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Walter Energy (NYSE:WLT)

Q2 2012 Earnings Call

August 02, 2012 9:00 am ET

Executives

Paul Blalock - Vice President of Investor Relations

Walter J. Scheller - Chief Executive Officer, Member of The Board of Directors, Member of Executive Committee, President of Jim Walter Resources and Chief Operating Officer of Jim Walter Resources

William G. Harvey - Chief Financial Officer and Senior Vice President

Daniel Paul Cartwright - President of Canadian Operations

Michael T. Madden - Chief Commercial Officer and Senior Vice President

Richard Allen Donnelly - President of Jim Walter Resources

Analysts

James M. Rollyson - Raymond James & Associates, Inc., Research Division

Shneur Z. Gershuni - UBS Investment Bank, Research Division

Brian D. Gamble - Simmons & Company International, Research Division

Garrett S. Nelson - BB&T Capital Markets, Research Division

Ralph Wayne Atwell - Global Hunter Securities, LLC, Research Division

Curtis Woodworth - Nomura Securities Co. Ltd., Research Division

Andre Benjamin - Goldman Sachs Group Inc., Research Division

Timna Tanners - BofA Merrill Lynch, Research Division

Brandon Blossman - Tudor, Pickering, Holt & Co. Securities, Inc., Research Division

Paul Forward - Stifel, Nicolaus & Co., Inc., Research Division

J. Christopher Haberlin - Davenport & Company, LLC, Research Division

Sam Dubinsky - Wells Fargo Securities, LLC, Research Division

David E. Beard - Iberia Capital Partners, Research Division

Operator

Good morning, and welcome to Walter Energy's Second Quarter 2012 Earnings Call. [Operator Instructions] I would now like to turn the meeting over to Mr. Paul Blalock, Vice President of Investor Relations. Sir, please begin.

Paul Blalock

Thank you, Merilee. Good morning, all, and thank you for joining us today. This call is being webcast live over the Internet and a recording will be available and archived on our website for at least 30 days. On this call, we may refer to forward-looking statements made in yesterday's press release, and we may make those and other forward-looking statements during this call. For more information regarding the risks associated with forward-looking statements, please refer to the company's SEC filings. Joining me today, on today's call are Walter Energy's CEO, Walt Scheller; and CFO, Bill Harvey, as well as other members of the management team, who will be available for Q&A. Now I'd like to hand it over to Walt.

Walter J. Scheller

Thanks, Paul. Good morning, everyone, and thank you for joining us. I'd like to begin today with a brief report on safety, which always comes first at Walter Energy. U.S. operations reduced the total recordable injury rate by 34% in the second quarter, and our Canadian operation's recordable injury rate was reduced by 26% compared with the year ago. Across the entire Walter community, we strive to ensure a safety culture for our employees and the communities in which we operate.

Turning now to our results. Second quarter met production of 2.91 million metric tons was within 50,000 tons of first quarter's 2.96 million metric tons record production. This represents a 17% increase from the 2.49 million tons produced in the second quarter of 2011. This strong production puts Walter on solid footing to accomplish our 2012 met coal production target of 11.5 million to 13 million metric tons.

Second quarter met coal sales of 2.84 million metric tons increased 20% over first quarter 2012. Mike Madden and his team has been globally marketing our suite of met coal products creating new opportunities and meeting our customers' needs even in a difficult macro environment.

It is also noteworthy to recognize that the strong production was accomplished with 2 mines having less than normal production during the quarter. First, Mine No. 4, was off-line for the majority of the second quarter. The extended longwall move was successfully accomplished just as the scheduled miner's vacation began. For the year, Mine No. 4 is on plan to meet its production target of about 2 million metric tons. Second, the Brule Mine in Northeast British Columbia currently operated by an outside contractor had higher mining waste removal in the second quarter which negatively impacted its productivity and cost. As you know, Walter is focused on reducing cost. In the second quarter, the consolidated cash cost of hard coking coal decreased slightly to $115 per metric ton. In the U.S., Underground cash cost fell to $107 per metric ton from $110 in the first quarter. For perspective, cost were $119 per metric ton in the fourth quarter last year. Clearly, our Underground operations are making progress for reaching our cost goal of $100 per ton by the year end. And I should remind everyone, that Walter's Underground operations represent the majority of our production and cash flow.

Switching to Canada, met production increased to 1.19 million metric tons from 994,000 last year. Hard coking coal cash cost decreased very slightly in the second quarter to $144 per ton versus $145 per ton in the first quarter. However, PCI cost were impacted by the higher mining waste removal at Brule due to the mining cycle and cash cost for PCI increased to $218 per metric ton from $208 in the first quarter. At the Willow Creek project, you may recall that our first quarter production was limited due to the wash plant outage and cash cost were $449 per metric ton on 120,000 tons. I'm pleased to report that in the second quarter, Willow Creek's production increased to 154,000 tons and cash cost declined to $259 per metric ton.

We also expect further increases in Willow Creek productivity to continue to reduce cost. More importantly, Willow Creek started mining hard coking coal and we now have in inventory approximately 65,000 tons that are low-vol Mine No. 7 type quality, which makes this coal one of the best in the world. I should also mention that we have recently contracted to sell some of the low-vol coal from Willow Creek at benchmark pricing. The biggest issue in Canada, however, is the contractor-operated cost structure of the Brule Mine. So we have accelerated our plans to move Brule to an owner-operated mine. We believe the combination of making Brule on owner-operated mine plus increasing productivity will over time significantly decrease cost. I would caution that while we've made the decision to move to an owner-operated mine, we have a great deal of work to accomplish over the coming months, including the retention of people who are critical to our success.

