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 Alpha Natural Resources (ANR). 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 Alpha Natural Resources
The following data, obtained from Alpha Natural Resources' latest 10-Q, is necessary to make the Z-score calculation:
Current assets: $2220 million.
Current liabilities: $1512 million.
Total assets: $16141 million.
Retained earnings: -$269 million.
EBIT (TTM): $464 million.
Total liabilities: $8729 million.
Market capitalization: $2460 million.
Revenues: $7790 million.
Using this data we get the following parcels:
1.2 * T1 = 0.053
1.4 * T2 = -0.023
3.3 * T3 = 0.095
0.6 * T4 = 0.169
0.999 * T5 = 0.482
This gives us an Altman Z-score of 0.78.
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.
Like with Arch Coal (ACI), Alpha Natural Resources' Z-score implies a high risk of insolvency. Again, this is probably 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.
Still, again I must emphasize the serious risk these companies face. One cannot over-expose himself to these kinds of situations. Positions must be kept rational and no margin should be used in buying these kinds of stocks. Next I will look at Peabody Energy (BTU) to get a feel for a more stable company.
Disclosure: I am long ANR, ACI, BTU.