WESTMORELAND COAL CO WLB
August 03, 2015 - 8:08am EST by
zipper
2015 2016
Price: 15.50 EPS 0 0
Shares Out. (in M): 18 P/E 0 0
Market Cap (in $M): 279 P/FCF 20 0
Net Debt (in $M): 1,000 EBIT 0 0
TEV ($): 1,279 TEV/EBIT 0 0

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Description

Overview

Westmoreland Coal (WLB) is a thermal coal mine operator which has a focused strategy of owning contracted and economically advantaged coal assets in the US and Canada.  Shares are trading at extremely depressed levels considering its cash flow generation of 15-20%+ contracted FCF yield, due to a combination of 1.) pervasively negative coal sentiment, 2.) technical factors and 3.) horrifically insensitive investor messaging.  We believe that the stock is easily worth twice its current trading value or more, but it may take 1-2 years for the story to play out, with more volatility to come, since the headlines are so negative at the moment.

WLB has previously been written up by vincent975 in June 2014, when it was trading in the 30's, and that entry is worth reviewing for more background.  We hadn't been able to get comfortable with the risk/reward at that time, but believe it is now very compelling at today's trading levels.  The fundamentals aren't very different from that time, but the situation has evolved quite a bit.

Description

WLB operates with a very different business model as compared to the rest of the coal industry.  While it does not have the lowest operating costs (since mines are subscale and widely dispersed), the company's mine production is economically advantaged for power plant customers, since mines are tied to specific power generation facilities or industrial load, and there is generally no substitute fuel source that is remotely price competitive.  A number of their assets are mine-mouth, meaning that the power plants are literally sitting on top of the coal mine and coal is fed via conveyor belt or truck.  For a small portion of their assets, the mines are not co-located, but still have a major transportation cost advantage vs. any other source of coal, resulting in an all-in cost that cannot be replicated by sourcing from major coal basins.  Replacing this coal supply with other sources would be very expensive due to the necessary capital outlay (ie. building rail link and terminal, or redesigning feeder/boiler to handle a different coal source).

Most of these assets are contracted to their generation customers, most of whom are either investment grade utilities themselves or entities which have contracts with investment grade utilities.  The company likes to brag that the weighted average life of these contracts is 10+ years, but it is important to note that this average is skewed by a few ultra-long-term contracts and that most expire between 2015-2022.  Contracts are cost plus or have escalators, and a few come with cancellation clauses.  These contracts, paired with the economic supply advantages of the assets themselves, provide an excellent baseline for cash flow visibility, but aren't without risk.

There's always a catch, and for WLB it is that these coal mines are captive to their respective customer by virtue of their co-location and high cost structure.  In other words, if the plant shuts down, there is no other buyer for the coal and the mine closes also.  Based on our experience in coal generation shutdowns and bankruptcies, the underlying coal supply contract counts for very little and reaching the facility's parent for compensation is a difficult path.  For an investor to believe in the WLB thesis, they must believe that the plants will continue to operate (at least for a little while longer, see financial discussion).  Please see asset-by-asset notes a little further below for why we see plant closures as low risk.  Essentially only older and uneconomical power plants get shut down, which is not the case for WLB's customers.

WLB owns an MLP, Westmoreland Resource Partners, (acquired last year, formerly called Oxford Resources) which is trading abysmally, due to 1.) MLP valuations in general in the face of rising interest rates and 2.) coal MLP valuations specifically.  In the interest of brevity, we will only say that it is an undersized MLP with some good, some junky assets and that WLB should put this MLP out of its misery.

Assets

WLB's coal mining assets in the US include:

  • Rosebud - serves Colstrip generation facility (owned by Talon/Puget, mine mouth, contracted to 2020, 2 of 4 units under study for decommissioning)
  • Absoloka - serves Sherburne generation facility (owned by Xcel, transportation advantaged, contracted to 2020, regulators have acknowledged plant's need for grid reliability)
  • Savage -  serves Lewis & Clark generation facility (owned by Talon, mine mouth, contracted to 2017, strong local regulatory support) and industrial demand 
  • Jewett - serves Limestone generation facility (owned by NRG, mine mouth, contracted to 2018, attractive position in dispatch curve)
  • Beulah - serves Coyote and Heskett generation facilities (owned by MDU/Ottertail, mine mouth, contracted through 2016, owner plans to build adjacent units)
  • Kemmerer - serves Naughton generation facility (owned by Berkshire, mine mouth, contracted to 2022, 1 of 3 units to convert to natural gas in 2017) and industrial demand

