International Coal Group ICO
January 26, 2007 - 12:16pm EST by
2007 2008
Price: 4.70 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 722 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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International Coal Group (ICO)
International Coal Group (ticker ICO) presents an attractive opportunity to buy a beaten-down and neglected stock at a significant discount to both its peers and the value of its underlying coal reserves. The stock price is currently depressed due to a “perfect storm” of bad news for the company throughout 2006 and negative sentiment around declining coal prices.

International Coal Group (“ICO” or the “Company”) is a coal producer of mid- to high- BTU, low-sulfur (high quality) steam and metallurgical coal.  Steam coal is primarily used by utilities for the generation of electricity.  Metallurgical coal is used as a key raw material for coke, which is used in the steel making process.  ICO operates primarily in the Appalachian region of the Eastern U.S., with mining operations in West Virginia, Kentucky, and Maryland.  The firm also operates a mining operation in the Illinois Basin, producing mid-to-high sulfur steam coal.  ICO operates 11 active underground mines (6 Central App, 4 Northern App, 1 Illinois), 12 active surface mines, and 7 preparation plants.
ICO was formed in May 2004 by an investor group led by Wilbur Ross.  In October 2004, the company acquired 5 major mining complexes and substantial reserves from the bankrupt Horizon Natural Resources at public auction.  The assets were acquired with a $290 mm cash bid (with A.T. Massey) and a $482 mm credit bid for 2nd lien Horizon bonds.  ICO also paid an additional $6.25 mm at closing for administrative expenses.  Ross bought only the physical assets of the mines, leaving behind the outstanding liabilities.  Horizon’s $87 mm deficit pension plan was assumed by PBGC in 2004, and ICO is not bound by the Coal Act, which would have greatly increased the legacy healthcare costs for retired workers.  These events left ICO without any significant legacy debt and a much stronger balance sheet than their competitors.

             Legacy Liabilites          Debt/Capital
                  ($ mm)      
Alpha               110                   65%
Alliance            116                   36%
ICO                 119                   23%
James River      120                   60%
Arch                 320                   49%
Massey            409                   60%
Foundation       772                   78%
Peabody           2,298                59%
Consol             3,553                75%

Legacy liabilities include post retirement benefits, black lung liabilities, reclamation liabilities, workers compensation, and Coal Act liabilities.                                                                               
ICO’s work force is 100% union free, and the company is led by a management team with an average of 25 years in the coal industry, including experience at Arch, Horizon, Alpha Natural Resources, and James River Coal.

In November 2005, the company completed the acquisitions of Anker Coal Group (for 14,840,909 shares of stock) and CoalQuest (for 9,250,000 shares of stock), which added 5 additional mining complexes and boosted reserves by 75%.

ICO came public on November 21, 2005 at a price of $11.00/share, and in December 2005 completed a $231 mm equity offering.  The stock price is currently near $4.80 (as of November 28, 2006), 56% below its IPO price.  The current enterprise value of $888 mm represents a 15% discount to the purchase price of the distressed assets (assuming an $11 stock price at the time of the Anker and CoalQuest mergers).

A key part of the potential upside to this story is the Wilbur Ross factor.  Ross has a history of purchasing distressed assets in unloved industries (such as steel, textiles, and auto parts), orchestrating a turnaround through cost-cutting and operational improvements, and later selling the companies at a huge profit.  Ross’s International Steel Group was sold to Mittal Steel for $4.5 B in 2002, a multiple of 14 times his original investment in less than 2 years.  Like steel, coal has been an unloved industry for many investors (but not those who purchased Ispat at $2 in 2002 and sold it at $40 in 2004 when it was acquired by Mittal).

WL Ross & Co. currently owns 24.5 mm shares of ICO, or about 16% of the total shares outstanding.  The firm made significant purchases of 2,000,000 shares on June 13, 2006 (at prices ranging from $6.51 to $6.90/share), and another 1,549,000 shares on June 14 at prices ranging from $6.86 to $7.00/share.

