By Michael Tian
As natural gas prices continue to fall and the outlook for coal -- especially from Central Appalachia -- worsens, we are becoming more nervous that leveraged coal firms may fall into distress in the next two or three years. Our concern centers on Central Appalachian miners that participated in blockbuster acquisitions in the past two years -- namely Arch Coal (ACI) and Alpha Natural Resources (ANR). We lowered our fair value estimates materially in large part because of this. In general, we foresee coverage and leverage ratios deteriorating over the medium term.
We expect Central Appalachian miners will face tremendous headwinds for at least the next two years. Spot CAPP thermal coal has plunged to $60 per ton. Contango brings pricing up to $70 by mid-2013. These prices do not make for economic production. We estimate that average cash production costs for CAPP thermal coal are about $60-$65 per ton today. Therefore, based on the current curve, producing thermal coal is money-losing today and will be barely profitable a few years hence. Given the very high capital intensity of the industry, these cash margins do not allow producers to reinvest in efficiency or to replace depleting mines. As the old saw goes, the best cure for low commodity prices is low commodity prices. However, in this case, natural gas acts as a cap on CAPP thermal coal. With gas at $2 per thousand cubic feet, CAPP coal is deeply out of the money in its core markets. Given current production costs, we estimate that gas needs to rise to at least $4.50 per thousand cubic feet before miners can produce coal and earn an adequate cash margin, which we set at $10 per ton. Given current prices, the coal-to-gas switch will continue, albeit at a slowing pace, for the next several years.
Benchmark metallurgical prices have fallen to about $205 per ton from $330 last spring. A very large part of this drop is coming straight out of the bottom line for CAPP producers. For the past several years, thermal coal has only been marginally profitable for CAPP miners. The vast majority of the profits have come from metallurgical coals. However, with the recent retrenchment, this vital source of profitability has been greatly weakened. Although CAPP producers can still earn decent margins on $205 benchmark coal, the loss of metallurgical pricing leads to significant negative operating leverage for CAPP coal miners.
High Realizations Today Means Trouble Tomorrow
Contract resets will be a big headwind in 2013, and we project falling earnings before interest, taxes, depreciation, and amortization for all coal miners, especially those in Central Appalachia. This is the biggest catalyst for potential financial distress in the next two years. In 2011, Arch and Alpha contracted out most of their planned 2012 production at reasonably attractive prices. Nearly all of Arch's thermal production and 75% of its metallurgical production is committed and priced. For Alpha, nearly 100% of 2012 steam production and 80% of met production was spoken for as of May 2012.
However, the picture changes dramatically for 2013. At Arch, only about 40% of our projected 2013 revenue is spoken for. Most of this involves the Powder River Basin and the Western Bituminous segments. Notably, nearly the entirety of the firm's metallurgical output is unpriced. Alpha does not specifically disclose 2013 contract positions. But since its portfolio skews toward metallurgical coal and Appalachia, both of which operate on much shorter contract terms than Western coals, it's a fair bet that very little of 2013 is committed and priced. A solid portion of its PRB output, as well as some Northern Appalachian thermal coals, probably makes up the contract book today.
Given the high realizations locked in for 2012, 2013 will look a lot worse by comparison. For example, Alpha sold its Eastern steam coals for $68 per ton in 2012. That will probably fall below $65 next year, assuming the current futures strip holds. Metallurgical coal may fare worse. The company locked in most of its 2012 metallurgical production at $127 per ton. We estimate this will fall to $105 in 2013, given current spot pricing. Arch faces declines of a similar magnitude in its Appalachian portfolio. For its open PRB position (50% of PRB production), we think realizations will decline to $12 from the $15 in the contract books. Meanwhile, costs are likely to creep up slightly from 2012 to 2013. Central Appalachian costs have inflated massively in the past decade. Even in 2009, when the basin was in severe recession, costs per ton increased several percentage points. Investors should not expect margin breathing room from cost declines. For the past decade, we have witnessed several coal booms and busts, and CAPP costs per ton have not gone down in aggregate for a single year. When there is a boom, costs go up a lot. When there is a bust, costs go up only a little. We see no reason for the next few years to be different, although we expect cost inflation to be significantly milder than it has been for the past five years.
