Alpha Natural Resources Earnings: The Good, The Bad, The Ugly

Feb.29.12 | About: Alpha Natural (ANRZQ)

Alpha Natural Resources, (ANR) reported its 4th quarter earnings and provided more color on the outlook for 2012. Despite an earnings miss, there were some good things communicated to investors...and of course some not so good things.

Alpha Natural Resources is a leading supplier and exporter of metallurgical (aka coking) coal. Pro forma for the company's acquisition of troubled Massey Energy (NYSE:MEE), ANR claims to be #3 globally in coking coal production behind Australia's BHP Billiton (NYSE:BHP), Mitsubishi Alliance and Canada's Teck Resources, (NYSE:TCK). Alpha is one of the most regionally diversified coal producers in the U.S., and enjoys more export terminal capacity than any other U.S. producer at approximately 25mm-30mm tons.

Below are direct quotes from the conference call, mostly from CEO Kevin Crutchfield.

THE GOOD:

As safety performance improved in the fourth quarter, MSHA orders were down approximately 45%. Turnover has improved steadily for several months and is now solidly in the mid-single digits for both legacy Massey and the entire organization.

Peter Epstein: This is encouraging because a knock against Alpha has been that they acquired a broken company in Massey Energy, (and paid too much). Turnover in the mid-single digits is very low, probably among the lowest in the industry, an impressive performance.

...we continue to be confident that significant operating synergies will be realized in 2012 and Alpha remains on track to achieve our previously stated synergy target of $220 million to $260 million annually by mid-2013.

Peter Epstein: Again, obviously a positive update on synergies. Some feared there would be slippage on the synergies number, but Crutchfield reiterated it. At the time of the merger, Alpha highlighted synergies of $200mm.

...our longwalls are actually running well right now, and as you know they have a big impact. We had a very, very good January. I don't know if we are ready to disclose the numbers, but a very good January.

Peter Epstein: Longwall operating performance can make or break a quarter, or in case of a company like Walter Energy, (NYSE:WLT) a year.

THE BAD:

...the challenges facing the industry have intensified in the last few months due to concerns about global economic growth impacting the steel market, extremely mild weather in much of the United States and competition from natural gas, which recently hit decade low prices, driving incremental coal to gas switching and effectively capping thermal coal prices at levels that render a portion of Central Appalachia products uneconomic.

Peter Epstein: These headwinds are well known by now and presumably priced into the stock price. Patriot, (PCX) and Arch, (ACI) articulated the same bleak outlook. CEO Crutchfield did not indicate that the headwinds were moderating. In fact, with the recent spike in oil, diesel costs could be another speed bump.

During the fourth quarter, Alpha's adjusted weighted-average coal margin was 17% compared to 24% in the year ago period and 23% in the third quarter. Compared to the third quarter, the reduced average coal margin reflects an increased proportion of Powder River Basin shipments and proportionately lower metallurgical coal shipments.

Peter Epstein: A disappointing coal margin, especially given that coal price realizations were up materially year-over-year and sequentially.

...the sequential decrease in adjusted EBITDA was primarily due to lower shipments in the east, particularly met shipments as some European customers stretched out delivery schedules...

Peter Epstein: Producers are not able to factor in this important development, namely that customers are pushing back on deliveries. No one knows how long this period of coal price weakness will last, so companies simply don't know what the 2nd half of 2012 will look like.

One of the areas if you look at our uncommitted or un-priced tons, I think it's about 17% of anticipated production, if you do the math on the mid-point that comes out close to 4 million tons. And I'd say you can assume those 4 million tons are largely on the lower end of the quality scale and somewhat at risk relative to either pricing and/or demand...

Peter Epstein: It's safe to say that no one wants to be stuck with lower quality coking coal in this environment. The company prudently advises investors that these lower quality tons are at risk. To be fair, some of the 4mm tons are already accounted for in reduced production guidance.

I think if you think about the cumulative cost curve for Central Appalachia, if you can break it out as steam, what's north of $75 per ton, maybe a quartile or maybe even a little less, 20% is uneconomic at current coal prices.

Peter Epstein: Up to 25% of central Appalachian coal un-economic today, that's a lot. Arch Coal stated that 50mm tons of production cuts are needed. At best, half of that has been announced.

THE UGLY:

Peter Epstein: Okay, I had to have an "UGLY" to make the title of this article work....

Based on the results of Alpha's recently completed annual goodwill impairment testing, we are required by U.S. generally accepted accounting standards to record a non-cash goodwill impairment charge of $745 million, due to changes in market outlook, particularly for thermal coal source from Central Appalachia as well as expected lower production and higher cash operating cost for both legacy Alpha and legacy Massey operations. This will permanently lower the value of goodwill carried on our balance sheet going forward, no matter what happens to Alpha's market value or the economics of these assets in the future.

Peter Epstein: Non-cash charges are frequently over-looked by investors and analysts. However, this is a stark reminder that thermal coal production in central Appalachia is in decline. The onus is on coking coal prices and exports to keep central APP coal viable in the long-run.

Overall Takeaway:

Management made a fairly compelling case that Alpha is well positioned for a turnaround in coal fundamentals. The company also is executing on merger synergies. However, the timing of a turnaround and the magnitude of a potential coal price recovery are unknown. A great deal of uncertainty remains for the industry. All of the following factors will be important to watch going forward:

  • Coking coal prices, will they languish at ~$205 per tonne, or rebound to $250 or more in 2nd half 2012?
  • Summer weather, mild or hot?
  • Diesel prices / Natural gas prices, more coal to gas switching?
  • Demand from Europe & Asia, (mostly China, but also Japan, Korea & India)
  • Utility customer demand / Inventory levels of thermal coal
  • Per-ton cost control in a declining production environment
  • Ongoing industry production cuts, we had better see more!
  • Timing of a rebound in domestic thermal coal prices, 2nd half of 2012 or not until 2013?

Disclosure: I am long ACI, BTU, ANR, PCX, CNX.

Additional disclosure: I'm a consultant for SouthGobi Resources.