Insiders have been buying stock throughout 2006, with 8 insider buys on the open market since June 2006, all at prices above $5.12.  The company’s CEO, Ben Hatfield, has made three recent open market share purchases, and all 8 top executives own shares in the company.  Stock options were issued during 2006 to purchase stock at a weighted average exercise price of $8.20/share.  In total, insiders (including WL Ross & Co.) own approximately 35% of the company’s shares, aligning their interests with other shareholders.
The company is led by a Board of Directors with significant experience in the power and coal industry, as well as representatives from several strong investment management firms with significant economic interest in the company:

• Wilbur L. Ross; Non-executive Chairman (WLR owns 24,537,423 shares)
• Bennett Hatfield, ICO’s President and CEO (owns 381,000 shares)
• Jon Bauer, Managing Partner of Contrarian Capital Management (Contrarian owns 11,032,565 shares)
• William Catacosinos, Managing Partner of Laurel Hill Capital Partners; Chairman and CEO of Texas-New Mexico Power
• Marcia Page, Managing Partner of Varde Partners, a distressed debt investment management firm (Varde owns 6,373,755 shares)
• Cynthia Bezik, financial consultant; she was previously SVP Finance and CFO at Cleveland-Cliffs from 1997 – 2003
• Wendy Teramoto, Chairman of the Board of Anker and CEO of CoalQuest.; she is a VP at W.L. Ross & Co.

The Coal Industry:
The United States produces over 20% of the world’s coal and is the second largest coal producer in the world (after China).  Coal-based power plants currently produce approximately 50% of the electricity generated in the U.S. each year, and this is expected to increase to 57% per Energy Information Administration (EIA) projections.  Coal is a preferred input for electricity generation as it is both low-cost and abundantly available.  On a relative basis, coal costs significantly less than natural gas or oil on a per KwH basis ($2,185 versus $6,614 for natural gas and $7,766 for oil).
The coal industry is defined geographically by 3 major regions of coal production, with each area having different coal characteristics, and transportation hurdles.

The Appalachian region consists of Northern Appalachian (NAPP) and Central Appalachian (CAPP) operations.  Appalachian coal is regarded as the cleanest (lowest sulfur content) and hottest burning (highest BTU) coal.  It is also the most expensive.  This type of coal is currently the majority of ICO’s production.  Appalachian coal mines are also typically located closer to end user utility markets in the Southeast.  Appalachian coal typically sells in the $40 - $60/ton range.

Powder River Basin coal is the least expensive type of coal.  It is also generally high in sulfur (“dirty”) and lower BTU, requiring more PRB coal (about 1.5 times) to generate the same energy as Appalachian coal.  PRB coal also faces higher transportation costs (primarily via railroad) to transport the coal to the end-user utilities.  PRB coal usually sells in the $12 - $20/ton range.

Illinois Basin coal is a potentially attractive story as it is high BTU and high sulfur.  Although the high sulfur content is typically a bad thing due to increased pollution, new EPA emissions standards due by 2010 may require more utilities to install S02 scrubbers or purchases emissions credits on the open market.  Scrubbers reduce sulfur dioxide emissions by 50 – 90%, and emissions credits allow users to emit a predetermined amount of sulfur dioxide.  These new standards would allow compliant power plants to reap the benefit of the higher BTU but lower cost (due to high sulfur content) Illinois Basin coal.  Illinois Basin coal production has been the fastest growing since 2004.  ICO is attractively positioned in the Illinois Basin with 496 mm tons of reserves (47% of their total).

