Walter Stub / Fording Pair Tra WLT/MWA/FDG W
November 14, 2006 - 8:46am EST by
2006 2007
Price: 40.13 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 800 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Recent events at WLT and a massive unwarranted valuation discrepancy vs. a public peer (FDG) now yield a momentary opportunity to earn 75% to 100% through a pair trade that also eliminates any significant exposure to underlying commodity risk and has a built-in catalyst.

Walter Industries (WLT) has been profitably recommended twice before on VIC (in both January and December of 2005).  What we are suggesting herein is a distinctly new opportunity and investment structure that will allow investors to take advantage of an exceedingly wide valuation discrepancy between two very similar pure-play metallurgical coal producers, while removing the volatility and commodity risk of betting on coal prices.


In short, our recommendation is to go long the public stub representing WLT’s captive met coal unit (the WLT Stub trading at a pro forma 3.8x EBITDA), paired against a short position in the significantly more expensive Fording Canadian Coal Trust (FDG – trading at an unwarranted pro forma 7.3x EBITDA multiple).






Because WLT is a diverse conglomerate with business interests not just in met coal, but also in water related products as well as homebuilding and related financial services, the implied value of a theoretical stand-alone met coal unit has previously been completely obscured (if not somewhat irrelevant).  However, just a few days ago (Monday, Nov. 6), the WLT Board announced the spin-off distribution of its 75% interest in its publicly traded water products subsidiary (Mueller Water Products – MWA).  This distribution is scheduled to occur on December 14, 2006, to shareholders of record as of December 6.  Only now, for the first time, can investors truly synthetically create the (pure play met coal) WLT Stub by shorting 1.94 shares of MWA for every WLT share they are long (the borrowed shares will be automatically covered by MWA shares to be received in the December distribution).


It is our view that this distribution will serve as a catalyst to highlight the absurdly cheap implied valuation of the WLT Stub, which is being obscured by the significantly more expensive MWA interest – MWA shares are currently trading at 14.3x 2007 EPS versus just 8.6x for WLT (and far less for the WLT Stub).  As the financials are separated and the valuations viewed independently, we believe that this discrepancy will become crystal clear and quickly rectified.


For simplicity of this analysis, we have conservatively assumed that WLT’s remaining Homebuilding/Finance segment, which is expected to produce over US$40m of EBITDA in 2006, is valued at just 5x EBITDA, resulting in a $200mm enterprise value (US$3.00 per fully diluted share).  We believe this valuation to be conservative as the Homebuilding/Finance segment produced $13m of EBITDA in the third quarter, for a $52m annualized EBITDA run-rate.

To be clear, we believe the WLT Stub to be significantly undervalued on an absolute basis and we also believe FDG to be trading at an unfairly rich valuation in its own right (justification for each of these views is in the sections that follow), making each of these very attractive stand-alone investment opportunities (long and short, respectively).  However, for the investor without a firm view on the future direction of met coal prices (which are quite dependent on global steel markets), we view this pair trade as a unique opportunity to eliminate the pure commodity price risk associated with either of these stand-alone positions. 


While our own research has lead us to conclude that met coal prices should come under pressure this year, the pair trade we are recommending is fairly agnostic on this point.  For example, if 2007 met coal prices were to remain flat (which we find very hard to believe), FDG would be fairly valued, while the WLT Stub should literally double in price just assuming a conservative 6x EBITDA multiple.  Conversely, if met coal prices in 2007 were to fall modestly to US$95/metric tonne, as we project (supporting evidence is below), we believe FDG’s share price would fall by more than 35%.  However, even at this lower pricing, the WLT Stub should still appreciate by 40% once its valuation is freed from its current structural confusion.


It is this massive valuation discrepancy that affords investors the opportunity to earn a gain of between 75% and 100% without any significant exposure to the underlying commodity risk.

WLT’s high quality met coal deserves premium pricing.

WLT produces an extremely high quality, low volatility, hard coking coal that is difficult for European and South American steel manufacturers to source.  This scarcity value allows the Company to command a premium to market pricing.  For example, in 2006, WLT realized US$115 per metric tonne versus US$107 for FDG.  This 5%+ positive differential has remained fairly consistent on a historical basis.


