Take a minute (when we are playing golf, my youngest son says take your time and hit the ball), look at the picture above, and describe what it resembles to you.
For those not nuanced in the subject, it is coking coal, a particular type of coal, that is both rare, and a necessary ingredient in steel production. Throughout my years covering the markets, coal has alternatively been a literal eyesore (a euphemism for my worst mistake ever), and a verifiable diamond, depending on the time frame, and pricing environment. Right now, today, we are definitely mining for diamonds in the coal companies, especially among the coking coal producers.
Front and center on the list is Peabody Energy (BTU), which has been my top pick for total returns in 2021, and it is delivering in spades in that regard, as sentiment swings from the pendulum of extreme fear to extreme greed. On that note, as I write this post, Peabody Energy shares are up 399.2% year-to-date through Monday, July 26th, an exemplary performer to say the least.
(Source: Author, StockCharts)
Partial peer Warrior Met Coal (NYSE:HCC), which owns some of the best coking coal in the United States, and who will actually produce more premium coking coal to the current version of Peabody, has actually declined 15.6% YTD through Monday, and hence, the underperforming shares are a relative and absolute opportunity from my vantage point.
(Source: Author, StockCharts)
This is especially true given the moonshot ramp up in metallurgical coal prices starting in May of this year, which echoes what happened in 2016, which I wrote about with an article on BHP Billiton (BHP) at that time, titled, "The Historic Fall And Rise Of Met Coal And The Bullish Case For BHP". If you live long enough, history often repeats itself, or at least rhymes, and that is certainly true in shorter order in the financial markets, as we see right now a scant five years later. The key difference is this time the price ramp is occurring amidst a commodity sector wide supply driven super cycle.
The scale of the current opportunity is enhanced for Warrior Met Coal, despite the ongoing strike by union workers, which started when coking coal prices were much lower, when one considers that Warrior Met Coal has historically paid a high level of dividends when met coal prices are in the zip code that they are in today. Thus, if you believe in the durability of higher for longer met coal prices, Warrior Met Coal has the chance to become a significant dividend payer, again, in the not-too-distant future.
Here is a long-term price chart of Warrior Met Coal, which is not that long, because the company, formerly known as Walter Energy, restructured in 2015, and emerged to trade again in April of 2017.
(Source: Author, StockCharts)
Before its demise, and then resurrection, Warrior Met Coal, grew from a miner that produced less than one million tons of coal, to one of the largest pure-play high quality coking coal producers in the world, driven off the strength of two extremely productive, extremely deep mines in Alabama's Blue Creek coal seam.
The current run rate of production at these two aforementioned mines is roughly 8 million tons, as shown by the slide from the company's First Quarter Of 2021 Results Presentation, which was produced on May 5th, 2021 (keep that date in mind).
(Source: First Quarter 2021 Results Presentation)
Why was the date important?
Well, on May 5th, 2021, benchmark premium coking coal prices were trading at roughly $100 per ton. Fast forward roughly 3 months later, and premium coking coal prices closed yesterday trading at roughly $214 per ton, with even higher pricing seen internally in China, as China struggles with supplies amidst a trade dispute with Australia.
With cash on the books of roughly $222 million at the end of their most recent quarter (March 31st, 2021), long-term debt of roughly $380 million (maturing on November 1st of 2024), and free cash flow generation of approximately $23 million in the first quarter of 2021 at realized pricing of $106 per ton, which was 95% of the benchmark price, Warrior Met Coal is already in good shape from a balance sheet, and profitability perspective.
(Source: Warrior Met Coal 10-Q March 31st, 2021)
Now consider that the benchmark premium coal prices are over $100 per ton higher today than for the realized pricing in the first quarter of 2021, and the potential free cash flow cadence quarter-by-quarter is enormous once we get to the third quarter of 2021. On this note, at $200 per ton, Warrior Met Coal is positioned to deliver free cash flow that approaches $200 million per quarter. Keep in mind that its market capitalization is roughly $900 million as of this writing, and its enterprise value is roughly $1.1 billion.
Now, of course, the elephant in the room is the ongoing strike with an unknown ending point, however, given the levels of current profitability today, and accompanying free cash flow generation, restoring the $6 per hour pay cut that striking miners took during the 2016 restructuring should not be an issue. In fact, since the current labor agreement has a component of bonuses based on coal pricing, this may already have happened, unbeknownst to many participating on both sides of the dispute.
Looking back to the special dividends paid in 2017, 2018, and 2019, Warrior Met Coal paid a special dividend of $11.21 on November 24th, 2017, $6.529 on April 12th, 2018, and $4.416 on May 3rd, 2019, all in addition to a regular dividend.
(Source: Yahoo Finance)
Keep in mind that realized coking coal prices during these "boom" years were lower than they will be at current coking coal prices, and your mind can start to wander with possibilities of future dividend payouts.
