James River Is Navigating The Coal Slump Masterfully

Jun.28.12 | About: JAMES RIVER (JRCCQ)

While the coal sector continues to face major headwinds, not only here in the U.S. but also across the globe, there are many reasons to be optimistic for the future, while the vast majority believe that the fundamentals have permanently changed. Even the Cape Cod Times (a small local paper that Buffett is probably eying) ran an article last week proclaiming that coal was being phased out for good.

Yet, like a lot of mainstream media consensus opinions, there is little to no substance here discussing supply curtailment effects (some being permanent mine closures), potential weather effects in future seasons, and natural gas rig and gas well decline rates. I suppose this type of coverage makes it easier for the long-term investor to do a little research to beat the herd.

Let's start with the herd's consensus on bankruptcy for James River Coal (JRCC). (I'm not so certain that Patriot Coal is headed that way, but that is a totally different scenario) This assumption could not be more ridiculous when you actually spend five minutes reading the 10-Q. Their debt structure looks like this:

Long-Term Debt:

2019 Senior Notes: $275 million paying 7.875%

2018 Senior Convertible Notes: $168.75 million paying 3.125% convertible at $30.55

2015 Senior Convertible Notes: $142 million paying 4.5% convertible at $25.78

That is a weighted average interest rate of 5.7% on $586 million in debt for an annual cash expense of $33 million/year. Do not get this confused with their stated interest expense which includes amortizing the discount of the convertibles, a non-cash accounting charge.

Cash Position as of 5/2/2012: approximately $ 188 million.

Cash interest expense in the first quarter: $3.6 million.

Total liquidity as of 5/2: approx $228 million.

Operational cash drawdown in the first quarter: $7.9 million including paydown of accounts payable by $31 million or 29% of total A/P.

Capex guidance of $125 million for 2012 has been withdrawn.

Conclusion: A balance sheet that is far from dire. With $30 million in EBITDA in the 1st quarter, they can easily hold on in a market like this for a couple years.

Contracts Signed for 2012:

JRCC has been proactive in managing their customers in due to the warm winter and have not had any, yes, you read that right, no cancellations or deferrals. From the May 2nd conference call:

"We're not seeing much in the way of pushback or delays or deferrals or things like that. We've had conversations with the utilities -- with our utility customers, but basically everybody is doing what they're supposed to do, and we continue to have very good relations there. So for those of you not familiar, there's been a fair amount of talk about in the industry, certainly since mid-February, early March, wherein everyone recognized what the winter has done to coal burn and to natural gas prices. So we haven't seen anything like that. We're pretty happy with where we are on shipments."

Wow. Imagine that, when you listen to the MSM, you get the feeling that every customer wants to cancel, renegotiate, or defer their coal orders. Unless these guys are lying, that is just not true as of May 2nd.

Let's look at what they have signed to ship in 2012:

Sales Position and Market Comments

As of May 2, 2012, we had the following agreements to ship coal at a fixed and known price (in thousands except per ton amounts):

2012 Priced

As of February 29, 2012

As of May 2, 2012

Change

Tons

Avg Price Per
Ton

Tons

Avg PricePer Ton

Tons

Avg Price Per
Ton

CAPP (1)

7,917

$ 94.37

8,618

$ 94.83

701

$ 100.02

Midwest (2)

2,776

$ 44.16

2,776

$ 44.16

-

$ -

Click to enlarge

They shipped 3 million tons in the 1st quarter and they've got 10.3 million committed, and actually priced 700k tons at $100/ton in the last couple of months. Further, they have another 600k tons that are sold but not yet priced. So the channels are sold through at stronger volumes than the 1st quarter.

Global Coal Demand:

What about met coal demand? Must be falling, right, hard-landings and property bubbles in China, India, etc.:

"Worldwide demand for metallurgical coal remains stable. In aggregate, our customers require about the same volume of met coal in 2012 as was consumed in 2011."

Peabody commented on met coal today:

"We expect global metallurgical coal use to increase 25 percent by 2016, translating to an additional 250 million tonnes of demand growth, with the bulk of increases led by China and India."

How about for thermal?

"China's coal imports are accelerating in recent months, and we project they will reach a record 285 million tonnes in 2012 as the country increasingly looks to the seaborne coal markets," said Boyce."

Furthermore, coal now accounts for more electricity generation globally than at any time since 1969. "The recent BP Statistical Review of World Energy reports that coal consumption grew by 5.4 percent in 2011 - the fastest-growing major fuel in the world."

Apparently, it is not a dire situation for global coal markets. The issue is price, and that is supply driven. Mark Anthony has done a great job graphing supply cuts. And there are shadow cuts that are not being reported. From the JRCC conference call:

"But as the industry was adopting to what needed to be done, what we started noticing in mid-March, and that's really the first bullet at the bottom here, cuts were accelerating but they weren't being announced."

Then, about the stockpiling at utilities:

"you look at what their weekly railcar loadings are that they put on their website, they're down about 20%, which would equate to 200 million tons."

"that is the large build in supplier inventory has already happened. And I'm not saying we're not still seeing a build -- we probably are, but the greatest proportion or the greatest portion of that build, we believe, has already happened. So the actual level of cuts in our opinion is somewhere between 140 million and the 200 million.

And speaking of the rails, what is up with the jump in coal loadings last week?
Click to enlarge.
Capture1195 Rail Traffic Remains ElevatedClick to enlarge

Source: valueplays.net.

Effect of Natural Gas Price on Coal:

You would have to be living under a shale rock formation to have not heard about utility switching, EPA regulations, and $2 natural gas prices. But while the MSM is convinced that this is sustainable, and we should run our electric toothbrushes on pressurized nat gas containers, the fact is that the industry it under stress, the wells are running at a loss, and the decline rates are high. Furthermore, the rig count is dropping. The futures curve is hinting at significant price appreciation over the next couple years.

Prices below $4 are unprofitable for the vast majority of wells. This excellent article also discusses the U.S. gas production ceiling, and that resource estimates in the U.S. have been cut by 42%. Mark Anthony takes up the steep decline curves in the existing well profile. When, not if, natural gas prices return to profitable levels, coal will receive a tailwind. JRCC describes the natural gas leading coal price phenomenon:

"If we have a normal summer and a normal winter, I think both the coal market and the gas market -- I think the gas market will lead. Clearly from my comments on what we see in the natural gas market, I think that will lead the coal market up. And so we'll see sort of what production looks like in -- what gas production looks like in October, November. By that time, the Haynesville [ph] should, should materially have come off."

Guess what? Natural gas futures are up 34% over the last month. And coal prices look like they're bottoming.

Funds dumping shares and capitulating:

Southern Sun dumped 3 million shares of their 11% stake a few days ago, pretty much at the bottom. Another huge 2 million share block went off at the close Friday. Short interest has grown to over 12.3 million shares representing 40% of the float. Certainly a nice number to cover when the cycle shifts.

Valuation:

This is the easy part. $95 million in market capitalization compared to $357 million of tangible book value.

There are lots of bargains in the sector, don't get me wrong. But when it comes to management performance, both financially with a favorable debt structure and proactive customer management in the sales department, JRCC has been navigating the cycle downturn quite well.

Other companies worth considering include Arch Coal (NYSE:ACI), Patriot Coal (PCX), Alpha Natural Resources (ANR), all trading well below book value, while Peabody (BTU), CONSOL Energy (NYSE:CNX), and Walter Energy (NYSE:WLT) are industry leaders.

Disclosure: I am long JRCC.