Peabody Energy: Will China Blink?
- Last week, given by very tight global inventories, record LNG prices, and improving global demand, both seaborne thermal and seaborne met prices hit all-time highs.
- Peabody owns excellent seaborne thermal assets and average seaborne met assets but has a lot of unhedged 2nd half FY 2021 and FY 2022 production.
- I share my 2nd half FY 2021 and FY 2022 Adj. EBITDA pro forma Peabody Energy models and discuss the nuances of this dynamic situation.
- This idea was discussed in more depth with members of my private investing community, Second Wind Capital . Learn More »
(This idea was originally discussed on September 28th and 29th and then formally written up and published, at 1 am EST October 1, 2021, for Second Wind Capital members).
In case anyone is wondering why shares of Peabody Energy (NYSE:BTU) have made a big leg up, in 2021, I decided to share my write-up and fairly in depth pro forma Adj. EBITDA model with SA's free site readers, albeit with a bit of a lag. I used to know Peabody Energy fairly well, pre-bankruptcy, and last week, I got back on the horse, as painful as that was, and I spent a significant amount of time getting back up to speed on the name. After a significant amount of work, going deep into the weeds, I write to share my findings.
In early 2020, China and Australia got in a bit of political pissing match, as there is no way to sugar coat it, and this resulted in China effectively banning all Australian coal imports (see this Reuters article that recaps the situation fairly well). Fast forward to the present day and there are numerous reports, from credible news outlets, that China is facing persistent power shortages, is very short coal inventories, and per Mother Nature, winter is only a few months away. All of this information is just a few Google searches away.
Now back in the day, George Soros and Jimmy Rogers famously shorted the British pound, betting against the Bank of England. As it turns out, Messrs. Soros and Rogers were right and made north of $1 billion on it, then a lot of money in the hedge fund world. That said, betting that China will have to lift its Australian coal import ban could be easily as lucrative and almost as great an investment call, if it actually happens. That said, I am not smart enough or delusional enough to pretend I can predict what China will or will not do.
Either way, the reason I have gone from zero exposure in Peabody Energy shares to a 14% sized bet, at $13.79 per share (the week of September 27th), can be found in the two Bloomberg charts enclosed below.
Exhibit A - Premium Coking Coal through the 2015 and 2016 highs
Exhibit B - Newcastle Seaborne Thermal Has Gone Parabolic
So just to be clear, I'm long Peabody Energy solely for its Australian coal assets. Although it is great that natural gas prices are trading in the $5s MMbtu, the highest prices since 2014, and this has led to more coal switching. It helps Peabody because it sells a lot of Powder River Basin coal, and the big leg up in natural gas prices helps U.S. thermal, at least in the short term. But I would argue that most of the big upside/ torque in Peabody's stock is via its Australia assets, notably its seaborne thermal.
Moving along, before we get into the weeds, I want to walk readers through Peabody Energy's FY 2018 Adjusted EBITDA. This way, you can see the price, units, and EBITDA margin per ton for each segment as well as the big drivers of that $1.38 billion of Adj. EBITDA. That said, FY 2022 met volumes will not be anywhere close to 11 million tons.
Source: Author's Chart utilizing Peabody's FY 2018 10-K
Next, and this is straight from Peabody's FY 2018 10-K, enclosed below are the average benchmark prices for various coal indices during 2018. Most, but not all, of Peabody's seaborne met is PCI coal, so this isn't the Premium Hard Coking Coal.
Moving along, again for your perspective, enclosed below is the history of Peabody's production by mine (please note that the Middlemount is a 50% JV so production isn't reported in Peabody's 10-K).
My next step was to get into the weeds and build a simple pro forma model of Peabody's 2nd half FY 2021 Adj. EBITDA. I did this by very closely reading its Q2 FY 2021 earnings call as well as reviewing its Q2 FY 2021 earnings release. If you look at the level of detail, and I will share two excerpts from BTU's Q2 FY 2021 conference call, I think you will see I built a good high-level model (this isn't half-baked).
To show you I've done my homework, before you review the model, please review a few excerpts from Peabody's Q2 FY 2021 conference call.
In the second half, we anticipate higher seaborne thermal volumes and expect to ship 9 million to 10 million tons between 5 and 6 million export tons, of which 3 million to 4 million tons are unpriced. Costs are expected to nudge higher with a greater mix of Wambo Underground tons and higher expected royalties. Wilpinjong volumes are expected to increase to over 7 million tons with 3.7 million export tons and finished the year strong.
Seaborne met volumes remain contingent upon a restart at Shoal Creek. Metropolitan is expected to ship up to 800,000 tons in the second half and CMJV volumes are expected to remain strong, approximately 2 million tons.
Yes, Nathan, it's Mark. I'll take a stab at this. Again, looking at 2 million tons for the CMJV in the second half and up to -- about 800,000 tons from Metrop, CMJV generally produces a benchmark PCI product. That's near $145 a ton today. Metrop produces really a blend, a soft hard coke -- semi-soft coking coal and a PCI blend. We probably realized about 80% of the premium hard coking coal benchmark from a pricing perspective on that. With a little over 2 million tons on price for the remainder of the year, there's certainly some upside here in the portfolio on prices given the current conditions. There is a bit that is priced. There's probably about 400,000 tons of the CMJV currently priced at about $100 a ton.
Here is My 2nd Half FY 2021 Pro Forma EBITDA Model
As you can see, I am modeling upwards of $569 million of second half FY 2021 EBITDA and one could argue that my assumptions are somewhat conservative.