Given today's prevailing met coal prices, and the scale that Warrior Met Coal produces coking coal, it is only a matter of time until Warrior Met Coal is more widely recognized for its free cash flow generation capabilities. With the current pricing, EBITDA on an annualized basis starting in the third quarter of 2021 could approach its current market capitalization, and free cash flow generated could easily be over 50% of its enterprise value on an annualized basis, even with a pullback in met coal prices from the presently elevated levels.
Think about that for a minute, and then think what its current market price and enterprise value are pricing in at the moment. Obviously, the ongoing strike, which passed the 100-day mark in early July is complicating the valuation story, however, even a full restoration of pre-restructuring wages and benefits would leave ample free cash flow for shareholders.
Looking at the graphic above, we are not at the elevated valuation stage yet, and for coal companies, the ESG headwinds are so formidable that they will prevent a lack of new supply coming online for the foreseeable future, no matter how profitable the current operations are in a snapshot of time.
In closing, for much of the past two years, even though the market bottomed in March of 2020, I have been pounding the table on the extremely out-of-favor commodity equities, and I still think we're in the early innings of what will be a longer-term price appreciation. Investors skittish of the commodity sector should research cast aside financials as they also will benefit from rising inflationary expectations and rising long-term interest rates. Understanding the bigger picture, then having an understanding of the bottoms-up fundamentals has been the key to outperformance, and this is a path that has not been easy with those participating confirming this reality. However, the road less taken is sometimes the better one, and I firmly believe that today, as traditional stocks, bonds, and real estate offer very poor starting valuations and very poor projected future real returns from today's price levels. More specifically, the out-of-favor assets and asset classes, including commodities and commodity equities and out-of-favor specific securities are where the historic opportunity has been, and that's where it still stands, from my perspective.
There is historic opportunity in the investment markets today. I have spent thousands of hours analyzing the markets, looking for the best opportunities, looking to replicate what I have been able to accomplish in the past. From my perspective, the opportunities in targeted out-of-favor equities today are every bit as big as the best opportunities in early 2016, and late 2008/early 2009. For further perspective on these opportunities, consider a membership to The Contrarian, sign up here to join.
This article was written by
Twenty plus year career as an investment analyst, investor, portfolio manager, consultant, and writer. Founder of Koldus Contrarian Investments, Ltd, which was incorporated in the spring of 2009. Dyed in the wool contrarian investor, who has learned, the hard way, that a good contrarian is only contrarian 20% of the time, but being right at key inflection points is the key to meaningful wealth creation in the markets. I believe we are near a meaningful inflection point, perhaps the biggest one yet, for the third time in the past 15 years.
Historically, I have had huge wins and impressive losses based on a concentrated, contrarian strategy. Trying to keep the good while filtering out the bad.Seeking to run an all weather portfolio with minimal volatility and index overlays to capture my strategic and tactical recommendations along with a concentrated best ideas portfolio, which is my bread and butter, but the volatility only makes it suitable for a small piece of an investor's overall portfolio. The following are a couple of my favorite investment quotes.
"Life and investing are long ballgames." Julian Robertson
"A diamond is a chunk of coal that is made good under pressure."
"Knowledge is limited. Imagination encircles the world." Albert Einstein
I’ve been on top of the world, and the world has been on top of me. I have learned to enjoy the perspective from each view, and use opportunities to persistently acquire knowledge, and enjoy the company of those around me, especially loved ones, family, and friends.At heart, I am a market historian with an unrivaled passion for the capital markets. I have had a long history and specialization with concentrated positions and options trading. Made money in 2008 with a net long portfolio, deploying capital in some of the market's darkest hours into long positions including purchases of American Express, Atlas Energy, Crosstex, First Industrial Real Estate, General Growth Properties, Genworth, Macquarie Infrastructure, Ruth Chris Steakhouse, and Vornado near their lows. Shorting, hedging, and option strategies also helped me in 2007 and 2009, and these are skills that I have developed ever since I started trading heavily in 1996.I enjoy reading, accumulating knowledge, and putting this knowledge to work in the active capital markets, learning lessons along the way.To this day, I continue to learn, and some of these learning lessons have been excruciatingly difficult ones, especially over the past several years, as I made mistakes allocating capital, including a sizable portion of my own capital (I always invest alongside my clients), to commodity related stocks. While all commodity related stocks have struggled since April of 2011, coal companies, which attracted me due to their extremely cheap valuations, and out-of-favor status (I am a strong believer in behavioral finance alongside fundamentals and technicals) have been the worst investing mistake of my career. The focus on the commodity arena has been the biggest mistake of my investment career thus far, yet in its aftermath, I see tremendous opportunity, even larger in scope than the fortuitous 2008/2009 environment.The capital that I accumulated and the confidence gained in navigating the treacherous investment waters of 2008 gave me the confidence to launch my own investment firm in the spring of 2009, right before the ultimate lows in the stock market. At the time I was working as a senior analyst at one of the largest RIA's in the country, and I felt strongly that the market environment was the best time since 1974/1975 to start an investment firm.
Disclosure: I/we have a beneficial long position in the shares of HCC, BTU, BHP, AND SHORT SPY IN A LONG/SHORT PORTFOLIO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication and are subject to change without notice.