WLT benefits from a superior geographic location.

WLT’s mines are located very near the port in Mobile, AL, allowing the Company to subsidize its production costs with lower rail freight rates.  The end result is that WLT’s port delivered cost per metric tonne (assuming normalized production) is about US$51 compared to US$66 for FDG (a 23% advantage).  Furthermore, European and South American customers pay lower freight expenses due to WLT’s convenient Alabama location (versus FDG’s distant British Columbia port).


Potential acquisition target.

Upon completion of the MWA distribution on December 14, management has indicated its intention to also spin off the Homebuilding/Finance segment.  This final restructuring action would leave the Company as a fully transparent, pure play, stand-alone operator of high quality metallurgical coal mines.  With its attractive geographic location and valuable product, WLT would make an attractive acquisition target for any of the large diversified, met coal producers (such as BHP or Rio Tinto) that are looking to gain a solid presence in the European and South American steel markets.


Market is ignoring future production capacity of WLT.

WLT is currently expected to produce a total of 5.8m short tonnes in 2006.  Although production difficulties at Mine #4 forced the Company to revise its original production targets downward, management comments on the recent earnings call indicated that the situation has been successfully resolved and that production is back to previously anticipated levels.  With this capacity back online and a US$200m expansion project that is already underway for Mine #7, the Company is now poised to bring total production to over 9m short tonnes by the end of 2008, an increase of 55% in just 2 years.  Although the market has clearly penalized WLT for its production difficulties this year, this level of material capacity expansion should overwhelm any short-term concerns regarding one-time production issues or even lower realized pricing.

WLT is cheap even if met coal prices come down to US$95 in 2007.

With Mine #4 back online, even at a realized price of US$95 per metric tonne (a 17% decrease from the US$115 WLT realized in 2006), the Company would be trading at just a 6x FCF multiple – well below FDG’s 13x FCF multiple under the same pricing assumptions.


Transparency is just around the corner.

WLT (and the WLT Stub in particular) suffers from a significant conglomerate discount that is particularly heavy given the perceived complexity of the current structure.  The already announced transaction (and the subsequent divestiture) should resolve this issue within the next couple of months.  Furthermore, we believe that a “cleaner” WLT will emerge with significantly improved analyst coverage and that the valuation of the Company’s met coal operations will finally be properly compared to a peer universe that is trading at twice the current implied multiple.



FDG is a high cost met coal producer for the Asian steel market.

FDG’s production costs have increased 40% in just the last 2 years, spiraling from C$28 per metric tonne in 2004 to C$39 this year.  This cost issue is further magnified by transportation disadvantages at both ends of the supply chain.  First, FDG’s mines are quite a distance from the closest Vancouver ports and the operation therefore suffers from high rail freight expense.  Secondly, FDG’s Australia-based competitors have an inherent ocean freight advantage given their relative geographic proximity to Asia (a benefit that WLT enjoys relative to FDG in both Europe and South America).  It is only the recently insatiable demand for met coal that has allowed FDG to effectively compete under this burdensome cost structure.


We believe met coal prices are heading lower in 2007.

On FDG’s recent Q3 earnings call, management admitted that keeping prices flat for the upcoming 2007 negotiations would be very difficult.  Most met coal producers negotiate pricing on an annual basis (the coal year begins April 1), with final discussions typically taking place between December and March.  During 2006, FDG’s average realized met coal price was US$107 per metric tonne.  Our own research has collected the following evidence to support our view on pricing for 2007:

-  Rio Tinto just recently sold a large shipment of met coal (estimated to be around 500-700k metric tonnes) at a price of US$83 per tonne

-  AME Mineral Economics (an independent industry consultant) is predicting 2007 met coal pricing of US$92/metric tonne

-  UBS is predicting 2007 met coal pricing of US$95/metric tonne

Between these public data points and our numerous private conversations, we believe there is a strong possibility for US$95 met coal pricing in 2007.  Of course, one of the benefits of this pair trade is that we can afford to be very wrong on the commodity price and still make an outsized return on the investment (details below).


