| 2013 | 2014 | ||||||
| Price: | 2.50 | EPS | $0.00 | $0.00 | |||
| Shares Out. (in M): | 36 | P/E | 0.0x | 0.0x | |||
| Market Cap (in $M): | 90 | P/FCF | 0.0x | 0.0x | |||
| Net Debt (in $M): | 701 | EBIT | 0 | 0 | |||
| TEV (in $M): | 791 | TEV/EBIT | 0.0x | 0.0x | |||
| Borrow Cost: | NA | ||||||
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Trade Recommendation: Capital Structure Arbitrage:
Buy 7.785% Senior Notes ’19 at 50c (15.5% current yield)
Short 4.5% Convertible Notes ’15 at 40c (11.3% current yield)
Adj. EBITDA ($ million) 143 61 (22)
TEV/EBITDA 5.5x 13.0x n/m
Net Leverage 4.8x 11.5x n/m
Gross Leverage 5.9x 14.0x n/m
Market Value $90 million
Senior Opco Debt(1) $142 million
Senior Unsecured Debt(2) $364 million
Senior Convertible Notes(3) $346 million
Cash (as of Q3-2012) $151 million
Enterprise Value (TEV) $791 million
_________________
(1) Off balance sheet $142 million Surety Bonds – approx 2/3rds asset retirement obligations, 1/3rd workers’ compensation; (2) Includes $270 million 7.875% Senior Notes due 4/1/19, $33 million workers’ compensation (not included in Surety) and $61 million Black Lung liabilities; (3) 4.5% $141 million Senior Convertible Notes due 12/1/15; 3.125% $205 million Senior Convertible Notes due 3/15/18.
I am bearish on James River Coal (JRCC), specifically on the company's thermal coal operation in Central Appalachia (CAPP), and expect the company to file for bankruptcy (again) in the next 12-18 months. I recommend a capital structure arbitrage trade as the asymmetrical play rather than an outright short. I view the 10 point spread between the 7.875% Senior Notes '19 (Seniors) and 4.5% Convertible Notes '15 (Converts) as significantly mispriced and expect it to be materially wider going forward. I believe the Seniors are the fulcrum security in the capital structure while the Converts are an expensive option on a coal price recovery. Although the company’s cost and price pressures are well known, namely its disadvantaged marginal operating position as the highest cost public coal producer in the CAPP region and participating in an industry facing structural downward pressure in thermal coal prices, I think the reason for the mispricing of the spread between the two notes is as follows:
(1) Converts are overvalued – given JRCC’s healthy liquidity profile and the lack of near-term restrictive covenants, the Converts are discounting a recovery in CAPP thermal prices before the company runs out of cash and the prospect of further debt buybacks – the Converts at 40c are pricing in my bull case. In my base case, however, the company runs out of liquidity by Q2-2014 and the Converts have no asset value support; and
(2) Seniors are fairly valued- the Seniors at 50c are discounting my base case. They have opco guarantees, downside protection in the company’s CAPP Met and ILB Thermal businesses, and also benefit from a potential recovery in CAPP Thermal coal.
The spread widening trade is a bet on my base case! The trade also provides positive carry on a current yield basis until the company files.
JRCC is a coal mining company that mines, processes and sells thermal and met coal through eight mining complexes located in eastern Kentucky, southern West Virginia and Indiana. JRCC’s mining complexes include 25 underground mines, 12 surface mines and 14 preparation plants. The company has three main businesses: CAPP Thermal Coal (53% of tons sold), CAPP Met Coal (23%) and ILB Thermal Coal (20%). Substantially all the company’s coal is sold to electric utilities, steel companies and industrial markets. In FY 2011, the company had 363 million tons of proven/probable coal reserves and sold ~11.8 million tons which generated $1.2 billion in revenue, $143 million in EBITDA and $(39) million in net loss. The company has a union-free workforce of 2,300 employees.
