Description

The negative backdrop for coal has presented us with the opportunity to purchase a structurally advantaged coal miner for a bargain price. 

Company description / Industry backdrop:

Foresight Energy (FELP) is a MLP that owns and operates four underground mining complexes in the Illinois Basin that have the capacity to produce up to 32mm tons of thermal coal per year.  FELP’s parent controls over 3 billion tons of reserves in the IB (100+ years of production).  Due to fantastic geology and over $2 billion of greenfield investment, FELP has the three most productive underground mines in North America (in terms of clean tons per man hour) and is the low cost producer in the Illinois Basin (IB).  

Despite the negative headlines, thermal coal remains a critical source of power given its low cost and base load reliability.  In 2014, coal’s share of U.S. electricity generation for all sectors was ~39%.  While coal’s share will likely shrink over time, it will remain a meaningful portion of electricity generation for the foreseeable future. 

The Illinois Basin (IB) is the only sizable domestic coal basin that is projected to grow production over the next decade.  Subsequent to the passage of the Clean Air Act of 1990 utilities were limited in their ability to burn IB coal, due to its high sulfur content.  However, with the passage of time, an increasing number of utilities have installed scrubbers (pollution control equipment), which allow them to burn high-sulfur coal.  As a result, IB coal has consistently taken market share, particularly from higher-cost Central Appalachian coal. 

Recent transaction with Murray Energy: 

FELP recently completed a transaction with Murray Energy (run by billionaire Bob Murray), the largest private coal company in North America.  For $1.37b Murray acquired 50% of FELP.  This works out to a purchase price of ~$21.50/unit.  Murray also acquired 77.5% of the IDRs (incentive distribution rights) and the option to obtain control of the GP at a future point for $25mm.  Prior to the transaction, FELP was 85% owned by Chris Cline, FELP’s founder.  No new units were created and the public float remains the same (~15% of units). 

Investment thesis:

Superior assets benefit from structural cost advantages: 

While other major IB producers have mining cash costs between $30-36/ton, FELP’s costs average $21/ton.  FELP’s primary advantage comes from the thick continuous coal seams which provide ideal geologic conditions for longwall mining.  Competitors, on the other hand, primarily use the room-and-pillar mining method, which is far less efficient and leaves half of the coal in place (as roof support). 

Additionally, because of its non-union workforce and relatively short operating history (production began in ‘07), FELP is not burdened by many of the legacy liabilities (pension, OPEB, environmental etc.) that have plagued other producers.  Furthermore, FELP’s mines are ideally located, with easy access to major railways and rivers (Ohio and Mississippi).  This keeps transportation costs in check which results in higher netbacks. 

FELP’s cost advantages are likely to remain over time because: 1) The longwall method is prohibited in Indiana (it makes the surface ground sink) where many competing mines are located and 2) longwall mining is not geologically feasible/practical for the majority of IB coal seams. 

FELP’s low cost position allows it to benefit from the price umbrella set by higher cost peers.  It also allows FELP to produce a substantial amount of cash, even when markets are cyclically weak (as they are today). 

Excess capacity embeds substantial earnings power: 

In 2014, FELP sold 22mm tons, well under its current capacity of 30-32mm tons.  Therefore, as demand grows, FELP can produce an extra 8-10mm tons without spending incremental capex (besides increased wear and tear of equipment).  All FELP would need to do is run more shifts. 

At $40/ton (current OTC spot price for mid-sulfur IB coal) realized prices and $21/ton of costs, for 8mm extra tons, FELP would earn an additional $150mm. 

Recent transaction with Murray de-risks distribution:

When FELP went public in mid-‘14 (at $20/unit), it was marketed as a vehicle with a double-digit percentage distribution growth.  However, recent weakness in coal demand likely gave investors increasing skepticism that FELP could grow, or even maintain, its current distribution level.

I think the Murray transaction substantially reduces this risk.  Murray brings an estimated $57mm of synergies that will fall straight to the bottom line.  These synergies primarily involve SG&A rationalization (FELP’s St. Louis headquarters is closing), improved buying power, and shared equipment  and infrastructure.  Additionally, Murray brings a robust pipeline of potential drop-downs.  In 2014, Murray’s 13 mining operations produced 63mm tons and $713mm of Adj. EBITDA.  These mining complexes are primarily Northern Appalachian (Ohio, Pennsylvania, northern West Virginia) longwall operations that are well situated on the thermal cost curve (although nowhere near as low as FELP’s mines). 

FELP’s parent now has the ability to financially engineer a rising distribution through accretive, tax-advantaged drop downs.  Even in a weak market, FELP will deliver a steady, rising distribution to unitholders, which should catalyze a re-rating in the stock as investor trust builds. 

Moreover, FELP’s incoming CEO (from Murray Energy) has already made comments about shifting some of Murray’s existing production to FELP to take advantage of its lower cost position.  For FELP unitholders this would be unequivocally positive. 

Murray’s incentives are well-aligned:

With MLPs, it is critical to think about the incentives of the parent because LP holders are basically at the mercy of the GP (this is spelled out clearly in any MLP prospectus).  In this case, I think incentives are well aligned because I believe Bob Murray is playing the long game.  In fact, he has repeatedly stated that his goal is to be the last man standing in the coal industry. 