So although caution is warranted that there is still some production risk in the PCI business in the near term, we still believe our full year production targets are reasonable. Overall in Canada, our met coal production is beginning to increase and we maintained positive margins of approximately $10 per ton across our met coal product portfolio. I believe Dan Cartwright and his team have significantly stabilized many issues in Canada in a very short time period, though it is clear that we have much more progress to make.

Moving now to the macro environment. Overall, Walter produces about 50% low-vol hard coking coal, 25% mid-vol hard coking coal and 25% low-vol PCI. Even in today's global environment, which can be characterized as choppy with increasing fears of global uncertainty, our low-vol products continue to be in high demand and command prices at or near the benchmarks. Our mid-vol products typically command a slight discount to the low-vol benchmark and today, there are some pressure for slightly greater discount from mid-vol. Our low-vol PCI also sells very well, commanding at or near low-vol PCI benchmark pricing. In the current marketplace, it's clear that Walter's high-quality coal portfolio is valued by the best customers and the most efficient steel mills. Therefore, we typically do not sell our coal on the spot market, which is currently focused on the short-term Asian demand and global supply. Nonetheless, investors should understand that in a market like the present market, the lower the quality of coal, the wider the discount to the benchmark price. Instead, at Walter we strive to contract our tons based on the benchmark and I'm pleased to report that customers are honoring those contracted prices for committed tons. As always, the pricing of new tons is negotiated.

Also, we had 2 customers request shipment accelerations to Q3, originally scheduled in Q4, due to continued demand for our quality coal. We remain focused on serving the needs of the best customers in the world. In Europe, our customers continue to perform well, taking deliveries as scheduled and fulfilling contracted tons even in a difficult economic environment where the euro has worked against them. Our customers in Asia are also proceeding with orders according to terms. In addition, our South American customers are continuing orders on a project basis as they build for the Olympics and the World Cup, although impacted by exchange rates.

To wrap up the macro discussion, Q4 2012 benchmark predictions from experts like Wood Mackenzie once again indicate low-vol pricing above $200 per metric ton, which would make 11 consecutive quarters for pricing above $200 per ton.

Now shifting to some of our other operations. Mine No. 7 is in its last week of miners vacation and Rich Donnelly's team has done a very good job of keeping that critical mine running well. So I should note that for the first time in many quarters, I'm extremely pleased to have little to say about Mine No. 7. Production is solid and the outlook for Underground operation is on track for reaching our production and cost targets. The same is true at Wolverine in Canada. Hard coking coal production increased to 466,000 metric tons, up from 408,000 tons last quarter.

In summary, Walter Energy safely mined almost 3 million metric tons of met coal for 2 consecutive quarters. Our coking coal cost were generally flat, as Underground operation is doing a bit better and Canadian cost stable at Wolverine, down at Willow creek and temporarily up at Brule due to mining cycle. I would now like to introduce our new CFO who will discuss our financial results. After which I will provide some additional comments. But before I hand it over, I'd like to thank Robert Kerley for serving in the interim role over the last year and for the hard work he has contributed. Now I'm pleased to introduce Bill Harvey, our CFO.

William G. Harvey

Thanks, Walt. I'd first like to underscore how pleased I am to join Walter Energy. My first day was July 9, so I certainly am going up some steep learning curves. However, over the past few weeks I have been tremendously impressed by the management team, the quality of the people and the assets of the company. I'll now take a few minutes to highlight several of the details in the financials.

First, earnings for the second quarter were $32 million, or $27 million from continuing operations. The difference relates to the sale of our Kodiak Mine, which has previously been in discontinued operations for an after-tax gain of $5.2 million. Revenues grew $46 million over the first quarter to $678 million as the improvement in production resulted in an increase in sales volumes, mitigated by the decrease in pricing. During the quarter, we generated cash from operations of $309 million. Our EBITDA was $145 million and we received a substantial benefit from working capital. In the quarter, we also repaid $100 million of term loan A and B. The effective tax rate for the second quarter was 15%. We currently expect the tax rate to continue for the balance of the year in the 15% to 17% range. Also during the quarter, we reported in other income loss of $5 million, which is the noncash impact of the write-off of our investment in Xtract of $5.2 million. Xtract was a small equity investment and part of the Western Coal acquisition.

Finally in the quarter, we spent $125 million of capital expenditures and have spent $246 million for the first 6 months of the year. Given the current economic uncertainty, we have now reduced this to $400 million or about $150 million for the balance of the year. We are slowing the pace of certain growth projects while maintaining optionality and investing in high return projects. As we look to 2013, we will continue to manage the company very prudently with respect to capital spending. I'll now turn it back to Walt.

Walter J. Scheller

Thanks, Bill. Second quarter results clearly demonstrate that met coal production at Walter Energy is stabilizing and Underground cost are tracking to our goals. We are addressing our Canadian challenges and are beginning to see stronger productions. We will move aggressively to an owner operated mine at Brule even as we work to optimize the mining plan for further cost improvement. However, caution on several fronts is clearly warranted. First, the macro global economic uncertainty has hurt the outlook for global steel production and we must clearly pay attention to the developments in Asia, particularly China demand, along with world supply, over the coming months. As I said earlier, we are pleased with the initial third quarter benchmark, but we believe there will be continued pressure on mid-vol pricing in the near term. Secondly, we will adjust our long-term marketing approach as necessary, but as a solid supplier to our global customers, we continue to believe that we have a market for our products. We do not believe the spot market is the best place for Walter. Third, as Bill said, we've adjusted our capital spending down to about $400 million in 2012. Even with the move to an owner-operated mine at Brule, which we believe is the right move at the right time, we're comfortable with this level of spending. Regarding inventory during the second quarter, we sold what we produced and that will be our target each quarter. If opportunities for reducing inventory present themselves at reasonable prices, we will certainly pursue those while remaining disciplined about how and when we sell our products.