Growth Opportunities for International Coal:
Overall electricity demand increases at 1 – 3% annually, and coal is the biggest input for electricity generation.  A general economic expansion bodes well for coal demand, with several large U.S. utilities planning future expansion projects.  ICO has a diversified customer base across regions, with the three largest CAPP customers being Georgia Power, Duke Energy, and Carolina Power and Light (the company has long-term 5 year contracts with all three of these utilities).  The three largest NAPP customers are American Electric Power, PP&L, and Allegheny.
• Duke Energy (ICO customer) is pushing for a $3B investment in two plants (Cliffside) stating they “need the capacity.”  These coal-powered plants will generate 2,800 MW.
• Duke Energy is also looking at the possibility of a $2.1 B coal gasification plant in Indiana which would be more environmentally friendly.

The Energy Information Administration projects U.S. demand of 1,948 mm tons of coal by 2030, up from ~ 1,185 in 2003.  EIA also estimates that world coal consumption will nearly double from 2003 to 2030, with coal’s share of world energy consumption increasing from 24% to 27%.

In addition to increases in global energy demand, ICO has significant internal growth opportunities with several planned expansion projects.  Although the company has trimmed its cap ex projections for the next 3 years, it will focus only on those projects which it believes will add the most immediate value and cost benefits. 

Several of the key expansion projects are as follows:
• Raven Complex (2006 Q3 start-up with an additional 1.2 mm tons annually)
• Sentinel Clarion Mine (0.8 to 1.0 mm tons annually)
• Beckley (opening mid-2007 to produce 1.3 mm tons annually of metallurgical coal)
• Tygart No. 1 (production in mid-2008 at 3.8 mm tons annually high-quality steam and metallurgical; this site features 200 mm tons of reserves in 2 deep mines.
These projects alone could add $376.5 mm in annual revenue assuming relatively conservative $45 steam coal and $60 metallurgical coal prices (and 50/50 steam and met production at Tygart).  ICO also has expansion opportunities with its Denmark Property (150 mm tons of reserves in Southern Illinois) and its Paw Paw Creek Property (100 mm tons in Southeastern Ohio).

“Our new 2006 projects, specifically Flint Ridge No. 2 Mine, Raven, and Sentinel Clarion, as well as our signature future projects, Beckley and Tygart No. 1, are expected to provide both long-term production growth and significant improvement in profit margins.” – Ben Hatfield, CEO during the 2006 Q3 conference call.

ICO recently bid $5 mm for selected assets of Buffalo Coal Company.  These assets would add additional coal reserves and mining permits, a preparation plant, and the rail load-out facility that ICO currently leases near their existing Vindex operations.
Overall, the company projects capital expenditures of $650 mm for the 2007 – 2009 period.  With a strong balance sheet and limited long-term debt, the company will also be well-positioned to take advantage of opportunities to acquire additional assets in a distressed environment (a model that Wilbur Ross has successfully implemented across other distressed industries).  Further industry consolidation would lead to increased pricing power and operating leverage for the remaining players.

ICO has also entered into an agreement with CDX Gas for the exploration and development of coal bed methane gas.  Methane can be cleanly burned as a fuel and is the principal component of natural gas.  Under a joint operating agreement between CoalQuest and CDX, ICO has the right to obtain up to 50% of the undivided working interest in each well drilled on property owned by Coal Quest.  Conventional natural gas fields in the eastern U.S. are typically located in sedimentary formations at depths of 2,000 to 15,000 feet.  In comparison, ICO’s coal seams which contain methane gas are typically less than 1,000 feet deep and are generally better formed than deeper formations, making extraction cheaper and easier.  This initiative has huge potential, and only first contributed to ICO’s results in Q3, with revenues of $0.3 mm from early drilling at two newly-developed coal bed methane wells.

Coal Reserves:
ICO’s coal reserves are some of the largest in the U.S.  The company controls over 1.0 billion tons of proven and probable reserves.  These reserves are approximately 70% steam coal and 30% metallurgical (which commands a higher price than steam).  In addition, the company has nearly 560 mm tons of coal resources, which are coal bearing bodies that have been sampled and tested but are not yet commercially viable until a final SEC evaluation takes place.