Murray just spent ~$1.4b to purchase FELP units at a 60% premium to the current market price.  His motivations were as follows:  1) FELP’s assets are incredibly attractive for all of the aforementioned reasons.  2) FELP was Murray’s most price-aggressive competitor.  Rather than continue to participate in a race to the bottom with the low cost producer, Murray chose the rational path of consolidation.  3) FELP is an opportunity for Murray to increase the value of his existing assets by dropping them into a tax-advantaged structure with a lower cost of capital. 

This third point is where GP/LP conflicts arise.  Murray owns 100% of Murray Energy and only 50% of FELP.  So it is conceivable that Murray could sell a mine to FELP at too high a price.  However, Murray has the most upside from his 77.5% share in the IDRs.  The IDRs entitle the GP to a 15% share of incremental distributions for amounts above $.39/quarter, 25% above $.42, and 50% above $.51/quarter.  Therefore, it is in Murray’s economic interest for the FELP structure to succeed. 

Any high-priced drop-down would be viewed negatively by unitholders and would likely be dilutive to distributable cash flow per share (particularly with FELP at such a low valuation).  This would hurt the value of Murray’s $1.4b investment in FELP and would impede his ability to access the capital markets in the future.  This would also limit Murray’s ability to do any future drop-downs and would impair the value of the IDRs. 

Instead, the most economically rational thing for Murray to do is to improve the valuation of FELP so that he can sell a combination of debt and equity to finance future drop-downs.  The playbook is simple.  FELP needs to be viewed as a trustworthy yield vehicle. 

Therefore, I think unitholders will benefit from accretive drop-downs and a steadily increasing distribution which will be revalued in the market at a lower required yield. 

Legislative optionality provides nice upside:

With only a few exceptions, coal-fired power plants located in Illinois are prohibited from burning coal produced in the IB and other high-sulfur basins.  This made some sense years ago when, as previously mentioned, IB coal was considered too dirty for consumption.  However, it makes absolutely no sense now given the advent and proliferation of scrubbers.  Despite this, only 8 out of the 53mm tons of coal burned annually in Illinois is produced in state.  Plants within a few miles of FELP’s mines are forced to pay for lower quality coal transported all the way from the Powder River Basin (Wyoming and Montana).  Indiana, on the other hand, incentivizes their utilities to burn Indiana coal.

Within the past month, a Democrat state senator and a Republican state representative have led a bipartisan effort to overturn this antiquated regulation.  The lawmakers’ primary goals are to create local jobs and bring in more revenue for the state (more volume = more royalties/taxes).  Illinois remains mired in a fiscal crisis, so any proposal for additional revenue should be well received.  While I don’t doubt that environmental groups will object, burning local coal leaves less of a carbon footprint than imported coal, so any environmental argument is meritless. 

Overturning this rule would have a substantial impact.  The IB produced 137mm tons in ’14.  Another 30-40mm tons of potential demand would have a massive impact on the IB producers.  FELP is in the pole position to benefit. 

Export optionality if international coal prices improve:

FELP exports coal to Europe out of a port in New Orleans.  FELP breaks even when API 2 (relevant OTC coal benchmark) is in the low $50s per metric ton, which puts them in the bottom quartile of the seaborne thermal cost curve.  Presently, API 2 is trading at $57, down substantially from the $130s, where API 2 peaked in early 2011.  Despite this, FELP is still making a low-single-digit margin on its export tons (~8mm tons in '14).  This is an impressive feat considering a substantial amount of international coal companies are burning cash at these levels. 

If seaborne thermal coal prices were to return to the mid $70s, where they were for most of 2014, FELP would earn an extra 120-150mm of EBITDA.   

High-ROIC reinvestment potential:

If any of the aforementioned growth drivers materialize, FELP has the enviable ability to reinvest organically at high returns on invested capital.  FELP has longer term plans to add up to five additional longwalls at its three main complexes; Hillsboro, Sugar Camp (which has two already), and Williamson.  Permitting is already in the works.  Each additional longwall would cost $250-300mm, a modest investment compared with the $2+ billion of capital Foresight spent to set up its operations thus far.  The incremental investment is far lower because any additional longwalls would share surface infrastructure. 

Assuming IB coal prices of ~$40/ton, each additional longwall would generate roughly $130mm of EBITDA ($40/ton price -$21/ton cost) x 7mm tons/yr.  At $35/ton, each longwall would generate ~$100mm of EBITDA, still a very attractive return on a ~$275mm investment. 

Key Risks:

Conflicts of interest:

As previously discussed, as an LP holder it is important to be aware of conflicts between the GP and LP units.  In this case, for the aforementioned reasons, I believe incentives are well-aligned.  However, this is a key issue to monitor going forward.  In the meantime, FELP has a couple of additional protections worth mentioning.  

First, Murray purchased subordinated units which, while included in FELP’s share count, have additional protections in place to ensure that FELP shareholders receive at least .3375 per quarter before the subordinated units get paid.  This downside protection is in place for an additional 9 quarters and  Murray has every incentive to make sure things go smoothly so his units convert to LP shares.