Overall, our focus on safely growing our met coal production this year is beginning to pay off. As I said previously, we are on track to reaching our production target of 11.5 million to 13 million metric tons in 2012. No other coal company has a met focus like Walter Energy, and in my view, the margins we generate on hard coking coal will continue to make us a one of a kind coal company. Thank you for listening. The team and I will now be happy to take your questions. Operator, please begin the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Jim Rollyson of Raymond James.

James M. Rollyson - Raymond James & Associates, Inc., Research Division

Walt, on the topic of Brule switching over to owner operated, what do you think the time frame for that is going to be?

Walter J. Scheller

I'm going to let -- Dan Cartwright's here with us, President of the Canadian operations. I'm going to let him cover that question.

Daniel Paul Cartwright

We're currently in negotiations with the mining contractor. The contract that they have expires on October 31. And so we are working on that transition and expect to be moving toward transition with our take over by the end of October.

James M. Rollyson - Raymond James & Associates, Inc., Research Division

All right, that's helpful. And, Walt, just in relation, when you add everything up to the $201 a metric ton you received on average in this quarter, when you look at kind of how settlements are shaking out in relation to benchmark and qualities and what have you, what do you think your hard coking coal average is looking -- shaping up to look like for 3Q? Because you have some of your peers that are kind of guiding more flattish sequentially as opposed to up, which is what the benchmark suggests?

Michael T. Madden

Jim, this is Mike Madden, I'll try and address an answer for you. First of all, we have not totally completed all of Q3, so there is some tonnages that are still open. But I can say for the -- our high-quality coal such as No. 7 and Willow, the hard coking coal, we are at achieving benchmark or very close to benchmark. We do see a drop off on the mid-vol. But again, I don't want to comment on that right now because we still are in negotiations.

James M. Rollyson - Raymond James & Associates, Inc., Research Division

Okay, helpful. And the last one, Walt, on the cost side of things, your goal in the U.S. is to get down to $100 by the end of the year. It seems like at $107 for the second quarter given that No. 4 was out for a good chunk of the quarter that you're tracking -- at least on track. Do you think you can get below $100 at some point this year?

Walter J. Scheller

Well. Again, our goal was to be at $100 by year end. If we can get it below $100 by year end, we'll certainly do that, but we do think our goal is well within reach.

Operator

Our next question comes from Shneur Gershuni of UBS.

Shneur Z. Gershuni - UBS Investment Bank, Research Division

My first question is just kind of a follow-up on the inventory comments that you have made. Your production and guidance remains relatively wide at this point right now. Given the relative weakness in the met coal market right now, do you plan -- is the low end of the guidance reflecting the fact that you may try to bring down inventories and stick to the lower end of the guidance and so forth from a production standpoint? Do you plan to produce it flat out basically to try and hit the midpoint? If you can sort of give us your color on how you would like to bring down those inventories that you built over the last 2 quarters relative to production decisions?

Walter J. Scheller

Well, first of all in the second quarter, even though our sales -- our stated sales are slightly above what our stated production is, we actually did not grow inventory at all in the second quarter. We have internal sales as well to ourselves at our coke plant which actually pushes our total sales slightly above our production level in the second quarter. As we look at our inventory, first quarter inventory primarily grew at Mine 4 and we look for a drawdown in Mine 4 inventory between now and through the third quarter and the rest of the year. We're actually hoping to build a little Mine 7 inventory. We been living kind of hand to mouth at Mine 7 for quite some time now and having a little inventory to port [ph] would be a good thing.

Shneur Z. Gershuni - UBS Investment Bank, Research Division

Okay. My second question is just related to your comments about benchmark potentially -- and thinking more about the fourth quarter than the third quarter potentially being above $200, the spot market right now and granted it's thinly traded and so forth, that seems to be suggesting something in the $180 zone. I'm just wondering if you can talk about the discrepancy between that in your view, if you can give us a little bit more color as to why you think that, that's going to be around the $200 other than what some consultant sort of saying it will be.

Michael T. Madden

Yes. This is Mike Madden again. I'll agree with you that the spot is very thinly traded, particularly right now. The other question is, is the spot price coming from the buyer or is it coming from the seller? Also we, traditionally, and we'll continue to do that, we contract our tons so we don't get into the spot market at all or very small. And I, honestly, if you look around the world, most of the coals that we see on the international market right now are contracted. Yes, there are a lot of people who are buying some coal month-to-month, but we don't do the month-to-month thing. So I would say the spot is a relatively small amount. It's probably inventory type coals or excess coals that people are trying to unload. I would say the high-quality stuff is still going to fall into a benchmark range.

Shneur Z. Gershuni - UBS Investment Bank, Research Division

There has been a relationship between kind of where spots settles out and where the next benchmark tends to be. So I guess that's kind of why we're wondering if that's sort of preluding what's going to happen in the end of August or early September when the next benchmark comes. And you feel that it'll still be above $200?

Michael T. Madden

I think it'll be -- yes, it'll be -- I don't think it'll go below $200 at this point. I think you're seeing a lot of this spot is -- traditionally, in Q4 we've seen where buyers have stepped out of the market or pulled back to draw down some inventory and not use cash at the end of the year. We're seeing that again. I guess, the big difference we are seeing right now is China. But as we all know, China can happen and turn around very quickly. So I still feel that sub-$200 is going to be difficult for a lot of people, I think.

Shneur Z. Gershuni - UBS Investment Bank, Research Division

Great. One last clean-up question. During the quarter you paid down about $100 million worth of term loan debt. Can you remind us about any covenant restrictions you have with respect to share repurchases?

William G. Harvey

It's Bill Harvey. Yes, we do have covenants with respect to share repurchases. There is a basket in that agreement that allows a small amount of share repurchases but we -- our bank agreement does preclude it other than the basket.