Recent History:
Since emerging from bankruptcy in 2004, the company has struggled on an operating basis. Besides 2009 and 2010, JRCC has lost money every year since its emergence. The combination of high unit cost mining operations and increasing balance sheet leverage led to perennial net losses and recurring negative free cash flow. In 2007, the company made a high risk decision to go into 2008 with a largely uncontracted position. The gamble paid off when CAPP thermal coal prices more than doubled during 2008 (driven by higher exports and a spike in the price of substitute fuels like nat gas to $13 per MCF and Brent crude to $140/bbl) and the company locked in some very lucrative multi-year contracts. As such, the company generated net income of $51 million and $78 million in 2009 and 2010, respectively. Management used this temporary window of strength to acquire International Resource Partners LP for $516 million in April 2011 (arguably the peak at over 6x EBITDA). While the acquisition was transformative in many respects and added much needed met coal exposure to the company’s suite of thermal coal, it also saddled JRCC’s balance sheet with significant leverage. During 2H2011 and 2012, the combination of multi-year contract roll-offs and materially lower price realizations once again exposed JRCC’s structural disadvantage as a high marginal cost coal mining operation with very limited flexibility to reduce expenses. In addition, CAPP is a mature basin which is become increasingly expensive and difficult to mine because of the lower yielding seams, escalating costs and stringent permitting and safety regulations.
Current Situation: Over the last two years, both thermal coal and met coal prices have experienced significant downward pressure mainly due to macro and technological forces outside the industry’s control.
The company’s profit margin between average price realization and cash cost has declined from $20 per ton in Q2-2011 to $6.40 per ton in Q3-2012. Including SG&A of $4.60 per ton, EBITDA per ton in the most recent quarter was modestly positive at $1.80. As a result of these revenue pressures and the limited flexibility to reduce its cost curve, the company has been burning cash and seen its cash on balance sheet decline from $209 million in Q3-2011 to $151 million in Q3-2012. The margin hit experienced by JRCC is reflective of the industry’s woes. In 2012, coal companies responded by idling the highest cost mines and reducing production by about 70 million tons (or ~7% of annual production) to 1.03 billion. Utilities still have 80-90 days of coal inventories, about 20-30 days more than normal, so a further production cut of ~70 million tons is warranted before we see price stability. JRCC’s CAPP Thermal mines operate at the high end of the marginal cash cost curve and are being subsidized by positive cash flow from the company’s CAPP Met and ILB Thermal segments.
What now? Potential Scenarios: Going forward, I see 3 broad possible scenarios: (1) Base case: No price recovery in short-term – status quo, the company restructures (in or out of court) in the next 12-18 months; (2) Bear case: Further price decline while industry continues to cut production – cash burn accelerates and the company has to restructure in the next 9-12 months; and (3) Bull case: Price recovery – happens while the company has sufficient liquidity; JRCC improves operating margins and stays out of bankruptcy for the foreseeable future (at least the next 2 years).
(1) Base Case: Assumptions on unit economics and key value drivers:
- Production: No significant change to capacity utilization and annual production levels.
- Average Price Realizations: Met coal stays in the $115/ton to $125/ton range, averaging ~$120/ton; CAPP thermal drops slightly from $79/ton in Q3-2012 to $75/ton; ILB thermal coal remains in the $45/ton context.
- Cash Costs/Ton: Management has already reduced the work week from 50 hours to 40-45 hours and cash costs remain at $77/ton.
- Capital Expenditures: On the Q3-2012 conference call, the CEO stated that $20 million per quarter is “barebones” capex to maintain current capacity.
- Asset-Based Revolver: As of Q3-2012, the company had ~$20 million available (used $61 million of the $80 million available to secure outstanding LCs). If unrestricted cash plus revolver availability falls below $35 million, company has to comply with 1.1x Fixed Charge Coverage Ratio financial covenant (which it will almost certainly violate).
- New Term Loan: Senior Notes have a carveout for $175 million secured debt; I assume $80 million is taken up by the Revolver (which is collateralized by working capital) and company obtains a new $95 million term loan in Q1-2013 which is secured by PP&E which primes the Seniors and Converts.
- Senior Notes: expect the company to violate its 2x Fixed Charge Coverage Ratio incurrence test in Q4-2012; though not material from a liquidity standpoint (given secured debt carveout), the company is not permitted to buy back debt subordinated to the Senior Notes.
- Result: Company burns through liquidity in Q2/Q3-2014.
2011 2012E 2013E Q1-14E Q2-14E Q3-14E
Tons Sold (million) 11.8 12.0 12.1 3.0 3.0 3.0
Average Price/ton $93 $86 $79 $79 $79 $79
Cash Cost/ton $76 $77 $77 $77 $77 $77
($ million)
Revenue 1,105 1,041 965 241 241 241
Adj. EBITDA 143 61 (22) (9) (9) (9)
Cash Interest 36 36 40 10 10 10
Capex 138 89 80 20 20 20
Pre-Tax FCF (32) (64) (142) (38) (38) (38)
Cash/Liquidity (incl new term loan in Q1-2013) 142 95 57 18 (20)
There is significant excess thermal capacity in the system and electric utilities are still working down high stockpiles. In addition, recent weather conditions have not stretched utilities to increase their coal burn. Larger coal producers, especially operators in less mature basins like PRB and NAPP, have significantly lower marginal cash cost per ton and can generate positive operating margin at a lower equilibrium coal price. In this case, I assume CAPP Thermal declines to $65/ton and CAPP Met drops to $105/ton. The company violates the Fixed Charge Coverage Ratio in the Revolver and runs out of liquidity in Q3/Q4-2013.
