Peabody Energy Corp. (TICKER: BTU) skipped a $71 million interest payment on March 15th and is currently in a 30-day grace period. On page 20 of its recent 10-K filing, the company announced: "We may not have sufficient liquidity to sustain operations and to continue as a going concern." Many observers (see articles from WSJ and Bloomberg) expect that BTU will shortly file for bankruptcy. S&P downgraded BTU to "D," stating that: "Given current market conditions and significant uncertainties surrounding coal sector fundamentals both in the U.S. and abroad, it is our opinion that this situation will eventually evolve into a general default and Peabody may choose not to pay all or substantially all of its obligations as they come due."
All for good reason. In Q4 2015, BTU's EBITDA was just $53 million, which annualizes to about $200 million - well below actual full-year 2015 EBITDA of $435 million, which was only achieved after $620 million of cost reductions. This EBITDA is against over $6 billion in total debt, for a leverage ratio of 14x based on actual 2015 EBITDA, but 30x based on Q4 annualized results. The company had to borrow $300 million in 2015 to remain solvent, and the situation has deteriorated throughout the year - with BTU bleeding cash flow, with no end in sight. The company simply cannot service $6 billion of debt, in addition to other liabilities like cleanup costs.
The current bond prices clearly reflect expectations of bankruptcy, with the bonds probably retaining little, if any, value, as the senior lenders will have first priority. The chart below, from Interactive Brokers, shows the current market for BTU's bonds as of the end of trading on April 6th:
The current market cap also reflects expectations of virtually zero value for the equity. The current market cap is about $42 million (less than 1% of the face value of the debt) - pretty much an indication of certain bankruptcy. So why is the stock still trading at $2.25/share and was actually up 9 cents on April 6th? It's difficult to say, but the price partially reflects the fact that there are only about 19 million shares outstanding after a 1-for-15 reverse stock split last fall, which reduced the shares from about 280 million. Combine this with what appeared to be a short-squeeze rally and probably some uneducated investors, and the stock is hanging around the $2.00+ range even though all indications are that the equity will soon be worthless.
We have been able to take advantage of this strange situation with a pair trade that will be quite profitable if BTU goes bankrupt - which we believe is a very high probability - and still quite profitable, but less so, if some miracle occurs and both the stock and bonds recover.
The first leg of this trade is to purchase BTU puts with the expectation that the stock will eventually be worthless. The puts we purchased are the $1.50 strike price of January 19, 2018 expiration. Why 2018? This is nearly two years away, and we believe that one way or another, BTU's outcome will be decided by then - either a bankruptcy and restructuring, which leaves the current equity worthless, or a remarkable recovery for everyone. We purchased these puts at $1.10, which would result in a $0.40 gain per share if BTU stock goes to zero.
The second leg of the trade is to purchase BTU bonds at 7.5 price. Why buy the bonds? In the unexpected scenario where the company saves itself and the stock price recovers, rendering the puts worthless, the bonds will certainly recover as well. The 2018 put date provides assurance that there is enough time for the outcome to play out.
The chart below summarizes the economics of this trade:
The first column shows the purchase of 30 put contracts (representing 3,000 shares) for $1.10 per share, for a total cost of $3,300. Next, the purchase of 4 bonds (we picked the 2018 bond - if BTU truly recovers, these will be paid back first) at 7.5, or $300 total cost, resulting in a total cost of trade of $3,600, as shown in the second column. (Commissions have been excluded to show the trades more simply; commissions through a low-cost broker will not have a material impact on returns). Finally, we highlight the outcomes. If BTU goes bankrupt, the stock will eventually go to zero, resulting in a 40 cent gain per put, or a $1,200 gain, less the $300 original cost of the bonds, which we also assume goes to zero, for a total gain of $900. This represents a 25% cash-on-cash return on the original investment.
What if BTU recovers? If the stock recovers, then the bonds will have recovered as well. So, the 4 bonds will be worth $4,000 (and surely before 2018 interest will have been paid, increasing the return of the bonds), and then deduct the $3,600 total cost of the trade to net a $400 gain, which represents an 11% cash-on-cash return on the original investment.
So what can go wrong? Perhaps even in a bankruptcy, the stockholders get some value, although it is unlikely given that $6 billion of debt that is senior to the equity. If so, the bonds will get value as well. If the stock price ends at $0.20 by put expiration and the bonds remain worthless (a scenario we find difficult to see happening), the put return gets cut in half and the total gain is only $300 - still an 8% return. What if the process drags out and the stock "hangs around" in the $2 range, while the bonds remains flat. This is possible, but we believe the January 2018 put date protects against what we call the "nothing happens for a long time" scenario. As noted, most likely, well before 21 months, BTU will either restructure with a wipeout to the equity, or a miracle will occur and everything will recover. (A similar strategy noted on SA involving shorting BTU stock will not work given the difficulty of finding shares to short, the very high cost (94% fee rate at Interactive Brokers), and risks of a short squeeze. A put can be held with no extra costs, risks, or concerns through expiration.)
Note: Despite the scenarios outlined above, "black swan" events can occur in every investment scenario, sometimes in ways no one can anticipate. As a result, the trade we executed above for our own account carries risks, which in this case are difficult to assess, and there are possibly scenarios regarding BTU that we may not have considered. Purchasing puts that expire worthless can result in total loss of the investment. Our investment to this strategy was relatively modest for our portfolio, and we would hesitate in "betting the farm" on these types of investments.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
Additional disclosure: We currently hold positions in BTU puts and bonds mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.