Given the ongoing panic in coal shares, I decided to do a series which will look at several coal stocks using the Altman Z-score. The purpose will be to get a feel for the relative risk of each coal stock. This article will be on Patriot Coal (PCX). The Altman Z-score, as defined by Wikipedia, is:
The Z-score formula for predicting bankruptcy was published in 1968 by Edward I. Altman, who was, at the time, an Assistant Professor of Finance at New York University. The formula may be used to predict the probability that a firm will go into bankruptcy within two years. Z-scores are used to predict corporate defaults and an easy-to-calculate control measure for the financial distress status of companies in academic studies. The Z-score uses multiple corporate income and balance sheet values to measure the financial health of a company.
The Z-score is a linear combination of four or five common business ratios, weighted by coefficients. The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).
The Z-score has 5 inputs:
- T1 = Working Capital / Total Assets.
- T2 = Retained Earnings / Total Assets.
- T3 = Earnings Before Interest and Taxes / Total Assets.
- T4 = Market Value of Equity / Book Value of Total Liabilities.
- T5 = Sales / Total Assets.
Which then come together using the following formula:
Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + .999T5
Calculation for Patriot Coal
- Current assets: $436 million.
- Current liabilities: $499 million.
- Total assets: $3663 million.
- Retained earnings: -$76 million.
- EBIT (TTM): -$124 million.
- Total liabilities: $3124 million.
- Market capitalization: $200 million.
- Revenues: $2310 million.
Using this data we get the following parcels:
- 1.2 * T1 = -0.021
- 1.4 * T2 = -0.029
- 3.3 * T3 = -0.112
- 0.6 * T4 = 0.038
- 0.999 * T5 = 0.630
This gives us an Altman Z-score of 0.51.
The Altman Z-scores are interpreted according to the following ranges (source: Creditworthy.com):
3.0 or more,
Most likely safe based on the financial data. Of course, mismanagement, fraud, economic downturns, and other factors may cause an unexpected reversal.
2.7 to 3.0,
Probably safe to predict survival, but this is a portion of the gray area and is below the threshold of relative safety.
1.8 to 2.7
Likely to be bankrupt within two years. This is the lower portion of the gray area and dramatic action may be required to effect survival.
Highly likely headed for bankruptcy. Rarely would a firm be expected to recover from a financial condition generating this or lower scores.
Not surprisingly, Patriot Coal shows up with the highest risk of the coal stocks I've looked at up to this point. And also not surprisingly, that risk is high as illustrated by the recent plunge in the stock, and the ongoing fears that PCX might be unable to secure new financing before a March 2013 debt maturity.
Up to this point, PCX's 0.51 Z-score is the lowest score of the coal stocks. This compares to 0.75 at Arch Coal (ACI), 0.78 at Alpha Natural Resources (ANR) and 1.58 at Peabody Energy (BTU).
We have seen how the Z-score seems to overestimate the risk of the coal stocks in general, due to:
- A very unfavorable point in the coal cycle;
- These companies being very capital intensive;
- The Altman Z-score not giving any weight to the coal companies' ability to generate a large cash flow, from the fact that depreciation and depletion of the coal reserves is a large non-cash cost that these companies have.
But with PCX, I feel, looking at the partials, that it actually underestimates the risk. This is because the capital intensity of the business makes for lower negative partials where PCX scores badly, whereas PCX's higher Sales/Total assets allow it to get closer to its competitors without that implying a much greater ability to survive financial hardship.
Still, all in all the result is not surprising with PCX showing as the riskiest coal stock this far, and certainly care must be taken if one is to hold a long position in Patriot coal. Margin use and overexposure should be avoided.
Disclosure: I am long ACI, ANR, BTU.