Operator

Our next question come from Brian Gamble of Simmons.

Brian D. Gamble - Simmons & Company International, Research Division

I wanted to start in Canada. You gave a little bit of detail as to why cost were what they were during the quarter. Maybe a little bit more clarity would help, I guess, why did the Brule specifically catch you offguard as it seems like it was a relatively big impacts relative to what you had previously expected?

Daniel Paul Cartwright

Brian, this is Dan Cartwright. Yes, I'll just kind of work through down through the mines quickly and spend most of my time on Brule. At Willow, as Walt said, we made a substantial improvement from Q1, kind of recasting the numbers that he showed there. We achieved a 28% production increase and that yielded a 42% cost reduction, so we feel good about that. I mean, we're -- I'll just remind everyone that, that mine is still a development project and most of our activities are directed toward getting ourselves set up to mine and that will continue, as we said before, into first quarter, but we're continuing on track with that. And the production volume that we're still looking at is still in that 900,000 to 1 million for the year that we had spoken previously. The best news though, as Walt mentioned before, is that we developed to the point that we could get into our low-vol hard coking coal, and so we're pleased to start seeing that show up and we'll be mining into that into the rest of the year. So Willow is tracking as we said before. Wolverine is our smoothest running operation. We had a substantial increase in production that Walt mentioned, 466 versus 408 in Q1. Cost were down slightly. We're working a little bit in development in our next area that we're going to. And there, the focus is on the basic things that I've talked before that we're putting in place in all our mines which have to do with mine planning, execution and process measurement, maintenance, cost management and supply chain. So those things are well underway there. And then I'd like to spend most of my time on Brule to explain what happened in Q2. I guess I'll begin by saying, first of all, that we are on track for the 1.8 million tons for the year and we still believe in the cost in the $130s. And I'm putting that s on the end of it because a lot of times when it gets played back, people think that we said $130 and we did not. What that means is $130 to $139.99. So I'll just reiterate that as we've done before. There is the caveat though, as Walt mentioned, as we're in transition on converting from a contractor to a company-run operation, that does put a little bit of uncertainty on the timing of it, but the achievement of costs in the 130s we continue to be confident on. But with respect to what happened in Q2, we had higher than normal mining waste volumes that was a function of the mining cycle. And just to -- I know some of you are very familiar with reserves here in Northeast BC, but just to describe them. Of course, they're in the Rocky Mountains which means that you're dealing in steep slopes and the seams just like the topography usually are on a slope or well or dipping in some cases very steeply. The way the mining is done is that, the mining areas are outlined and then benches, and when I say a bench that's an area that the equipment runs on, then start at the top of the sequence where you're going to be mining. And the height of the benches typically are 12 to 15 meters and that's regulated by how safely and the reach of the shovel that's actually mining on there, mines the bench starting at the top and working its way down to the bottom of the lowest seam. As the mining progresses on each bench from top to bottom, the mining takes the waste until it encounters the coal seams and typically there's 1 or maybe even as many as 4 or 5, it just depends on the particular reserve. When it encounters coal seams then the coal is mined and shipped to the plants. And you continue to work your way down through that area and that determines the coal versus the waste amount. And typically, when you're in those sloping areas, you don't get too much variations. Seams can come and go or the thickness might change a little bit but typically, it's fairly common. Where you do get into some variation though, is when you get to the areas which are relatively few in these deposits, where the seams tend to flatten out. And that happens at the access of the synclines and anaclines, for those that are familiar with this, but basically it works flat. And just from a general standpoint, if you can imagine if you have -- what that creates is a feast or famine situation with respect to coal. If you happen to be in a bench that has the coal seam lying into it, then it's a feast situation, where you're mining a disproportionately high amount of coal. But conversely when you're getting down to those seams, typically, you're in a famine situation where you're mining mostly rock. It's part of the mining cycle, what happens in these mines and every other mine in any BC and truck shovel operations really over the world in that. What happened to us here in this case is we were in such a situation in Q2 -- in that -- for a period of about 5 weeks we were in a situation where we mined very little of the coal as we were working our way through the inner burden down into the area where the bulk of our coal lies. And so during that time frame, we did have raw coal piles at the mine and if you looked at the coal being shipped from the mine that really didn't vary very much. And that's what our focus is, to continue to keep our shipments up. We were also focusing on direct ship coal prior to that time because of the plant outage there at Willow when we were doing our work, so we were working on that. What was happening though and what we were not focused on was the fact that those piles were not being replenished. And from an accounting inventory adjustments standpoint, that resulted in a $20 million charge that normally would not hit in that current period. So when you take that $20 million over the tons of Q2, it amounted -- it added $50 a ton to the cost of the production in Q2. Now practically because that's a part of the normal cycle it needs to be spread over a much longer period of time, so just at a high level if you set that aside and take that off and normalize, if you will, we're back down in the low $150s, slightly better than we were in Q1. So -- and again, that's a fair comparison to do because that's part of the mining and that's why we say that it's a part of the mining cycle. But I will also say though that we -- again, we believe in the cost in the $130s. So $150s is a ways from there. So as Walt said, when we looked at our requirements to reduce the cost because they're not acceptable to us, the primary tool that we have to do that is take the mine over from a contractor operation to a company-run operation. And so about a month ago we began negotiations with the mining contractor toward the things that we might do. And the agreement was that we would start a transition and plan to have that done by October 31. As I hope you can appreciate the -- because we're in negotiations, it's not appropriate to talk about the details of where we are. The issues that we're talking about is the transition of the workforce and some of the equipment although we already own and have on our own 70% of the stripping equipment already. So it's not as much as it might sound. But in any case, that is the reason for the cost. And I guess what I would say is for the remainder of the year, while the ability to determine what's going to happen in the second half of '12 is a little bit difficult to project, the timing of -- due to the transition, one thing we do know is that the lower seams at Brule that we were working our way down to, we will be in. And so we will recognize the positive side of that mining cycle during the course of that. And that's why we're confident that we'll get down into the 130s.