At current production estimates, the company’s reserves have a 72 year reserve life, the longest of any of the major U.S. coal players.  Furthermore, 72% of these reserves are owned and only 28% leased.  This not only reduces the royalty payments that ICO must make to the land owners but also provides a potential source of revenue from land which it could lease to other parties.  ICO’s average royalties paid amounted to $1.76/ton produced in 2005, where most competitors pay between $3.00 - $5.00/ton in royalties.  In addition, Peabody Energy pays production royalties on 62,330 acres of federally leased land of 12.5% of gross proceeds for surface-mined coal and 8% for underground-mined coal.

The following table analyzes the proven and probable coal reserves for competitors across the industry.  Reserves are broken down into coal type with pricing assumptions per ton of: CAPP $47.25, NAPP $43.00, Illinois Basin $34.00, PRB $10.15.

                 Reserves       Reserve Life   % Owned        Reserve Value     EV/Reserve Value
                 (mm tons)        (years)          (vs Leased)      ($ mm)                
Peabody        9,479              46              42%               214,946                 5.9%
Consol           4,546              65              56%               170,721                 3.9%
Arch              3,076               29              13%              52,525                   11.3%
Massey          2,260               52              16%              106,501                 2.7%
Foundation     1,708               26              45%              51,463                   4.3%
ICO                1,060              72              72%              42,158                   2.1%
Alliance           549                 26              5%                20,749                   6.6%
Alpha              490                 19              3%                22,726                   6.3%
James River     225                 24              7%               10,393                    3.1%
ICO’s EV/Revenue Value is by far the lowest of the group, and their percentage of reserves owned is the highest in the group.
2006 Financial Projections:
• $900 mm total revenues (versus $1.0 B previously projected)
• $65 - $70 mm EBITDA (down from $130 - $150 mm)
• 17 mm tons of production and 20 mm tons of sales (versus previous guidance of 18 mm tons produced and 22 mm tons sold)
• Loss of $10 - $15 mm, EPS of ($.07) – ($.10) (versus original guidance of $23 - $33 mm in net earnings and $.15 - $.21 EPS)
• Capital expenditures will likely be $200 mm for the year
• Total coal costs/ton for 2006 YTD are $43.04.  In Q3, costs increased to $46.24, 104% of total revenues.
• 2006 costs were negatively impacted by $51.7 mm through Q3 from the start-up costs of five new sites.  In addition, coal costs were also affected by sales which required ICO to initially pay freight and handling and then get reimbursed, which more than doubled freight and handling costs to $14.2 mm.

Currently, ICO estimates 17 – 19 mm tons of production and sales of 18 – 20 mm tons for 2007 (essentially the same as 2006).  Given the negative impact of several unusual events in 2006 and the near-term growth opportunities from ramping up production at newly-developed mines, these projections seem conservative.

Based on simple valuation metrics like P/E or EV/EBITDA, ICO does not appear cheap.  However, when you dig deeper and look at the company’s strong balance sheet and tangible coal assets, the company stands out as being very inexpensive on a relative basis to its peers.  The company has the lowest Price/Book and Total Debt/Equity values of any company in its peer universe.  ICO also has a relatively high level of Cash/EV.  However, the company’s stock is down 50% in the past 6 months, the worst performer of the group after James River Coal.

                     Mkt Value (mm)     EV (mm)       Price/Book    Price/Sales    EV/Sales       EV/EBITDA
ICO                     $722                   $888                 1.1              0.8              1.1                16.0
James River          $159                   $318                 1.6              0.3              0.6                 7.0
Alliance                $1,270                $1,370              5.6              1.4              1.5                 5.5
Alpha                   $986                   $1,440              3.4              0.5              0.7                 5.7
Foundation           $1,610               $2,200               4.5              1.1              1.5                 8.0
Massey                 $2,000              $2,920               2.8               0.9              1.3                8.2
Arch                     $4,870              $5,960                3.7              1.9              2.4                14.7
Consol                  $6,260              $6,630                5.1              1.8              1.8                8.7
Peabody               $11,100           $12,640               4.7              2.2              2.5               14.1