It is worth a deeper asset-by-asset review, but I'll try to sum things up as follows: Almost all of these plants are either owned by regulated utilities or entities that have power purchase agreements (PPAs) with regulated utilities.  These utilities are all investment grade and have no reason to want to shut down these plants, because 1.) the power they provide is cheap compared to alternatives - keeping rates low, 2.) the requisite environmental upgrades are in place, and therefore ongoing capex is minimal and 3.) they get paid according to how big their asset base is - less assets = less earnings.  For the one facility that truly runs merchant (ie sells into power markets), Limestone/Jewett, it has an excellent position in the dispatch stack such that it looks unlikely for it to become uneconomical in any reasonable commodity price environment.  The plants that has greatest near-term risk are Colstrip 1 & 2, which are very old units and require capex spend to keep compliant, and the Naughton plant, for which one unit is being converted to natural gas. 

WLB has recently signed an agreement with BHP to acquire the San Juan mine.  San Juan serves the San Juan Generating Station (owned by New Mexico utility PNM, operated as regulated utility asset).  The coal plant needs to be transferred from one PNM affiliate to another for the deal to go through, and approval is not expected until the end of the year.  All indications on the regulatory side suggest the regulators will approve the transaction.  Once this happens, the mine's coal supply contract goes into effect and would run through 2022.

WLB's coal mining assets in Canada include:

  • Paintearth - serves Battle River generation facility (owned by ATCO, mine mouth, contracted through 2022)
  • Sheerness - serves Sheerness generation facility (owned by TransAlta/ATCO, mine mouth, contracted through 2026)
  • Poplar River - serves Poplar River (owned by SaskPower, mine mouth, contracted through 2015 but renewal negotiations underway, brand new facility)
  • Estevan - serves Boundary Dam, Shand (owned by SaskPower, mine mouth, contracted through 2024, co-located with carbon capture facility being developed)
  • Genesee - serves Genesee (owned by Capital Power/TransAlta, mine mouth, contracted through 2055, brand new facility)
  • Coal Valley - serves seaborne market, which is doing terribly 
  • Activated Carbon - sells activated carbon internationally
  • Char - BBQ briquette supplier

Like the US assets, the Canadian assets are either owned by regulated utilities or by entities which have PPAs with regulated utilities.  There has been some agitation around provincial or nationwide coal legislation, but we believe that initiatives are preliminary and that any eventual coal legislation would entail a long transition period.

WLB also owns some money-losing assets/liabilities, most notably ROVA (loss-making plants which WLB is obligated to operate under contract through 2019) and Heritage (workers' comp, medical, other legacy coal mine rexpenses).

Financials and Valuation

Management has forecasted 2015E EBITDA of $235-$270 million, implying EV/EBITDA at ~5x.  (Note all financials discussed here are consolidated in terms of the MLP, as this is how it is reported and for all practical purposes, they are one entity in our view.)  Given some Q2 operational issues, weather and customer outages, plus what appears to be a cool summer season so far, we anticipate WLB will come in at or just below the forecast range, even though management has reaffirmed guidance.  EBITDA breakdown is approx. 62% US coal (incl. the MLP), 52% CA coal,  -3% Power, -5% Heritage and -6% Corporate. 

What is really key to valuation is the cash flow profile.  We emphasize that an investor in WLB should believe in a huge margin of error, because downside surprises do happen (operating issues, unexpected plant retirements despite economic operations, supply switching - search Beulah/Coyote, etc.) and we're unlikely to see upside surprises.  We model a few hypothetical outcomes for a sense of valuation:

  • An NPV of only their existing contracted business at 10% CoC (one could argue it is much lower for contracted assets) and assuming 6 years only (no sense guessing at what happens far into the future) gives us a base value of $12/share
  • Assuming that contracts are all renewed through the 6 year horizon only and then end gives us a value of ~$20/share
  • Alternatively, assuming not all contracts are renewed but that just half of EBITDA survive as going concerns past 6 years, we get to ~$30/share
  • Finally, if we find the business to be unusually resilient and everything goes to plan, we see valuation in the range of $50/share

To be conservative, we also net roughly $3/share for additional costs associated with coal liabilities in a shutdown scenario.