Brian D. Gamble - Simmons & Company International, Research Division

Great color, Dan. I appreciate all that. I'll limit myself to one quick follow up. The CapEx reduction for the back half of the year, you mentioned slowing some growth projects. Could you maybe detail exactly what those were? And was there any planned 2012 production associated with those projects if the money had been sent?

Walter J. Scheller

Sure. This is Walt. We've slowed down our growth projections in West Virginia. We had intended to start another couple of units up at our Maple mine. Those have been delayed. We pulled that capital out. So we will not achieve that production increase which was scheduled to begin late, I think, mid-third quarter and for the fourth quarter. That will impact us this year about 0.25 million tons or so and next year probably closer to 0.5 million tons. And we are also slowing our project down in Wales. We had expected some tons from that operation this year. And by slowing down, we're looking into whether or not those tons will come online late '13 or 2014, so we've slowed that project down a bit. Those are really the 2 impacts, near-term impacts from the capital reductions.

Operator

Our next question comes from Garrett Nelson of BB&T Capital Markets.

Garrett S. Nelson - BB&T Capital Markets, Research Division

Just a follow-up to that last question, of the new CapEx guidance of $400 million, can you breakdown how much is maintenance and how much is growth? How lean can you run the company in order to preserve free cash flow? What's a good maintenance CapEx number for Walter these days?

Walter J. Scheller

Good maintenance CapEx of -- as we move forward is $200 million a year. And that really starts to kick in, in 2013 because a lot of the capital spent in 2012 was growth capital, as we purchased the equipment, continued purchasing in equipment for Brule, brought the prep plant online at Willow and purchased equipment for Willow. So there was probably a heavier loading of growth capital in 2012. And I don't have the exact numbers in front of me, but I would expect that the growth capital, out of $400 million, probably $250 million in 2012 was growth and $150 million was maintenance.

Garrett S. Nelson - BB&T Capital Markets, Research Division

Okay. And any idea what CapEx might look like for next year?

Walter J. Scheller

No. We're still working -- we're beginning to work on our budgeting process. I've said in the past, where we said, given our growth projects that we would -- our goal is to bring the Blue Creek Mine online in 2018 and Belcourt-Saxon before too long after that. And to do that, those projects will take with maintenance capital $450 million to $500 million. We're going to carefully look at the market and see whether it's appropriate to begin that level of spending or scale that back a bit and push it out a little.

Operator

Our next question is from Wayne Atwell of Global Hunter.

Ralph Wayne Atwell - Global Hunter Securities, LLC, Research Division

Could you explain the advantage of -- obviously, there's a lot of advantages in going to the owner-operated at Brule. Presumably, you eliminate the margin that the contractor would have, but what else will you benefit from?

Daniel Paul Cartwright

This is Dan, it -- really there's a couple of things in contractor operations and as I've done them in other parts in my career, they certainly have their advantages. But a disadvantage that they have is many of them are structured as this one is, as where it has certain rates for moving in this case bank cubic meters and moving coal. There is no way to be able to improve efficiencies and benefit from that because the extra volume that you're able to move through efficiency you pay the same rate for. Whereas when you're operating it on your own, you have that ability to benefit from the additional productivity and incremental costs. And that's really the biggest reason.

Ralph Wayne Atwell - Global Hunter Securities, LLC, Research Division

Okay. And do you have longwall scheduled for the third and fourth quarter?

Walter J. Scheller

Longwall moves?

Ralph Wayne Atwell - Global Hunter Securities, LLC, Research Division

Yes.

Walter J. Scheller

Yes, we have a longwall move in the third quarter at Mine 4 that will occur late in third quarter. And -- well I'll Rich Donnelly talk a little bit about the operations in Alabama.

Richard Allen Donnelly

Yes, just real quickly. The longwalls at the Brookwood Mines, the No. 4 Mine, and as we've talked before we've got several small panels we're doing this year. So we still got 2 more longwall moves this year. One will occur in the third quarter and one in the fourth quarter. As we get into next year, we'll get into slightly longer panels and things will start improving and our production will go up. At No. 7, the E2 panel finished up as I think we've already talked about. The E3 panel is coming out nicely. It's mined completely through the zone where we have the problems on E2, so we're in the pretty smooth sail. And it will move in the fourth quarter. And in the north, the No. 7 will be moving right towards the end of the fourth quarter into the end panel. Not sure [indiscernible]

Ralph Wayne Atwell - Global Hunter Securities, LLC, Research Division

Is that 2 moves during the fourth quarter for 7?

Richard Allen Donnelly

Yes. Each of the 2 longwalls at 7 will both move. One of them would be probably middle of the quarter and one of them will be right at the end of the quarter.

Ralph Wayne Atwell - Global Hunter Securities, LLC, Research Division

So that -- it sounds like there's one move in the third and 3 moves in the fourth?

Richard Allen Donnelly

That's correct at the Brookwoods Mines.

Ralph Wayne Atwell - Global Hunter Securities, LLC, Research Division

Okay, great. And will there be much CapEx associated with taking over Brule as an owner-operated?

Daniel Paul Cartwright

I don't think so. That's part of the negotiation now and we've got several options that we have on that -- so that's factored into our numbers here that we've been talking about.

Operator

Our next question comes from Curt Woodworth of Nomura.

