Seeking Alpha
Value, deep value, special situations, contrarian
Profile| Send Message| ()  

Alpha Natural Resources (ANR) 2.375% Convertible Senior Notes due April 15, 2015, have a Yield to Maturity (YTM) of 8.229%. According to the ANR 2011 10-K, they are convertible "at an initial conversion rate of 18.2962 shares of common stock per one thousand principal amount." This equates approximately to $54.66 / share.


Source: Finra Bond Details

A convertible bond is a hybrid security that has both debt and equity characteristics. In this specific case, it is a bond with an embedded call option. This means you will receive 8.229% per annum returns from the bond; plus, the value of a $54.66 April 2015 call option.

There are 3 different scenarios to consider: Bankruptcy, Low Coal Prices, and High Coal Prices.

Companies go into bankruptcy when they can no longer meet their obligations. The chart below highlights the contractual obligations and other liabilities for ANR over the life of bond.

(click to enlarge)

Source: Data from ANR 2011 10-K

The most glaring item is the Long-Term Debt due 2015-2016. $585,000,000 is a term loan due in 2016 and does not affect the convertible bonds. $946,173,000 is the principle on convertible notes being returned. As of Q1 2012, Alpha had $2.22 billion in current assets, of which $488 million was cash. On top of this ANR has a $1.1 billion credit line available.

In 2011 ANR had operating cash flows of $685 million. Acknowledging that 2011 was a tough year for coal, and assuming that operating cash flows remains constant from this point on, ANR would produce roughly $2.74 billion in operating cash flows for the years 2012-2015. Realistically, a significant portion of this cash flow will go towards CapEx and financing growth. ANR also has the ability to sell assets, raise debt, and raise equity. Below is a table indicating how much flexibility ANR has.

Actual Covenant Levels; Period Ended 31-Mar-12

Required Covenant Levels

Minimum adjusted EBITDA to cash interest ratio

8.5

2.5x

Maximum total debt less unrestricted cash to adjusted EBITDA ratio

1.95

3.75x

Source: ANR 2012 Q1 10-Q

Therefore, it seems likely that ANR will survive through 2015. As a self-check, if your analysis says the equity is good, then the bonds are good.

The market is valuing Alpha using current market conditions. These conditions include: low thermal prices, low metallurgical prices, and weak volume. If these conditions do not materially improve, then ANR will not breach the $54.66 level by 2015, making the embedded call worthless.

The good news is that coal prices are expected to increase from current levels. Coal's fate is intertwined with natural gas's. As natural gas prices rebound from historic lows, coal prices will follow. At a natural gas level of $2.50-$3.00 it becomes more economical, from an energy generation perspective, to use coal as opposed to natural gas. The current spot price for natural gas is $2.39. Central Appalachian Coal, which makes up 40% of Alpha's revenue, is currently trading at $55 per short ton. By the end of 2014 it is expected to increase to $74.

(click to enlarge)
Source: EIA Quarterly Coal Report

Metallurgical coal, which accounts for the majority of Alpha's profits, is highly dependent on Europe and Asia. If there is substantial increased spending in Europe, which is the final destination for 38% of ANR's met coal production, 1-2 years down the line, this would prove to be a huge boon for ANR. Asia accounts for roughly 18% of ANR's met coal production. An additional wild card would be Australian coal production. Alpha competes directly with Australian coal producers, including the Australian arm of Peabody (BTU). If Australian production is hampered by severe weather and flooding, which previously occurred during the winters of 2010 and 2011, then coal prices would increase significantly.

Conclusion
The per annum yield of 8.229% in today's environment is highly attractive. It is unlikely that ANR is not able to meet the 2.75% note's obligation. If any of a number of unlikely events occur, the price could easily return to historical highs, providing gains up to 60%.

Issuer Name:ALPHA NATURAL RESOURCES INC
Coupon Rate:2.375%
CUSIP:02076XAA0
Maturity Date:4/15/2015
Source: Alpha Natural Resources Offers A Better Way To Profit From Coal