverty - coal consumption, even under a "2-degree world", is not going to zero in our lifetime.
For starters, Chinese coal demand is projected to continue increasing after COP21.
Figure 10: Project Chinese Coal-Fired Electricity Generation Capacity: INDC Scenario
(Source: International Energy Agency, 2015)
As is India's coal consumption.
Figure 11: Indian Primary Energy Demand: INDC Scenario
(Source: International Energy Agency, 2015)
On a global basis, total thermal coal consumption is projected to decline by 2030. If correct, this would mean that companies like JOY need to refocus away from its current core markets of Australia, Latin America and North America and towards China, India and other emerging market nations. Many companies, including JOY, had already adopted this ethos based on projected GDP growth rates. That strategy is now supported by the evolving carbon emission dynamics resulting from the Paris Agreement.
JOY already has both manufacturing facilities and service offices in China as well as service offices in India. Over 65% of its 2015 revenues were sourced from outside of the United States. The company appears well positioned to adjust its focus to changing commodity demand patterns around the world; whether the cause of that shift is relative GDP growth rates or regulatory responses to climate change and COP21.
Figure 12: Global Coal-fired Generation Capacity Changes by Region: INDC Scenario
(Source: International Energy Agency, 2015)
It should also be noted that most of the focus on thermal coal consumption has been with regard to power generation. Metallurgical coal (or coking coal) is used in steel production and, while not exempt from carbon emission concerns, is viewed very differently from thermal coal. JOY's customers use its capital products for mining both thermal coal and metallurgical coal. It is not yet clear how much of an impact COP21 will have on global steel production. The key focus of COP21 is on energy production & use, which accounts for two-thirds of global greenhouse-gas emissions. The primary carbon reduction measures advocated under a "2-degree world" include energy efficiency, fossil-fuel subsidy reform, upstream methane reductions and renewables investment. Thermal and metallurgical coal face very different regulatory futures. While thermal coal is currently JOY's largest single revenue source by commodity type, it only comprises 40% of consolidated revenues and 80% of those thermal coal sales are in countries other than China and India (see Figure 13). Growth opportunities are still available in met coal (18% of consolidated revenues), copper (20%), iron ore (6%) and other less environmentally sensitive commodities.
Figure 13: JOY 2015 Revenue by Commodity Type
(Source: Investor Presentation, 2015)
There is one final environmental risk we need to consider before moving to a potential upside.
Fossil Fuel Divestment Campaign
The fossil fuel divestment movement is a generic reference to the sale of investment assets, including stocks and bonds, in fossil fuel producing companies. The divestment movement seeks to indirectly reduce climate change through investment decisions. By late 2015, it was estimated that almost 200 insurers, cities and other investors controlling more than $3.4 trillion in assets and over 600 individuals had publicly committed to divest over $50 billion in fossil fuel stocks. We are not aware of any examples where the divestment campaign has extended beyond (a) the owners of the carbon producing reserves (e.g. coal, crude oil, etc) and (b) coal-fired power generation utilties, to the capital suppliers in those industries.
Earlier this month, Norway's $810 billion sovereign wealth fund (Norges) announced that it had divested 16 coal companies after Norway's Parliament passed a law in 2015 requiring divestment of companies whose businesses rely at least 30% on coal. Norway's law is thought to also require the divestment of coal-fired power generation companies but not coal equipment suppliers, etc. Also in 2015, the State of California passed a law (SB185) requiring CalSTRs and CALPERs to divest thermal coal investments by July 2017 (metallurgical coal is exempt). Earlier this month CalSTRs announced it was divesting all of its remaining thermal coal stocks, including its holdings in Cloud Peak Energy, Hallador Energy, Peabody Energy and Westmoreland Coal.
This provides the JOY share price with a significant, ongoing valuation advantage over its fossil fuel mining customer. All things being equal, JOY should trade at higher multiples than miners who are exposed to fossil fuel divestment risk (see Ansar, Caldecott & Tilbury, "Stranded Assets and the Fossil Fuel Divestment Campaign: What Does Divestment Mean for the Valuation of Fossil Fuel Assets" (University of Oxford, October 2013)). Or put differently, if an investor wants exposure to fossil fuel price upside but doesn't want to risk owning a stock that might be impacted by a fossil fuel divestment campaign, they could look at a company like JOY.
Speaking of coal price upside scenarios…
Carbon Capture & Storage - Upside Potential?
It is interesting to note the role that the EIA expects Carbon Capture & Storage (CCS) to play in the reduction of global carbon emission in a post Paris Agreement / COP21 world (see Figure 14). Over the last 20+ years we have seen numerous examples of electric utilities, technology companies and National governments make bold commitments to the development of CC&S technology. We are not yet convinced that CC&S will become cost competitive in the near term but we have to acknowledge that if National governments implement their carbon reduction commitments under COP21 - including perhaps a national carbon tax and/or a cap-and-trade system - that this should provide CC&S with a material relative cost advantage.
When so many companies and governments have made public commitments to developing CC&S technology there is always the possibility of a technological breakthrough.
In other words, at this point in time we would not invest too much of our own capital in CC&S-related stocks. However, if you can get CC&S exposure for next-to-nothing in a post-Paris Agreement world, the CC&S exposure could end up being very lucrative for shareholders.
Figure 14: Carbon Capture Projections by Sector and Region
(Source: International Energy Agency, 2015)
It is not clear if JOY can provide the capital equipment and operational services required by CC&S developers but, for the purposes of this analysis, it doesn't actually matter. If CC&S becomes commercially viable it will enable material increases in coal consumption (or slower rates of coal production declines). This could represent a significant longer term upside for JOY's customers and, by extension, its share price. Which is to say that the JOY common stock incorporates a free call option on the successful commercialization of CC&S.
Our liquidity analysis suggests JOY will only go bankrupt if its CFFO declines at more than 20% every year between 2016 and 2022. This would need to be combined with no reductions in the current level of capital expenditures. As a result, the bankruptcy risk appears low and the intrinsic value of the common equity shares is positive. Moreover, the company still has a number of corporate finance levers it can pull if it needs to improve its liquidity profile.
A 12% bond yield and the possibility of a double digit capital gain on a split-rated bond with robust liquidity downside scenarios appears to us to be a very attractive risk-reward proposition. At the moment, the bond market is implicitly sending the signal that the common equity shares are worthless. As the bond market reprices the bonds to more accurately reflect JOY's liquidity profile, we would anticipate a substantial share price rally for JOY shareholders.
The implications of COP21 and the Paris Agreement for JOY - and the global mining sector in general - might be overstated. It is not clear to what extent concerns over coal production post-COP21 are reflected in the JOY share price. Either way, the successful deployment of CC&S, which was given a major boost at COP21, could provide a significant upside for the JOY share price.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in JOY over the next 72 hours.
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.