Majority of FDG is owned by retail investors who seem to be basing valuation solely on current dividend policy.

As is the case with many Canadian Income Trusts, FDG’s income and withholding tax characteristics have largely discouraged many institutions from holding the shares, leading to the creation of an investor base that is dominated by less sophisticated retail investors.  It seems that these shareholders are focused primarily on the C$0.80 dividend that FDG just paid in its most recent quarter, which implies an annualized C$3.20 distribution.  Under this scenario, the current share price (US$19.23 or C$21.66) implies a dividend yield of 14.8%, which perhaps seems reasonable given the industry cyclicality, high operating leverage, commodity price exposure and the government’s recent proposal to eliminate the tax-friendly status of Canadian Income Trusts.  However, the issue with this retrospective valuation approach is that it does not properly discount for the impending dividend cut that is all but certain if met coal prices come under pressure in 2007.  For instance, if dividends were to return to the level of just 2 years ago (C$1.37 in CY2004), this same simplistic dividend run-rate valuation approach would yield a share price of just US$8.12 (or C$9.25) per share, resulting in a 57% correction from today’s levels.

THE VALUATION – Revealing a massive discrepancy in similar assets:


A detailed overview of the current capital structure calculations for both companies follows:



WLT Stub:

Share count = 44.3m basic WLT shares as of September 30, 2006 + 22.1m shares from convertible bond holders = 66.4m fully diluted shares. 


Share Price = US$40.13 (Walter Industries share price) less US$25.53 (1.94 spin-off ratio * US$13.16 – MWA’s share price) less US$3.00 (Value of Homebuilding/Finance Business assuming 5x multiple on 2006E $40m EBITDA) = US$11.60.


Market Cap = 66.4m fully diluted shares * US$11.60 = US$769m

Enterprise Value = US$769m (Market Cap) + US$274m Term Debt – US$79m Cash + US$123m Underfunded Retirement Obligation = US$1,087m





Enterprise Value = 147m shares * C$21.66 = C$3,184m Market Cap + C$70.6m Asset Retirement Obligation + C$47.7m Underfunded Retirement Obligation + C$16.9m Neptune Obligation + C$246m FDG Debt – C$417m Present Value of 4 year Canadian Income Trust Tax Shield = C$3,148m



Key Valuation Assumptions:


Please note that seabourne met coal prices (not to be confused with the more common thermal coal commodity used by utilities) are typically quoted in metric tonnes.  However, WLT quotes its tonnage and prices in short tonnes, which can be converted to metric tonnes by multiplying by 1.1.  Because of the 5%+ premium that WLT has historically realized versus FDG’s met coal prices, we have assumed in the analysis below that this 5% differential continues.


Key Drivers:

-         WLT Mine #4 Costs – US$51 per metric tonne

-         WLT Mine #7 Costs – US$56 per metric tonne

-         FDG Costs – C$75 (or US$67) per metric tonne


-         WLT Maintenance Capex – US$60m

-         FDG Maintenance Capex – C$50m


-         WLT 2007 Production – 7.2m short tonnes (7.9m metric tonnes)

-         FDG  2007 Production – 13.9m metric tonnes



Implied Valuations under Various Seabourne Met Coal Prices:


We believe that a free cash flow (FCF) multiple is the most accurate methodology by which to value the two companies’ relative valuations.  Since pricing assumptions are the most influential drivers of free cash flow, we have evaluated the results under a range of reasonable seabourne met coal prices and our conclusion is that unreasonable valuation differentials exist under any pricing scenario:


(in US$ per metric tonne for FDG)

-         $105:  WLT = 4x FCF / FDG = 9x FCF

-         $100:  WLT = 5x FCF / FDG = 10x FCF

-         $95  :  WLT = 6x FCF / FDG = 13x FCF

-         $90  :  WLT = 7x FCF / FDG = 17x FCF

-         $85  :  WLT = 9x FCF / FDG = 24x FCF

-         $80  :  WLT = 12x FCF / FDG = 40x FCF





Based on the detail above and today’s closing share prices, we would recommend the following trade proportions to maintain neutral overall net exposure (on a dollar basis):