Overly complex math often leads us astray, so a simpler way to think about things is that management has estimated 2015 levered FCF at $60 million, or ~20% yield.  We see this CF target as very achievable and likely increases post the San Juan acquisition, though could also decline due to downside surprises.  So, we're looking at the equity value being paid off in about five years, and everything beyond is NAV optionality.  (The assets would still have significant NAV assuming their attached generation plants are not shut down because this FCF estimate does spend adequately on mine capex.)

Optically, debt is high at ~$1B due to WLB's empire-building, implying debt/2015 EBITDA of 4.8x (our forecast is more conservative than management guidance).  The good news is that there are no major debt maturities until 2018, and fixed charge and EBITDA covenants look well supported under all but the worst scenarios.

Why Is Price Depressed?

Coal is a four letter word today, with major long-only institutional investors tripping over themselves to divest.  Compound that with most of WLB's peers either in bankruptcy or rapidly approaching bankruptcy, and it is not surprising that the sentiment is very negative.

The CEO, Keith Alessi, did some good things early on, but has been less than stellar in his latest investor communications.  Particularly during the Q2 earnings call, he ranted about why the market was mispricing his stock and then said a few things that were baseline economically rational, but which shareholders heard as: 1.) we won't do share buybacks right now, 2.) we may issue equity to complete the San Juan deal, 3.) we don't want to pay down debt, 4.) we may dilute you more so we can go out and do more deals and 5.) we still think pushing assets into the broken MLP is a great idea.  The company later issued a retraction that it did not intend to issue equity to finance the San Juan deal, and what the CEO actually said multiple times offline was that they were looking into all of the various options, including possibly setting up for share repurchases via amendment to RCF.  Regardless, his lack of judgement on the call was just plain poor.

If there is an activist reading this, can I recommend you run a campaign to fix management's comp structure?  A slug of their compensation appears to be linked to FCF growth (not FCF/share growth) and their stock grants are based on price as of the grant, so it seems like they have somewhat misaligned incentive to do asset acquisitions, even if funded by equity, and not to give a damn about today's share price.  Why not a tiered options-based grant structure with lots of out-of-money strikes?

Through our networks, we believe some hedge funds who had major positions in WLB have unwound their positions due to across-the-board under-performance in their natural gas-leveraged bets over the past several weeks.  This would have exacerbated the recent dive (traded into the 13's at one point), and should point to selling pressure (hopefully) abating in the near future. 

Catalysts

Although the idea of an LBO is frequently floated, we do not believe it is likely today, as few PE investors will touch the coal space right now and anyone who would seek to buy them out would never pay anywhere near full value for the assets. 

Therefore, we believe WLB is a self-help story right now.  The best way to realize value for shareholders would be for the company to reverse course on its "get bigger" strategy and focus instead on directing its excess cash flows toward a return of capital to shareholders.  Consolidating coal assets in a depressed environment is long-term rational, but it is irrational for the company to ignore the cost of capital the market is assigning to the shares.  There are several steps to getting back to where WLB should be trading:

  • Amend the revolver, and start repurchasing shares
  • Buy in the MLP, which provides no value attribution benefit nor financing advantages) and initiate a small dividend
  • Pay down debt (not trading at discount, but we've spoken to a number of investors who said the equity would be a great investment, except they can't get comfortable with debt level)

The investor commentary out there is crystal clear - if management takes proactive steps to unlock cash flow for shareholders, there will be a massive revaluation.  If management is not willing to take these steps and stock prices remain depressed, we see it as likely that an activist (existing or new) steps in and forces the issue.

Ownership

We note there is a large shareholder named Charles Frischer who holds 6.7% of outstanding shares and has been vocal about his opinions (see http://edgar.sec.gov/Archives/edgar/data/106455/000119380515001280/e613955_13da-westmoreland.htm and http://edgar.sec.gov/Archives/edgar/data/106455/000119380515001127/e613884_13da-westmoreland.htm).  He hasn't gotten to the point of being full activist, but puts pressure on management.  We do note that there are some big funds in this: Venor Capital just filed a 13-G after it took a 5.8% stake on Friday and Tontine has been a 6.1% holder for some time.  There are a number of other hedge fund characters in the shareholder base, some of which have been shaken out as mentioned above.

 Risks

Incorrect about contract renewals/plant shutdowns

Climate change policy risk, primarily in Canada; most coal generation retirements in US are now known

Canada currency risk - continued weakening of currency

Western Canada economy - country appears to be sliding into recession, and the West looks especially vulnerable

Refinancing risk - probably outside of our horizon

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Share repurchase 

MLP buy-in + dividend

Debt reduction

Activists force change

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