Patriot Coal (PCX) has consistently generated negative cash flow. Coupled with potential maintenance covenant violation issues and current debt maturities, the banks and capital markets have balked at the notion of further funding the company in the current weak coal environment. In the following we will look at the reasons for why PCX failed and begin a valuation analysis. This article is a follow up to a prior piece titled "Patriot Coal: Standing At The Precipice".
Q: What were some pivotal items that precipitated the bankruptcy filing?
A: It has been well reported that the customer default on a purchase obligation in May and the overall weak coal market are what drove PCX to the edge. There were many other clues that some investors chose to ignore however, and those include the hiring of Blackstone, the CEO resignation in late May, the principal accounting officer resignation in June, the hiring of AlixPartners, and finally the possibility of breaching the bank maintenance covenants.
Q: Could bondholders have pushed the company over the edge?
A: In early May, 2012 PCX announced they were going to refinance the convertible debentures. The intent was to put new secured debt in place to take out the convertibles. In the bond world, such a move is referred to as 'priming' the unsecured class. Effectively, they were taking subordinated debt and making it secured. By doing so the recovery at the senior unsecured level would have been greatly diminished. This is further rationale for unsecured bondholders to push for a bankruptcy filing sooner rather than waiting. If bondholders were to wait, they risk being further subordinated in the capital structure.
Q: What legacy liabilities does Patriot have?
A: The primary legacy liabilities that are of concern at this point include postretirement benefit plans, workers comp, selenium water treatment obligations, end-of-mine closure costs, reclamation obligations, underfunded pension and obligations to an industry fund. You can find further information on page 82 of the 2011 10-K. Many of these liabilities stem from when PCX was spun out of Peabody (BTU) and also from Magnum, which was formerly part of Arch Coal (ACI).
Q: Shouldn't there be a lot of mine closures and layoffs at this point?
A: A bankruptcy filing allows the company to restructure. The word restructure is key, and does not mean close down. Perhaps some PCX mines will shut, and maybe some out of the money contracts will be eliminated. However, on the whole, PCX will now be afforded protection from creditors and will run the mines without pressing concern for bank covenants, interest payments and profit expectations. The company will be restructured as a going concern. Once legacy liabilities are eliminated or reduced, PCX should have a strong financial profile and be a leader in the markets in which they compete. To get to that stage will require compromise by the many constituents in the PCX capital structure. In short, once the company works through the pain, there is light at the end of the tunnel. As an aside, I invite all PCX employees or contractors of PCX to add their insight here. At times like this, many workers get nervous, but really the last thing creditors want to see is a mass exodus of the workforce. I'm not saying that the bankruptcy is necessarily positive for jobs in the short run, however if the restructuring is done correctly the long term viability of PCX is much more secure.
Q: How can a coal company be valued in bankruptcy?
A: In this case we will analyze valuation from two angles. First is value/ton of reserves. Second is value/ton of annual production. You must adjust for location (CAPP, ILB, PRB, etc.), quality (Btu content, sulfur content, seam thickness, etc.), underground versus above ground mining, impact of MSHA regulations, mine type (longwall, continuous miner, truck & shovel, etc.), percentage of reserves that are metallurgical coal and quality of metallurgical reserves among others. I like to look at past M&A to look over all the data. I think if you look back at what Wilbur Ross paid to cobble together International Coal Group, and what was paid for many other CAPP, NAPP and ILB assets in the last ten years you will get a sense of what the PCX assets are worth. I will say that currently, I believe the assets to be worth $1.3 billion on a liability free basis. Now that valuation figure can be debated, but that is where I come out.
Q: Can you walk through the value/ton of reserves approach?
A: Wilbur Ross paid $0.79/ton of reserves in 2004 when he bought Horizon for $786mm. Consol (CNX) paid $1.68/ton for Amvest, PCX itself paid $1.18/ton for Magnum in 2008. Deals at the peak include Massey buying Cumberland in 2010 for $2.31/ton and then Alpha Natural Resources (ANR) buying Massey at $3.06/ton. There are many more but I think the message is clear. Now I have stated I believe PCX to be worth $1.3 billion, so that backs into $0.67/ton of reserve, in line with prices back when the sector was last in its true down cycle and when we experienced a significant bankruptcy in the sector, namely James River Coal (JRCC). With all the looming EPA regulations and MSHA rules, coupled with the production shift from natural gas producers as a result of improved drilling techniques, we are left with a sector that suffers from very high costs and declining demand. So, to value these assets at $2/ton, and with the knowledge that the Magnum part of PCX was acquired for $1.18 in a better environment, we need to take a conservative view.
Q: Can you walk through the value/ton of annual production?
A: PCX sold 31mm tons of coal in 2011. The question is how many tons will they produce in 2012 and in the years further out? Horizon was acquired at $60/ton, Anker at $51/ton, Nicewonder at $74/ton, Amvest at $68/ton, Magnum at $39/ton (those are the assets PCX acquired), Cumberland at $123/ton. I project PCX will sell 21.9mm tons in 2012. At this time, 21.9mm tons seem like a reasonable figure to use going forward for the business. A $1.3 billion valuation backs into $59/ton. $59/ton may appear generous given historical valuations, however that does also factor production dropping by 29% in 2012.
Q: Now that I am comfortable with the valuation of PCX, how can I calculate what the stock and bonds are worth?
A: Once we are comfortable with a firm valuation, we can then look at the entire capital structure all the way from bank debt to the stock. For PCX, that includes debt that is on the balance sheet, and the numerous off balance sheet items that chew up their cash flow. It is my view that the liabilities, ranging from underfunded pension, asset retirement obligations, workers comp, mine reclamation and closure costs among others all must be factored in. The precise waterfall analysis will be left for a future article after some of the bankruptcy claims can be reviewed. However for the time being, I will wrap up by saying that once all the liabilities are considered, I calculate there is nothing left over for the equity.
Conclusion: There is a lot to be learned from the Patriot Coal experience. Investors should continue to be diligent in their analysis and not believe this situation is an anomaly for the coal (KOL) industry. Although PCX is asset rich, that does not mean they are invincible. Off balance sheet liabilities remain more important than ever and it is crucial for investors to always dig into the details. Further, using a valuation metric such has book value per share is fraught with errors. For one, book value can be written down, so forward analysis is critical. Many investors have taken the route that since PCX announced they are working on a bank refinancing, at some point it will be successful. What many equity investors often fail to grasp is that bank and bond lending is in many regards similar to buying a stock. Lenders want to see a viable business, and simply asking for a loan is not reason enough for granting one. PCX should be able to now work through the liabilities in a prudent manner and come out the other side as a going concern with the caveat that legacy shareholders will more than likely be wiped out. The bankruptcy filing is one small step for the coal industry, one giant leap for Patriot.
Additional disclosure: This article is for informational purposes only, it is not a recommendation to buy or sell any security and is strictly the opinion of Junc Bond. Every investor is strongly encouraged to do their own research prior to investing.