As of Friday's close, three U.S. coal companies happen to have Enterprise Values of close to $5.5 billion, Arch Coal, (ACI) Alpha Natural Resources, (ANR) and Walter Energy, (NYSE:WLT). By comparison, Peabody Energy's (BTU) Enterprise Value is almost double that. What does one get from an investment in one or more of these companies? One gets quite a lot in Walter Energy, my top pick in the U.S. coal sector.
In a previous article I commented that Walter's then newly promoted CEO Walt Scheller was the only person willing to take the job. The Company had been plagued by production shortfalls due to difficult mining conditions. The acquisition of Western Coal was in the early stages of integration. Costs in Canada were very high and there was still a lot of heavy lifting to be done to ramp up production.
A year later, Walt has proven to be a good leader. Costs in Canada are slowly coming down and production capacity up. Consistent and solid production from the U.S. over the past few quarters reminds investors of why Walter can not be ignored in any discussion of the top global producers of premium hard coking coals. WLT management believes they can reach 20 million tons of coking and PCI coals by the end of the decade. When things are running relatively smoothly, one is inclined to believe them.
Things don't always run smoothly. Geological conditions in Walter's Alabama mines are very difficult. A few good quarters does not mean that production problems are behind them for good. However, a key difference in my mind is that globally the supply of premium low-vol hard coking coal is so fragile, that investors are getting used to disruptions. In Queensland, Australia we've had two 100-year floods in the past 4 years. BHP, (NYSE:BHP) the largest premium hard coking coal producer in the world, is currently the subject of labor unrest, and faces a week-long strike next week.
Canada's Teck Resources, (NYSE:TCK) the 2nd largest premium hard coking coal producer has also experienced strike activity and severe winter weather in recent years. In Mongolia, a giant coking coal deposit called Tavan Tolgoi was expected to be producing up to 15 million metric tonnes of coal by 2015-16. Due to political bickering, that project is not likely to reach that level until 2017-18. Vale and Rio Tinto, (NYSE:RIO) are ramping up production of new sources of high quality coking coal in Mozambique, but infrastructure constraints are slowing the arrival of those tonnes as well.
Walter enjoys reliable and low-cost shipping routes to its main port in Mobile, AL. It has a shipping advantage over east coast producers into South America. Once the expansion and upgrade of the Panama Canal is completed in 2014, Walter will be very well positioned to ship faster and less expensively into China.
Due to recently signed deals to acquire contiguous coking coal reserves, Walter's mine life in Alabama has grown significantly. Brownfield expansions will be cost effective and low risk. The incremental tons from the newly acquired reserves will be of similar quality to existing coal output as Walter will be tapping the same Blue Creek coal seam.
Shame on me for going this far without mentioning the frequently discussed topic of M&A. Walter has been the subject of takeover speculation for years. Companies recently mentioned as potential suitors include, Anglo American, BHP and Teck Resources. I think WLT would be a good fit for Vale, (NYSE:VALE) as well. If coking coal prices are indeed moving higher again in 2h 2012, takeover speculation will probably resurface. This backdrop should help support WLT stock in the next few months.
Management is cautiously optimistic, as can be seen from reading the Outlook section of the Company's recent 10-Q filing. The following are direct quotes:
In the second quarter of 2012 we are beginning to see signs of strengthening demand and improved pricing for our hard coking coal. Improvements in global steel pricing, reductions in steel inventories and the tightening of metallurgical coal supplies, has led to increased global prices.
In Europe, while the market has remained spotty, our customers' products continue to be in high demand... In Asia, our customer relationships remain strong. Demand is returning, and we see renewed requests for additional shipments.
While no one knows for sure that the sell-off in WLT and coal stocks in general is over, the risk/reward for WLT at $49 is compelling. If WLT were simply to rebound to where it traded on Monday, May 14th, that would be a 25% gain. Like many SA readers, I've been tempted to jump back into the coal stocks a few times lately. Last week's sell-off was enough to get me off the fence. I'm a buyer of WLT stock below $50 per share and would back up the truck below $45 per share.