The Peabody Energy(NYSE:BTU) puzzle has literally astounded me for quite a while. It makes literally no sense. I cannot understand how a company that has already essentially declared bankruptcy, is completely under operating costs on every property they own, and where the bonds trade at 6, yes that's right 6 cents on the dollar can still be worth $50M. Let's get into it.
Consider this: Peabody Energy made $80M in gross profit last quarter. Wow that's pretty great huh? $80M is a lot right?
First, let's get that in perspective. In 2011, the company made $2.4B in gross profit. That was the height of the commodity boom, when everybody thought coal was going to stay at over $100 forever. Chinese demand was still growing, and everybody was happy. Even the most costly mines were profitable, and the situation was essentially much like that of oil in 2014. People were funding projects with $70-80 breakevens, much like oil companies did with shale simply because people thought the prices were going to stay that way forever.
However, this proved to be not the case. Over the next 5 years, coal went into a massive bear market, and simply put, there isn't any end in sight. Coal is a commodity, cyclical like every other one, and when everybody saw the massive profits made at $100-$150 coal, everybody rushed in with billions in financing.
And because of that, the coal market went into massive oversupply. Peabody was one of the bad actor companies that funded those $70-80 mines, along with Arch Coal, Patriot, and Alpha Natural Resources. Coal is estimated to be oversupply by 10%, according to Alberto Migliucci, Chief Executive Officer of Petra Commodities, an advisory firm specializing in natural resources. Serene Lim, an analyst at Standard Chartered covering the coal market, also calls coal "structurally oversupplied."
Now for Peabody, the situation is even worse than for many others. There are some companies that managed to get out of the bust alright as they had good properties and did not load up on massive debt. However, at Peabody, that's not the case. To be fair, Peabody's properties aren't completely horrible, but their problem is that they have billions in debt. $6.3 billion, to be exact. And to top it off, $5.9 billion of that matures this year, as seen in their 10K.
I'll explain the reasoning that almost all of their debt is considered short term right now, and this is because Peabody doesn't have the liquidity and cash flows to pay the interest on their debt, which amounts to $400 million dollars a year. Because of this, creditors can trigger a prepayment clause, which requires all of the principal and interest to be paid immediately. If it isn't the company will be taken over by creditors.
This is what probably will happen right now, because simply put, nobody, and I mean nobody, absolutely nobody will extend $6 billion to a poorly performing company in a cyclical industry. Why would they, if they can just buy the debt for pennies on the dollar?
So here's my recommendation to you, readers. Buy the debt, short the stock. The stock is absolutely worthless, and the debt probably is too, but in order to make a market neutral profit, this is what you should do.
There is essentially only one scenario. Peabody goes bankrupt and enters Chapter 11. Great! Your short worked out completely, and you made 100% on it, and your debt is probably worth something close to the six or so cents you bought it for, possibly much more if there has been restructuring and coal has recovered slightly.
You could also try going long the debt only, or short the stock, but I do believe those open you to more risk. The bonds could essentially stay flat for a long time, and shorting the stock only could leave you exposed to the massive jumps in stock price like what happened in mid-March.
Disclosure: I am/we are short 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.
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