Curtis Woodworth - Nomura Securities Co. Ltd., Research Division

I have a question for Mike on just kind of what's going on in the market. And you mentioned that spot activity is obviously very thin and maybe it's not clear whether some of the spot market activity is coming from the buyer or the seller. But if you have a $30 per ton move in spot in 3 days without kind of the macro shock or anything significantly happening, I mean, clearly it's -- it's either distressed cargoes or people are really trying to move tonnage, as the whole seasonal move down in steel is occurring. So I just wonder if I could get a little bit more of your color on really what you think is driving it? How much tonnage is associated with that? And obviously, we've seen in the past when either the spot goes up dramatically, the benchmark doesn't settle at that and vice versa and it seems like right now you're still coming out on the side that the benchmark will sell above it but any color you can have on kind of this dramatic move would be helpful.

Michael T. Madden

Curt, I would, and again, this is my thinking, I would say that you're probably seeing the impact of spot mainly coming from BMA. As you know, they came off their force majeure. They went into a policy last year of month-to-month or combination of month-to-month and quarterly pricing. A lot of customers were turned off with that approach and they looked for diversity. So initially, I think BMA lost market last year. And then they went into their labor issues and they lost further ground. Now they're coming back and a lot of the customers have already done their diversity and they don't really want to go back in that direction. There's still a strong resistance in our portfolio of customers from -- for a month-to-month policy. So I think a lot of the spot right now is being driven by BMA coming back in with volume that they need to dispose off.

Curtis Woodworth - Nomura Securities Co. Ltd., Research Division

Okay, that's helpful. And then just the last question is, after you make the shift to the contractor or from contractor to owner-operated at Brule, what would be the base level kind of cost performance? I know you mentioned the 130s, but could you get below that after the shift or was the 130 number more of a target preshift to owner-operated?

Daniel Paul Cartwright

Well this is Dan. What we had said earlier and I guess, just remind to people, the shift to a company-owned operation really is something that we had planned all along. It was done at Wolverine a few years ago, done in Q1 at Willow and we had planned to do Brule next year and so now we're moving that forward. But when -- at least my first one of these calls was in January and the question as I took it was, what do we think that we could run these operations in within a 12 to 18 month kind of period and the answer was the 130s that we said. But our goal is certainly is going to be to drive beyond that. And the way we're going to do it though is what I've described before is blocking and tackling, better mine plans, measured executions with real focus on the process that drive the KPI's reliability-centered maintenance, day to day cost management with some tools we don't currently have now and we've got a lot of ground to gain in supply chain. So with all those areas that we have and underway plus we're strengthening our team there, our intent would be to drive beyond that certainly in the longer term.

Walter J. Scheller

I'm going to add one thing onto that. As I try to caution during my opening comments, as we switch, as we transition, it may require us to adjust our production levels slightly for a period of time. And while that may cause our production levels to drop, our expectation is even at that, our per ton cost will more than offset the difference. But we could have lighter than projected production levels for a period.

Curtis Woodworth - Nomura Securities Co. Ltd., Research Division

Okay. And then just quickly on Willow in terms of getting to 1 million ton run rate for this year, it seems like that would mean you'd have to be doing potentially I guess close to 400 per quarter by the end of the year. So is the run rate for Willow for next year closer to 1 5 [ph] or higher in terms of the shift to the really premium low-vol? What percent of the production next year you think would be in that category?

Daniel Paul Cartwright

We are in the -- next year we -- as Walt said, we're still working on that now but we would expect it to be at least 1 5 [ph] Next year. And our low-vol hard coking coal would be about half of the production.

Operator

Our next question comes from Andre Benjamin of Goldman Sachs.

Andre Benjamin - Goldman Sachs Group Inc., Research Division

I think the majority of the questions have actually been handled. Kind of one housekeeping question. Do you guys have any carryover or price volumes for third quarter that would cause a major difference between what you realize in the benchmark for 2 25 [ph]? And then guess how light of a discount are you seeing for the PCI coal that you're selling in Asia?

Michael T. Madden

This is Mike, Andre, it's -- we're looking at Q2 into Q3 it's about 360,000 tons. About 100,000 of that is Alabama, the balance is from Canada. So it's not a big amount of tons we're looking at.

Andre Benjamin - Goldman Sachs Group Inc., Research Division

Great. And then I guess, similarly, I know we've been talking a lot about Brule. You gave a lot of color on the cost. Is there any step change that we should expect in the volumes or is this primarily just a way of managing the costs as we go into 2013 and '14?

Daniel Paul Cartwright

Well, our focus is to improve our efficiencies and our productivity, so we don't have to rely on volume given whatever ways the market goes. But nominally, Brule would -- we're saying it's 1.7, 1.8, and could be pushed higher if the market dictated.

Operator

Our next question comes from Timna Tanners of Merrill Lynch.

Timna Tanners - BofA Merrill Lynch, Research Division

I wanted to ask you just a little bit more taking a step back about your commentary, it seemed much more cautious this quarter. So I wanted to clarify if that was primarily because of what you're seeing in the spot market and the impact on your mid-vol or if there's something larger that you're also seeing that you could give us some color on?

Michael T. Madden

This is Mike. Actually, we're probably taking a cautious look because China right now is a total uncertainty for us. Everybody talks about Europe, but frankly speaking, our schedules today for Q3 into Europe are actually looking better than Q2. So we're not looking as Europe as being as dismal as the press has played out. But we do not sell very much coal into China. But as you know, China does drive Asia. But Japan is looking pretty good and Korea is looking pretty good. So all in all, it's going to take some watch to be honest with you. And the next 2 months, I think, is going to be very critical to see which direction we're going.

Walter J. Scheller

And I guess part of the initial caution and concern we have is that with all the high-vol tons that have been sitting out there available in the market, it's put a lot of pressure on the mid-vol tons. So I think until all the inventory is worked off, there's going to be pressure on the high-vol and mid-vol market.

