I don't think that Walter Energy, (NYSE:WLT) is abBuy at Thursday's close of $59 per share because of my increasingly bearish view on coal fundamentals. Benchmark quarterly coking coal prices are down from $330 per metric tonne last summer to a projected $205 - $210 per tonne in 2nd quarter 2012, down about 37%. Most analysts expect the 2nd quarter to be the low of the year, AND that Q3-Q4 prices will rebound to $225-$250 per tonne. However, as I highlighted here, if benchmark prices don't bounce, another round of earnings cuts will be unavoidable.
In the past few weeks, sentiment and fundamentals have only gotten worse. Doyle Trading Consultants, (DTC) sent out a note on Wednesday describing a cargo of premium hard coking coal that sold for $175 per tonne. DTC's investigative work found that Teck, (NYSE:TCK) was the seller. Teck had to sell because inventory at their main West Coast port is too high. Consol Energy, (NYSE:CNX), facing similar excess inventory issues, temporarily idled one of its best and lowest-cost coking coal mines. This, in addition to Alpha, (NYSE:ANR), Patriot, (PCX), Peabody, (NYSE:BTU) Cliffs, (NYSE:CLF)and Arch, (NYSE:ACI) having already cut coal production guidance.
While these latest events are not good news for any coking coal producer, it should be remembered that Walter produces one of the best coking coals in the world. Production guidance is for 11.5mm - 13.0mm tons, approximately 75% (~9mm tons) of it premium low-vol hard coking coal. Of the 9mm tons, about half are expected out of the U.S. and half from Canada. If Walter achieves production within its guidance, it would be roughly a top 12 global producer this year.
Based upon a meeting I had with WLT management last week, the company is optimistic that operating and geological issues in the U.S, are behind them and that 2012 will be a relatively clean year. As discussed, I believe that market conditions will dominate company specific performance this year. Thus, I'm forced to revert back to the same angle on Walter Energy as before, the possibility of a takeout. Periodic talk of buyouts should create a floor under WLT's stock price. In this article I suggest that a floor might be $50 per share, a price at which existing holders might double down and/or new investors jump in.
Therefore, a trade that I'm considering, but have not executed, is selling Put options on WLT, and/or Arch, Alpha, Peabody, Teck, etc. By writing, (selling) Jan- 2013 $50 Puts for ~$7 per contract, the breakeven price on the underlying stock would be $43, ~26% below the current price. Assuming that the stock did not get put back to the Put seller, the annualized return would be ~20%. I'm comfortable with possibly owning WLT shares at an effective price of $43. Even if consensus EPS for 2013 is cut by a further 25% to $5.6 per share, I would still be entering the trade at a 7.7x P/E on earnings that presumably would be a lot closer to a trough.
This type of trade is risky. If I were to enter into a trade like this, it would be a relatively small trade. Last year I successfully sold (and covered) Put options on WLT, CNX, ANR and BTU.
Disclaimer: Options on coal stocks can be highly illiquid. This article should be read for illustrative purposes. Please be aware that writing, (selling) options is risky. I do not currently have this trade on. I might pull the trigger on a trade like this if I could hope to achieve an annualized return of 25%. The preceding paragraphs describe my thought process. I'm running through this analysis on a number of other coal stocks as well.