Source: Author's model based on Q2 2021 conference call
Also, although much harder, and of course prices can change, I put together a quick FY 2022 pro forma model. Again, my assumptions are conservative, especially in light of where seaborne met and seaborne thermal are presently trading. That said, Peabody's Coppebella and Moorvale mines are mostly PCI, which often trades behind, to well behind, premium hard coking coal. Per Peabody's management, its Metropolitan mine is a mix of soft and hard coking coal and generally gets 80% of HCC prices. On the seaborne thermal side, at Wilpinjong, Peabody has domestic volumes, which get a much lower price than export volumes. The export volumes at world-class Wilpinjong mine tend to trade at a slight discount to AP5, and AP5 usually trades well behind Newcastle seaborne thermal. As for Powder River Basin coal, these are mostly annual contracts, so almost all of FY 2021 PRB coal was sold at very lousy prices of $11.06 per short ton. That said, I am assuming Peabody can get $12 per short ton in FY 2022 given where natural gas is trading.
Peabody has a decent amount of debt, and this is expensive debt because they had to roll $459 million of March 2022 debt via an exchange offered at 8.5% and 10% interest rates. Starting mostly in Q2 2021 and as recently as last week, Peabody's management has been selling equity and doing debt for equity exchanges. By the way, besides very low spot coal prices due to the initial Covid impact, this $459 million March 2022 debt was the primary reason why shares of Peabody Energy briefly traded sub $2 per share. I'm not sure many speculators fully understood or, even today for that matter, have fully worked out that this was the reason. Let's face it, the wolf was at Peabody's door and the possibility of default and a second bankruptcy was a real risk, again, hence why its stock traded so low.
Given where seaborne met and thermal are trading today, these debts for equity swaps are somewhat puzzling, frustrating even. That said, there are covenants in its capital structure such that 100% of Wilpinjong free cash flow has to go to retiring collateralized debt tied to that mine.
As of August 2, 2021, per the filing of its Q2 FY 2021 10-Q, Peabody had 114.3 million shares outstanding. It is a little tricky to precisely track Peabody's share count in real-time, as Peabody issued an 8-K earlier in the week that they swapped more equity for debt, when the stock was in the $13s, so I will just assume 120 million shares outstanding.
$17 per share x 120 million shares equals a $2.04 billion market capitalization. As of June 30, 2021, Peabody had $548 million of cash and $1.42 billion of debt, so excluding pension and reclamation liabilities, we are talking about an enterprise value of about $2.9 billion. By the way, Peabody has to maintain strong liquidity as it posts letters of credit and surety bonds, because coal is so hated. And as I mentioned earlier, no question, Peabody's debt is expensive, especially in such a low interest rate world, but we are talking about coal and ESG.
1) Outside of the standard risks that thermal coal is in secular decline, at least in the U.S., future coal prices are always unknowable, volatile, and an uncertainty.
2) Elliott Management took a massive equity stake in Peabody via its ownership in Peabody's unsecured and secured debt just before and after its Chapter 11 filings. Elliott has been reducing its exposure, albeit opportunistically and slowly. And if you read Elliott's latest SC 13 filing, they also sold covered calls for October 15, 2021 $15 and $16 calls to the tune of 750K shares per tranche.
3) China might not blink as the 2022 Winter Olympics are coming up and there is a lot of ESG pressure to clean up carbon emissions and air quality.
Other Things To Consider
Management guided the street to $50 million to $60 million of reclamation cash outflows in 2021 and for a few years as well as $30 million of pension/ OPEB cash outflows, also for a few years. So FY 2021 interest expense was guided to $190 million and FY 2021 CAPEX was $200 million as this was a big growth investment year with an emphasis on growing seaborne thermal and seaborne met production (in this case, Peabody's Management had great timing, for once).
So if you think about FY 2022, if my pro forma Adj. EBITDA numbers are reasonable, when you do your free cash flow calculations, just keep in mind that we need to back out $90 million of reclamation/pension/OPEB, assume about $125 to $150 million of FY 2022 CAPEX, and perhaps $200 million interest expense (depending on how much debt gets exchanged or retired via robust 2nd half FY 2021 cash flow).
Putting It All Together
The objective of this piece was to share my detailed pro forma Adj. EBITDA for the second half 2021 and FY 2022. No question the biggest x-factor is trying to work out the odds that China blinks and imports Australian coal, even if it is for three months and to tide them over for winter. Again, I am not smart enough to think I can pretend to know what China may or may not do. That said, given the uniqueness of this setup, it is plausible that China might be forced to import Australian thermal. Moreover, with the record seaborne met and seaborne thermal prices, we have clear signals that global coal inventories are thin and demand remains solid.
Even though Peabody's Australian coal has some nuances to it, this isn't pure HCC and its Wilpinjong export coal volumes get AP5 prices, not Newcastle prices, the NPV of Peabody's shares is off the chart with where spot prices are presently trading. Moreover, in light of these spot prices, I would argue that my 2nd half FY 2021 pro forma Adj. EBITDA estimate is fairly reasonable/conservative based on management's guidance and my pro forma FY 2022 pro forma is equally, if not more so, conservative - in the context of the present spot prices and current supply and demand backdrop.
Either way, this is my thought process for taking this tactical bet from zero percent of my portfolio to 14% last week (the week of September 27th at an average cost basis of $13.79).
Second Wind Capital is a value oriented investment service with a strong recent track record of exceptional outperformance. The focus is mostly small cap value, but opportunistic and open minded towards special situations. In 2020, the total return of the portfolio was +93%. Through September 30, 2021, my portfolio is up +88%.
This article was written by
I actively invest my own capital and for a few family members.
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