Timna Tanners - BofA Merrill Lynch, Research Division

Okay. So there goes my follow-ups are going to be on China and mid-vol, but I guess just specifically on mid-vol then. It seems like a common theme this quarter that everyone's scouring the globe for areas to place their tons. Are you seeing a lot of competition? Do you think there'll be any further curtailments on mid-vol or high-vol? What do you see in that market.

Michael T. Madden

Well, again, this is Mike. The high-vol, in our opinion is getting to level for where you're going to have to see some production go off. It's just getting extremely low, if we believe the numbers we see out there, which I think we do. And again that's being driven by the dismal thermal market, particularly here in the states. Everyone is scrambling now to see where they could move, what was thermal coal a year ago into a high-vol met market. So it's putting pressure on the mid-vol coals, particularly the higher mid-vol coals, because sometimes there's only a discrepancy of 3% to 5% on the volatile. So a buyer has to consider the differential in the pricing versus the value in use, obviously. So it's a difficult one to call, but we definitely feel that high-vol coals will probably have to come off the market first. We see that.

Operator

Our next question comes from Brandon Blossman of Tudor, Pickering, Holt & Co.

Brandon Blossman - Tudor, Pickering, Holt & Co. Securities, Inc., Research Division

I'll just -- stick to PCI for my question. It looks like just given Q2 production versus sales, that sales are kind of driving the boat here in Q1 and Q2, around 20% of total sales. It looks like the guidance has changed a little bit to lower that mix for the full year. How do we think about the mix of PCI in the second half of the year and then going into '13 in terms of sales?

Michael T. Madden

Yes. We're -- this is Mike again, Brandon. We're not really seeing any. We're starting on 75%, 25% basis, I mean, plus or minus 5%, but generally it's 75%, 25%. Right now we're still on that basis.

Walter J. Scheller

I guess one thing I'll add in there, is in any given quarter, a single cape vessel's 150,000 tons, so a single vessel coming into or out of the quarter right at the end can make a difference in that 5% very quickly. But it's 75%, 25% year-on-year.

Brandon Blossman - Tudor, Pickering, Holt & Co. Securities, Inc., Research Division

So just given that then, first half versus second half we should look for a little bit more, on a percentage basis, PCI?

Michael T. Madden

Well, again, that's going to be dictated on the scheduling that we get from customers. I couldn't give you a definitive answer on that. But our objective is to stay in that 75%, 25%.

Operator

Our next question comes from Paul Forward of Stifel, Nicolaus.

Paul Forward - Stifel, Nicolaus & Co., Inc., Research Division

I just wanted to follow-up on the contractor taking over at Brule in -- or taking the mine to in-house operations. I was just wondering if you could talk a little bit about the -- just the labor markets in Northeast BC. And I think you mentioned earlier about there being some potential risk of some volume impact as you make this transition. I guess, that would be my first question. The second one would be, I guess, on a related sense, if there is going to a little bit a potential volume hiccup considering the weakness of the PCI markets, why not consider idling some of the operations for a while and wait for some pricing that can really kind of justify the decision to produce instead of preserving the resource?

Daniel Paul Cartwright

This is Dan again. With respect your first question about the Willow [ph] situation there in Northeast BC, it is tight, as it always has been. If anything, if -- for some of the market situation and some of the discussion from some of the operators there, if anything, it might have loosened up a little bit. But still, again, we just went through this in Q1 at Willow and we're up to pretty close to full staffing on that. So again, we've been able to attract the employees there. We are already have people working in conjunction with the contractor at Brule to talk jointly with their employees and so we've already began that process and identified their -- and identified ourselves with them. And you raised a good point about strategically what do we want to do in terms of production levels and so on, in light of the market in the resource preservation and so on. It could well be that, that would factor into what we do. But one of the things that we have to be cognizant of is the workforce is not going to sit and wait if we would elect to cut back dramatically. The people that we know there are good people and they've done well. And so we're concerned about doing things that would discourage them from coming on board with Walter and of course, that always plays into safety and planning. So I think those points that you raised, Paul, are good to raise and we have them before us. But again, I think focus on, first on positioning ourselves with the workforces, probably, the primary focus as we work to this negotiation.

Walter J. Scheller

And I'll follow-up from what Dan said and say, earlier I mentioned that we believe this is the right decision at the right time. And it's for those reasons surrounding the market conditions. We certainly wouldn't want to be putting any production at risk if PCI prices were still north of the $200 range. But with prices where they are as we can do our best to manage our cost structure to a point where we are profitable with the pricing for PCI where it is today really sets us up for the future when we anticipate pricing going back up.

Operator

Our next question comes from Chris Haberlin of Davenport & Company.

J. Christopher Haberlin - Davenport & Company, LLC, Research Division

The cost targets that you have laid out, the $130s in Canada and approximately $100 in the U.S. I guess, are those targets at point in time targets or are they sustainable targets? And maybe said a different way, can you maintain those levels of cost despite some of the challenges that are inherent in the industry with waste removal, longwall moves, sequencing, cutting conditions and so forth?

Walter J. Scheller

Yes, our expectation as we exit the year with run rates in Alabama in the -- at the 2 -- at Mine 4, Mine 7, at or below $100 a ton. And we anticipate being able to maintain or improve upon that level as we roll forward. Of course, we're going to have the potential for, in any given quarter, for the number of longwall moves to impact you. And if you have longwall moves followed with miners vacations and all those things happening in the same quarter, you could easily have a quarter here there where that numbers missed. But if I look on an annual basis we anticipate Alabama getting to $100 by the end of the year and then hopefully improving beyond that. Up in Canada, our expectation is, as we've said, is to get Wolverine and Brule into the $130s and to continue to operate them at that level. But again, as Dan explained, the mining sequences up there, it's possible in any single quarter for something to happen to swing those out of line, but over the year they come back in line and would be in the $130s. Willow, we've talked about being a little higher cost than that, but right now for those -- that's kind of the story for the those 5 operations.