Additionally, until Murray exercises his option to gain control of the GP, Chris Cline (who owns 35% of FELP and 0% of Murray Energy) has the ability to block anything he doesn’t like.  Murray is unlikely to exercise his option until August 2016, when FELP’s unsecured notes become callable (they have change of control provisions that discouraged Murray from buying control in the recent transaction).  Moreover, even when Murray has control, Chris Cline will still be a large and influential shareholder that will help keep Murray honest. 

Operational risks:

Underground mining is a dangerous business that is fraught with challenges.  At present, FELP’s Hillsboro complex is having issues with high carbon monoxide readings, likely caused by an underground fire.  Remediation of the problem has cost several million dollars so far and the mine is presently idled.  FELP is also having challenges with worker safety at its Sugar Camp complex, where miners have had a disproportionate amount of accidents in the past couple of years including two deaths.  FELP needs to improve its safety performance at Sugar Camp or else the Mine Safety and Health Administration (MSHA) could mandate increased compliance and potentially bring civil penalties.

Structurally low natural gas: 

IB coal is generally competitive with natural gas at ~$3.50/mmbtu and higher and FELP has cash costs about 2/3 of the average IB producer.  As long as “normal” natural gas prices are $3.00 or higher, FELP coal is well “in the money” for utilities with the capability to switch between gas and coal.  While the days of $6.00-8.00 gas are probably behind us, $3.50-4.00 seems like a reasonable estimate of the “new normal” for domestic natural gas prices.   While some Marcellus plays may still be profitable at <$3.00, the swing producers that set the price of Henry Hub are earning well below their cost of capital. 

Distribution cut:

Yield-oriented investors (FELP’s public shareholder base) are particularly concerned with the stability of the distribution they receive.  FELP’s distributable cash flow is currently above its distribution (~1.2x coverage ratio) and I expect it to remain so.  However, if coal prices continue to decline, in the absence of mitigating drop-downs, the distribution could be at risk in ’16 or ‘17. 

Environmental regulations:

Under the Obama administration, the EPA has been on the warpath against coal.  At present, the most topical regulation is the Mercury and Air Toxics Standards (MATS).  This mandates that coal-fired power plants either install pollution controls (scrubbers) or shut down.  This rule is generally negative for industry-wide coal demand because it accelerated the closure of some older, sub-scale coal-fired generation capacity (in aggregate MATS is expected to eliminate 10-15% of capacity).  However, the rule is arguably beneficial for FELP in the medium run because more coal-fired plants will have pollution controls that enable them to burn IB coal. 

A longer term risk is a proposed EPA regulation called the Clean Power Plan which includes even more onerous emissions standards for existing fossil fuel-fired electric generation units.  If enacted, the requirements would phase in between 2020 and 2030, and would result in operational restrictions and material compliance costs, which would certainly affect future unit retirement and replacement decisions for utilities.  The Clean Power Plan has invoked strong resistance from industry groups and will likely be substantially delayed and modified. 

Valuation:

Using the midpoint of 2015 guidance, FELP trades at 8.9x distributable cash flow and 10.4x EV/NOPAT (in this case, EBITDA-Maintenance CapEx as MLPs are not taxed).  Its distribution is $.37/quarter, a yield of 10.2%.  FELP has 22.1mm tons (20.4mm priced) of production under contract for 2015 and 16.1mm (12.6mm priced) tons under contract for 2016.  For context, FELP sold 22mm tons in 2014.

This valuation is far too cheap considering the quality of FELP’s assets, the fact that coal prices (both domestic and export) are cyclically weak, and that FELP is producing well below its capacity.  Moreover, at this price you are paying nothing for the optionality around higher export prices and favorable legislative developments, nor are you paying for the ability to reinvest within the franchise at high incremental returns on capital. 

While 2015 EBITDA is guided to ~$400mm, this is well below FELP’s normal earnings power.  I estimate normalized EBITDA of ~$520mm.  This gives FELP credit for some (6mm tons) of its excess capacity assuming $16 margins ($37/ton price - $21/ton cost).  It also assumes realized prices are $5 higher on its export business (5-6mm tons in '15).  I assume maintenance capex of $3/ton x ~30mm tons of capacity.  I increase cash interest expense by $9mm (to $112mm) to account for 200bps higher interest rates on FELP’s variable debt. 

To summarize, $520mm of “normal” EBITDA – $90mm CapEx – $112mm cash interest – $0 taxes (MLP) = $318mm of “normal” distributable cash flow.  Given 130mm units outstanding, that works out to $2.13 distributable cash flow per share to the LP (adjusted for IDR waterfall).  I think FELP will maintain a 1.2x coverage ratio and trade at an 8% yield.  This works out to a $22.20 fair value, which is 53% upside from here.  While it may take some time for fundamentals to stabilize and sentiment to rebound, we get paid 10%+ to wait. 

Catalyst

- Increased production driven by coordinated cutbacks at Murray Energy
- Continued market share gains within IB
- Higher natural gas prices reverse coal-to-gas substitution
- Positive IB coal legislative outcome
- Accretive drop-downs
- Increased export prices