The end result of falling realizations, potentially falling production, and higher costs is lower EBITDA year over year. Although we assume a gradual recovery in profitability past 2013, the extremely high leverage ratios Appalachian miners should experience between 2012 and 2014 point to a material chance for financial distress for these companies. We will note, however, that Arch has recently taken steps to issue new debt and loosen covenants in order to improve its liquidity profile.
Uncertainty Revolves Around Natural Gas Prices and China
An extraordinarily hot summer that burns down existing coal and gas stockpiles would be extremely beneficial. Several dollars of additional pricing when negotiating 2013 contracts may mean the difference between breaching and not breaching covenants. On the other hand, with a mild summer, gas prices may decline further, which would mean an even worse 2013. The same goes for the Chinese economy, the health of which, especially regarding fixed-asset investment, is vital to the metallurgical coal market. We've seen anecdotal signs that China may be slowing, and met coal has fallen partly as a result. On the other hand, economic conditions may change quickly and another round of stimulus is also possible. We believe the risk/reward for thermal and met coal prices over the two years is roughly balanced, and our projections largely assume the current pricing structure remains roughly intact.
A Look at Capital Structures
Arch will refinance its looming $450 million 2013 debt maturity through additional debt issuance, which removes one immediate risk. Nevertheless, leverage ratios will remain very high for at least three years and free cash generation will probably be quite anemic. We think the company's leverage ratio will breach 5 times in 2013.
At Alpha, cash interest costs are much smaller, liquidity is higher, starting leverage ratios are healthier, and there are no significant maturities until 2015. Still, the firm has a good chance of tripping covenants in 2013-14. We also note that our base-case EBITDA forecast is a factor below current Street expectations. We expect the company to receive waivers at a cost if necessary, but like Arch, it will be many years (if ever) before Alpha can generate enough cash to deleverage materially. Alpha's concentration in Central Appalachia, with its severe long-term challenges, makes repairing its balance sheet a challenge. Furthermore, its $900 million asset retirement liability and $1.2 billion underfunded postretirement obligations, which are not explicitly included in this analysis, will weigh on the firm for the foreseeable future. Still, given Alpha's better starting position, a dilutive event is somewhat less likely in the next few years, unless coal prices (especially metallurgical) decline further.
Long-Term Consequences for Capital Budgets
One of the consequences of the current environment is that miners are cutting capital budgets whenever possible. Arch has cut its 2012 capital budget (excluding royalty payments to the government) to $425 million, which is about $110 million less than projected depletion, depreciation, and amortization. Alpha is spending $650 million in 2012 (after reducing its budget by $100 million in February), some of which will go toward fixing Massey's mines. In the next several years, all miners, but especially Appalachian ones under some distress, will be pressured to cut back even more to conserve cash and pay down debt. This natural reaction could easily have far-reaching consequences.
Coal mining is an extremely capital-intensive industry. In the past decade, large coal producers have invested an average of about 11% of revenue in capital expenditures. Free cash flows are not easy to come by, with the majority of EBITDA and operating cash being consumed by capital expenditures. This is somewhat surprising, given two substantial coal booms from 2005 to 2011. More alarmingly, even after spending so heavily on capital expenditures, organic production growth is scarce. The data are not easy to parse through because of acquisitions, but Alpha's and James River Coal's peak organic production probably came in 2006, with all subsequent volume from acquisitions. In fact, part of Alpha's free cash flow generation probably came at the expense of falling organic production. Arch is in a slightly different situation, but it's likely that after acquiring Jacobs Ranch in late 2009, 2010's 161 million tons will stand as an "organic peak" for many years. Even before 2010, virtually all growth since the beginning of the decade had come through acquisitions. Even though Arch has absorbed International Coal Group's portfolio and growth prospects, we do not believe absolute volume will surpass 2010's peak for several years.
Coal mining, especially in Appalachia, is a game where you invest a lot just to stay in place. If a miner doesn't invest, its mines can quickly deplete or its costs will become uncompetitive with the market. It can be very difficult to climb out of this hole. James River, for example, has never reversed its legacy underinvestment stemming from events in the early 2000s that drove it to bankruptcy, despite heavy expenditures in the past few years. Therefore, if financial pressures force miners with poor balance sheets to cut back on investments for the next two to four years, the consequences could stay with them for much longer than that. The risk for Arch and Alpha, the most at-risk large miners that we cover, is that events in the next several years end up hurting their structural competitive positions.
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