                    Cash (mm)    Cash/EV        Op. Cash Flow  (mm)   Total Debt (mm)        Debt / Equity
ICO                  $28.0         3.2%                  $51.2                          $194.0                        0.29
James River       $1.8            0.6%                 $39.5                          $161.4                        1.59
Alliance             $36.6          2.7%                 $226.5                        $144.0                        0.64
Alpha                $11.5         0.8%                  $276.3                        $464.0                        1.62
Foundation        $45.1           2.0%                $234.6                        $635.0                        1.79
Massey             $257.7        8.8%                  $183.7                       $1,100.0                     1.52
Arch                 $28.3          0.5%                  $276.0                        $1,120.0                     0.84
Consol              $215.6        3.3%                  $658.0                        $477.4                        0.39
Peabody           $317.4        2.5%                  $714.9                        $1,700.0                     0.72

From a normalized earnings power standpoint, 2009 should serve as a baseline as ICO’s upcoming expansion projects will be in place by late 2008 and many of the start-up costs which have hindered profitability thus far will no longer be relevant.
I estimate future baseline earnings in 2009 of $1.20 per share using the following conservative estimates:

* 18 mm tons of coal sales as starting point in 2007 (low end of projections)
* 2% annual coal demand growth from electrical plants
* Expansion projects completed by mid to late 2008 – Raven (1.2 mm annual tons of steam coal), Sentinel (0.8 mm tons steam), Beckley (1.3 mm tons metallurgical), and Tygart (1.9 mm tons steam, 1.9 mm tons metallurgical).  These projects add $376.5 mm in total coal sales at $45 blended steam and $60 met coal prices.
* Assumed coal sales prices: CAPP $47.25/ton, NAPP $43.00/ton, Metallurgical $60.00/ton, Illinois Basin $34.00/ton
* Breakdown of coal sales: 75% CAPP, 17% NAPP, 8% Illinois (2006 estimates)
* 152.1 mm total shares outstanding
* Coal production costs could be reduced to $37.50/ton with additional operating efficiencies and lower labor and transportation costs.  Resulting EBIT margins under these assumptions would be about 21%, within more mature peer ARLP’s recent range of 17 – 22% EBIT margins.

Applying a reasonable 8.5 multiple to the $1.20 EPS results in a stock price of $10.19, or nearly 120% above recent prices in the $4.70 range.