J. Christopher Haberlin - Davenport & Company, LLC, Research Division

So I guess, looking forward, we could expect to see -- I guess maybe I was just surprised by the size of the swing in cost at Brule, which was kind of $40 to $50. That's something that, I guess was that -- is that repeatable? I mean, we could see that level of swing again?

Walter J. Scheller

In a single quarter, I can't rule out that in any single quarter that we couldn't have something like that happen where we were primarily removing waste at a coal mine. And that could happen at Wolverine, Willow or Brule. But again, our focus is looking at what are our costs going to be for the year and those tend to smooth out -- smooth themselves out.

J. Christopher Haberlin - Davenport & Company, LLC, Research Division

Okay. Then moving to realizations, I guess hard coking coal realizations in the U.S. in Q2 were kind of approximately a $15 a ton discount to the benchmark and that's a little bit wider than maybe it typically has been in the past. Does that reflect any softening in the met market or was there a disproportionate amount of No. 4 coal in the mix there. Were there any lower-priced tons from carrying over some -- from some point in the past that causes realizations to decline?

Michael T. Madden

Yes, this is Mike. First of all Canada had -- their carryover was higher priced. And when you look at the U.S., the met -- Alabama mine coals got diluted with some of the sales that were out of West Virginia and Walter Mineral, the surface met products. That's where the differential lies.

J. Christopher Haberlin - Davenport & Company, LLC, Research Division

And then on met, just given the pullback in met prices we've seen. Can you just kind of the talk about where you see marginal cost globally?

Michael T. Madden

That's a tough one there.

Walter J. Scheller

We're hearing that some of the marginal cost operations are really coming in the 180s. So that's one of the reasons we believe that you're going to end up with pricing staying where it is. You have the potential for new operations with the carbon tax in Australia making a significant impact. So and I think right now I'd have to say the 180s.

Operator

Our next question comes from Sam Dubinsky of Wells Fargo.

Sam Dubinsky - Wells Fargo Securities, LLC, Research Division

Just a couple of quick housekeeping ones. Your thermal -- U.S. thermal operations, the cost declined pretty significantly or at least relative to other parts of your business, I think about $13 to $14 a ton. What was the reason for that and how should we model thermal mining cost going forward?

Walter J. Scheller

Well in the last quarter call, we said that our cost were up and we, actually, we're not positive in margins in our thermal operations because we had a longwall move in North River. And very simply, the reason costs are down so much in Q2 is we didn't have a longwall move in Q2. And in quarters where we don't have a longwall move, we anticipate cost staying about where they were this quarter. And if we have a longwall move, cost will swing upward.

Sam Dubinsky - Wells Fargo Securities, LLC, Research Division

Do you have any more longwall moves for the thermal operations at planned?

Walter J. Scheller

I don't think we have anymore this year. Rich?

Richard Allen Donnelly

The one at North River maybe right at the end of the year. It could go in this year, or early next year.

Sam Dubinsky - Wells Fargo Securities, LLC, Research Division

Okay, great. And then just a follow-up question on your balance sheet. Do you have any target debt levels or net debt levels for next year?

William G. Harvey

This is Bill Harvey, we have not defined a target debt level. We did repay $100 million of debt in the second quarter and are focused -- one of our main focuses is on debt reduction but at this point, we do not have a target.

Operator

Our next question comes from David Beard of Iberia.

David E. Beard - Iberia Capital Partners, Research Division

Most of my questions have been asked, but I did want to just get a little bit of more detail relative to U.S. costs, because you mentioned where you exit the year. But that really contemplates 3 longwall moves in the fourth quarter. Is this better cost out of No. 4 keeping overall costs down or can you hit those targets with that number of longwall moves in the fourth quarter?

Richard Allen Donnelly

Yes, this is Rich Donnelly. When you look at the -- what happened in the second quarter at No. 4, the longwall moved, but it was an extended move because our development was behind due to all these short panels, we've talked about several times. As we go through the year at all 3 of the longwall operations, the moves are just standard moves. They're not extended moves. They'll be roughly 10 days. It's all built into our models and we're pretty confident we could hit these numbers pretty well.

David E. Beard - Iberia Capital Partners, Research Division

Okay, great. And then just a bigger picture question, when you look at the development at Blue Creek, it's my understanding this is doing [ph] a very favorable cost, even with coke and coal prices depressed where they are. I'm just wondering if that development is still proceeding on pace and what would cause you to accelerate or decelerate that development?

Walter J. Scheller

Well, first of all, in the second part first. It's very difficult for us to accelerate that project. We are going forward as quickly as we can with that project. We're moving forward with all the permitting. So the only thing that would cause us to decelerate that project would be if we had such either such severe market conditions that we pullback significantly on all growth capital. It would take something like that for us to slow this project down. We still anticipate having that longwall in line by 2018. And when you look at our Alabama operations, and this one is considered to be much like our Mine 4 or Mine 7, if you just take into consideration what we're using as an exiting run rate of $100 cost with market, with the market at $200 a ton, we're talking about $100 margins. So this is a tremendous project and one that we want to push forward just as hard and as fast as we can.

Operator

This concludes the question and answer session. I'd like to turn it back for closing remarks.

Paul Blalock

Thank you for listening today. If you have any questions, we're available to help.

Operator

This concludes today's presentation. Thank you for your participation. You may now disconnect.

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Source: Walter Energy Management Discusses Q2 2012 Results - Earnings Call Transcript

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