(3) Bull Case
The CEO on the Q3-2012 earnings conference call said: “we do think a material (thermal) price recovery is forthcoming….(the supply-demand rebalancing) is in the 4th or 5th inning, so we don’t exactly know the timing”. Management continues to be bullish on thermal coal prices based on declining natural gas rig count and dissipating storage overhang. On the met coal side, high quality coking coal has traded up to $170/ton in January 2013 from $145/ton in Q4-2012 due to a combination of re-stocking from a low inventory base and some seasonal adjustment. JRCC’s brand of met coal is HIGH-VOL B, which is lower quality coking coal and trades at a material discount to higher grades. In this case, I assume CAPP Thermal increases to $90/ton and CAPP Met jumps to $130/ton. The company is still burning $10-20 million in FCF per year but has sufficient liquidity for the foreseeable future.
In two out of the three cases, the company hits a liquidity wall and has to restructure in the next 12-18 months.
Investment Process:
I believe the market is overestimating the strength of the company’s liquidity profile based on management’s recent public market debt purchases, $171 million of available liquidity and a carveout in the Seniors for an additional ~$95 million of secured debt. In Q3/Q4-2012, management bought back $61 million of debt: $5 million face value of Seniors and $56 million face amount of 4.5%/3.125% Converts for $24 million (average price of 39c). This would imply a price of ~50c for the Seniors, ~40c for 4.5%s and ~36c for the 3.125%s. Given that +90% of the debt repurchases were in the Converts, the market is discounting a continued backstop and pricing in my bull case. The Seniors, however, continue to reflect my base case. I expect the company’s liquidity profile to deteriorate significantly while waiting for a price recovery and the spread between the Seniors and Converts to widen materially to more accurately reflect the fundamental value of both classes of securities. In my base case recovery, the Seniors are worth 44c and Converts recover 0c.
2) What is the level of mispricing? Significant! +30 points
Recovery analysis based on sum-of-the-parts – it is important to remember that SOTP analysis is only relevant in a break-up/asset sale scenario. While the company discloses its financials in two segments, CAPP and Midwest, I believe there is sufficient mine-level disclosure to separate the company into three distinct segments: CAPP Thermal Coal, CAPP Met Coal and ILB Thermal Coal. Of the company’s eight mining complexes, two are dedicated to met coal, one is based in South Indiana (ILB) and the remaining five are located in East Kentucky (CAPP) and focus on thermal coal operations. JRCC is in a situation where two cash generating businesses (CAPP Met, ILB Thermal) are subsidizing significant cash burn in the bad business (CAPP Thermal).
CAPP Met Coal: Bear Base Bull
Total Shipments (000s) 3,000 3,000 3,000
Price/Ton $105 $120 $130
Cash Cost/Ton $95 $95 $95
Spread/Ton $10 $25 $35
EBITDA pre-SG&A (million) $30 $75 $105
Multiple 5.0x 5.0x 5.0x
TEV (million) $150 $375 $525
ILB Thermal Coal: Bear Base Bull
Total Shipments (000s) 2,750 2,750 2,750
Price/Ton $37 $45 $50
Cash Cost/Ton $37 $37 $37
Spread/Ton $0 $8 $13
EBITDA pre-SG&A (million) ---- $22 $36
Multiple 4.0x 4.0x 4.0x
TEV (million) ---- $88 $143
CAPP Thermal Coal: Bear Base Bull
Total Shipments (000s) 6,400 6,400 6,400
Price/Ton $65 $75 $90
Cash Cost/Ton $80 $80 $80
Spread/Ton (15) (5) $10
EBITDA pre-SG&A (million) $(96) $(32) $64
Multiple 3.0x 3.0x 3.0x
TEV (million) n/m n/m $192
Given the recurring cash burn associated with operating a marginal business that has a negative operating spread and costs $5-6/ton in capex to maintain current capacity, absent a recovery in CAPP coal prices, I expect management to significantly reduce exposure to CAPP Thermal in 2014.