Reasons for the Discount:
•  ICO issued surprise profit warnings and lowered expectations twice in 2006 after cash costs for coal production increased significantly and production fell below initial projections.  ICO faced increasing costs from all key input costs such as diesel fuel and lube (a $9.5 mm expense increase 2006 YTD), steel, explosive blasting supplies ($2.8 mm increase), tires ($1.9 mm increase), repairs and maintenance ($2.6 mm increase), and contract labor ($2.0 mm increase). 
•  The company experienced several unusual events such as the closure of its Stony River deep mine, the bankruptcy of a key coal supplier, an extended construction outage at its Sentinel Mine, adverse geographical conditions at the Sycamore No. 2 mine, and a fire at the Illinois mining complex which resulted in one-time costs of $4.6 mm and idling of the mine (lowering production).  These events are unlikely to continue forever.
•  The stock appears expensive when viewed by traditional valuation techniques such as P/E or EV/EBITDA.  The negative earnings over the past 12 months will probably eliminate the stock from many investors’ radar screens.  However, it is important to consider the value of the company’s reserves and the competitive advantages that should improve the company’s operations going forward.
•  The coal industry is often unloved by investors looking for high ROIC and consistent profitability.  However, given the proper industry developments and time frame, contrarian investments in cyclical and troubled industries have provided huge returns for those willing to dig deeper.  Also, in a positive sign of improved discipline, coal companies have been quick to cut production during the recent price weakness in order to save costs and stop falling coal prices.
•  2006 saw the lowest coal prices in several years.  Spot prices for coal have been on a downward spiral since late 2004 after reaching historic highs.  High coal prices in 2004 and 2005 brought an increase in production from many marginal producers.  This increased coal supply and, in turn, brought lower prices.  Many of these higher-cost producers have since struggled with reduced margins and have shuttered production.
•   In 2006, milder than normal weather led to weak overall power generation, and the nuclear power plant fleet operated without any significant disruptions.  At some point this will turn around, and the long-term fundamentals for coal demand seem strong.  Had investors purchased Peabody Energy after the similarly weak 2001/2002 period for coal, they would have been rewarded with returns of nearly 600%.
•  The January 2006 disaster at the company’s Sago Mine, which killed 12 workers, brought a significant amount of bad publicity.  Initial findings concluded that an explosion was triggered by a lightning strike in a sealed area of the mine.  It appears that the result of this disaster will be a $15.2 mm impact to 2006 EBITDA, of which $11.7 mm was already incurred in Q1.  While there are ongoing investigations into exactly what happened, ICO’s internal probe revealed no obvious negligence and seems consistent with the preliminary MSHA and WV OMHST investigations to date.  The company maintains substantial insurance policies to provide protection against employer negligence.
•  There is a fear of increased coal supply from Chinese producers.  Coal is China’s primary energy source, and given the country’s growth prospects and increasing energy needs, it seems logical that China will first focus on fulfilling its own energy needs.  Coal exports from China have been declining, and in September 2006, China cut the tax rebate on coal exports to zero.  Transportation costs for coal imports are also significant, as coal has a very low value per ton.
•  ICO is not covered by many sell-side analysts and is often ignored in industry coverage.
•  Competitors operating in the Powder River Basin may benefit from lower prices and increased investment in railroads.  When the price of PRB coal gets low enough, it can be substituted for Appalachian coal and shipped to utilities on the East coast.  In addition, many Appalachian locations have become difficult to mine as the geologically “easy” coal has already been extracted.  Lehman Brothers estimates that the breakeven price for $50.00/ton CAPP coal is $17.25 for PRB based on the additional transportation costs and lower energy content per ton of PRB coal.
•  In the short-term, coal stocks tend to trade with momentum in the natural resource markets and, in particular, natural gas prices.  Cheaper natural gas prices below $5.50 would probably lead to marginal switching to natural gas in lieu of coal from utilities with dual-power source plants.  High natural gas inventories and sustained natural gas prices in the $4.00 - $4.50 range would hurt coal prices.  However, when natural gas prices get low enough, producers shut down rigs and curtail production to bring prices higher, thus creating a “floor” to natural gas prices.  Coal stocks fare better in periods of hot weather, when electricity usage increases from air conditioning use.  Hurricanes and natural disasters, which can hurt natural gas production and break pipelines, are short-term positives for coal.
•  The move toward more environmentally-friendly forms of energy could impact coal demand or investor sentiment.  However, coal can still be used in the “clean” production of electricity with the use of S02 scrubbers.  Also, coal gasification is a newer form of energy which produces less pollution.
•  The management team may not be able to successfully integrate their acquisitions in order to improve operational efficiencies and reduce production costs.


* Increased coal prices as demand catches up to reduced coal supply
* Increasing long-term demand for coal as a stable and abundant energy source. Improvements in clean coal technology could further improve coal's chances of being the energy source of choice for U.S. energy dependence.
* Significant expansion opportunities at new and existing mine locations, as well as acquisition potential from ICO's strong balance sheet
* Increased operating efficiencies as mines mature given ICO's ability to become the low-cost Appalachian coal producer.
* Improved industry dynamics from prudent mine closures and consolidation
* Settlement of Sago Mine lawsuits and waning headline risk from coal mine safety regulation
* Monetization of significant methane gas assets
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