  1. Buy Long 1 share of WLT (currently US$40.13)


  1. Sell Short 1.94 shares of MWA (currently US$13.16 * 1.94 = US$25.53 equivalent)


  1. Sell Short 0.60 shares of FDG (currently US$19.23 * 0.60 = US$11.60 equivalent).  This ensures a full hedge (on a dollar basis) against the Walter Stub after accounting for the conservative $3.00 valuation of the Homebuilding/Finance unit.  Note that we would recommend shorting the US listed security (FDG) as opposed to the Canadian listed security (FDG-U CN) as the daily volume is roughly 2.3x greater on the US exchange (US$24m per day).




Major capacity expansions.

WLT is currently spending over US$200m in expansion capex on Mine #7.  When these expansion efforts are completed, the Company will have over 9m short tonnes of production capacity (a 55% increase from today’s levels).  At this production run-rate and assuming our projection of a more modest met coal price of US$95 per metric tonne, WLT Stub is currently trading at just a 3.3x FCF Multiple or a 30% FCF yield.


Value of Homebuilding/Finance segment.

This business unit is expected to produce over US$40m of EBITDA in 2006, creating a substantial margin of safety in our valuation (US$3.00 per fully diluted share assuming just a conservative 5x EBITDA multiple).  It is our belief that management will announce its intention to spin off or divest of this segment early in 2007.




Operational mine risk at WLT.

As mentioned earlier, WLT has had production issues with Mine #4 this year.  Although management now maintains that the mine “has operated near historical levels since late September”, we are conservatively modeling just 7.2m short tonnes of production in 2007, which assumes no incremental benefit from the current 7 East Expansion project which is already underway and expected to add 2.7m short tonnes.  Our 2007 production projection is also far short of management’s previous guidance of 7.8m short tonnes.  Any extra production volume would provide meaningful upside to our estimates.  Although WLT’s investor base has historically shown a tendency to focus on short-term production swings, we believe that the longer term capacity additions (to a total of 9m short tonnes by 2008) should overwhelm any one-time operational issues.


The unlikely repeal of recent Canadian tax legislation could benefit FDG.

FDG’s shares fell 12% on November 1 when the Canadian government announced its intention to effectively begin treating income trusts as corporations for tax purposes beginning in 2011.  Given the conclusive tenor of the announcement and the scope and extensive effort of the review that lead to this decision, we believe any significant modification or repeal of this guidance to be a very remote possibility.  Furthermore, the guidance was put forward by the minority party within the Canadian government who historically had resisted such legislation (as opposed to the majority Liberal party, which has typically supported it).


1. Management has announced its intention to distribute its holdings of publicly traded MWA on December 14, 2006 (to shareholders of record on December 6), which will result in a stand-alone Walter Industries that consists of the company’s Natural Resources segment (met coal) and the Homebuilding/Finance segment. We believe this event will immediately highlight the unfairly depressed valuation of the WLT Stub as the underlying financials and valuation will no longer be consolidated with the significantly more expensive MWA assets.

2. Annual met coal contracts for 2007 should be announced sometime between December and March. We believe these announcements will reveal that met coal supply has increased relative to demand and that prices will be at moderately lower levels versus 2006. If this conclusion is correct, then the realization of this news should place significant downward pressure on FDG’s shares.

3. In Q1 2007, we believe that WLT management will announce details regarding its intention to spin off or divest its Homebuilding/Finance segment (which is currently expected to generate over US$40m of EBITDA).

4. We believe that a “cleaner” WLT will emerge with significantly improved analyst coverage and that the valuation of the Company’s met coal operations will finally be properly compared to a peer universe that is trading at twice the WLT Stub’s current implied multiple.

5. As a stand-alone entity, we believe WLT’s high quality, low cost, strategically positioned metallurgical coal mines represent an extremely attractive acquisition candidate, particularly for large international met coal producers looking to gain additional low-cost supply access to the European and South American steel markets.
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