Adding it all up: Bear Base Bull
($ million)
Total Enterprise Value 150 463 860
Plus cash (incl LC collateral release) 40 40 40
TEV 190 503 900
Less:
Secured/Opco Debt:
- Revolver Draw 80 80 80
- New Term Loan 95 95 95
- Surety Bonds 142 142 142
- Pension Obligations 26 26 26
343 343 343
Recovery to Secureds: 55% 100% 100%
Residual Value: n/a 160 557
Senior Debt:
- 7.875% Senior Notes 270 270 270
- Workers’ Compensation 33 33 33
- Black Lung Liabilities 61 61 61
364 364 364
Recovery to Seniors: 0% 44% 100%
Residual Value: n/a n/a 193
Convertible Debt:
- 4.5% Notes 141 141 141
- 3.125% Notes 205 205 205
346 346 346
Recovery to Converts: 0% 0% 56%
Trade: 1 x 1
Long Seniors 50c 0c 44c 100c
Short Converts (40)c (0)c (0)c (56)c
Spread 10 points 0 points 44 points 44 points
Gain / (Loss) in bond points (10) 34 34
3) What are the revaluation catalysts?
i) Q4-2012 drop in liquidity: the cap structure arb trade is a bet on the base case where management continues to burn cash for the next 4-6 quarters while waiting for a price recovery. When management reports quarterly results on March 7th, I expect the company to burn ~$30 million during Q4 and liquidity to drop to $140 million (prior to a new term loan) from $171 million in Q3. The sudden drop in available liquidity and an expectation of a more challenging 2013 versus 2012 may cause the Converts to start pricing in the base case.
ii) An operational restructuring: the company takes action to shut down its cash burning CAPP Thermal operations and conserve cash flow. Management seems to have significant inertia to undertake the necessary restructuring given that 80% of the 363 million tons of proven/probable reserves is attributable to CAPP Thermal.
iii) The bull case also presents a spread widening opportunity: assuming production levels normalize and prices begin to improve, the company should generate $100-120 million in run-rate EBITDA. On a pure recovery basis, the spread should jump from 10 points currently to +40 points. In the interim, however, given the ~3x leverage difference between the Seniors and Converts, the Seniors (covered in this case) could arguably trade at a 500bps YTM premium to the Converts (still impaired). Assuming 10% YTM on the Seniors and 15% on the Converts, the Seniors should trade at 90c while the Converts trade up to 75c.
4) What are the risks to the investment? 10 points downside (current spread)
The two tails - bear and uber bull:
In either case, it is unlikely the spread will recalibrate to 0 overnight. If prices begin to recover or decline further, my expectation is that the rate of change will be slower than what the industry has experienced over the last 4-5 quarters given the lower base of annual production (bear case) and prevailing ~30% spread between nat gas and coal prices (uber bull case).
(i) Production cut – I am not assuming any production cuts for the next two years. Thereafter, if the company runs out of cash prior to a price recovery, I expect management to significantly reduce its exposure to or even exit the CAPP Thermal business entirely. It is worth noting that shipments to Georgia Power Company (GPC) accounted for 11% of the company’s 2011 revenue. GPC has been reducing its reliance on coal and adding new nat gas-fired units to replace older coal units at certain facilities. GPC has regulatory approval to decertify two coal-fired generating units in 2013. Any reduction in demand from existing customers and a prolonged delay in replacing those customers would obviously erode the company’s ability to absorb fixed costs and squeeze operating margins further.
(ii) Stricter regulation – we have seen an unfavorable impact of stringent government regulation on CAPP-based producers due to the tighter safety rules in mining mature, thinning coal seams in underground mines. If we see more fatalities and tougher regulation, maintenance capex for CAPP operators will almost certainly rise.
(iii) Liquidity hit - The company currently has sufficient liquidity to wait 12-18 months for a recovery in coal prices. Hence, any macro, industry or company-specific events that limit the company’s access to capital and accelerates cash burn would obviously be very detrimental to the company.
Summary:
Mispricing – the spread is dislocated because the Seniors are discounting my base case while the Converts are pricing in the bull scenario where sufficient liquidity in the near-term leads to solvency in the longer-term.
Valuation – spread is 10 points, should be +40 points – 10 points downside / +30 points upside.
Catalysts – the base case: uncompetitive company facing secular industry headwinds; expect poor Q4-2012 performance and a challenging 2013/2014; prospect of covenant violation and liquidity crunch in next 12-18 months.
Main Risks – the bear case or the “uber bull” case where the spread collapses.
Free Options – production cut; tighter regulation; reduced access to capital
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