Description

The post-reorg energy universe hasn’t been much fun the past several months but one of the lesser discussed and interesting situations is Foresight Energy.  Having gone through a difficult and ill-timed change-of-control default in late 2015 it has now emerged into what is less of a capital markets problem but more of a coal still sucks problem.   Given the backdrop of the coal and energy capital markets over the past ~20 months a very nasty default resolved itself in the form of 16 million additional common units versus an initial 130 million unit count, and a refinance of 7.875% unsecured notes into 11.5% 2L’s and 1L’s that includes a tiered excess cash flow sweep.  Leverage is currently around 4.3x EBITDA with the following cash flow sweep feature:

 “Retained Percentage” means, with respect to an Excess Cash Flow Period, 25%; provided that, commencing with the Excess Cash Flow Period for the fiscal year ending December 31, 2018, such percentage shall be (i) 50% if the Secured Leverage Ratio at the end of such Excess Cash Flow Period is less than or equal to 4.00 to 1.00 and greater than 3.00 to 1.00, (ii) 75% if the Secured Leverage Ratio at the end of such Excess Cash Flow Period is less than or equal to 3.00 to 1.00 and greater than 1.75 to 1.00 and (iii) 100% if the Secured Leverage Ratio at the end of such Excess Cash Flow Period is less than or equal to 1.75 to 1.00.

The key part to this investment thesis is a secured leverage ratio < 4x which can be handled several different ways.

Market perception

This is a highly levered commodity producer that sells coal, can’t even pay out distributions, the sponsor is a maniac, and it’s illiquid. 

Reality

The sponsor Murray Energy (MEC) is known for being quite litigious so I will refrain from neither confirming nor denying the maniac accusation.  But clearly there are investors that dislike his general tone and demeanor.  That aside I think it misses the point that his interests are very much tied to the common returns of FELP over time frames that matter for most investors looking out a couple years.  The reason for this lies in the subordinated share structure that never had a chance to season.

As part of the acquisition in 2015, MEC paid roughly $1.3bn for an 80% stake in the GP including 65 million subordinated common units.  The founder Chris Cline continued to hold roughly 40 million common units with a total unit count of 130 million.  The subordination on MEC’s shares would last until they paid out three years of minimum quarterly distributions (MQD’s) of $0.3375.  Due to a change-of-control triggered default, their ability to continue paying MQD’s went out the window.  It was hampered even further by the fact that one of their best mines (Deer Run at the Hillsboro complex) went up in flames.  Literally.  It’s been on fire for about two years now.  Suddenly tons had to be shifted around at their three other mining complexes and costs per ton went up as pricing in Illinois Basin (ILB) coal went down.  Truth be told they probably would have had to cut the distribution down to zero in early 2016 regardless of the change-of-control default.  There was a complicated out-of-court restructuring that culminated with some bond tenders and exchanges that kept Foresight equity in tact for MEC.  It wasn't the cleanest reorg but it gave MEC a chance to salvage their investing in FELP.

As for common unit holder’s situation post restructuring, MQD’s have now accumulated to $2.80 that must be paid out before MEC can start earning a return on the subordinated units.  MEC only owns about 10 million common units purchased in March of 2017 at $6.30 that were issued in conjunction with backstopping the debt refinance in April of 2017.  Even though Bloomberg or Yahoo finance show a market cap of ~$600mn for the purposes of a current common unit holder that’s not quite true (currently 80 million common units è pay out $2.80/unit è share count increases to 145 million common units).  Based on the recent dividend announcement of $0.0647/quarter MEC is pulling out about $2.5mn/year from FELP on his roughly $1.3bn investment.  

Let me stop there for a second.  I’ve heard several investors voice concerns that MEC will “try to steal” FELP.  To which I’ll respond the way my mother used to respond when I politely asked for a new gadget.   “With what money? The money we don’t have?”  Just take a gander at MEC bonds if you want to get an idea for his financial position.

Capital at the MEC level isn’t sufficient to take FELP private.  Now if I were MEC and wanted to take FELP private under these conditions, 1) I probably wouldn’t take what little cash I had to purchase new common units at $6.30, 2) I wouldn’t pay any dividends because 85% of that cash will be going into other unitholders including Chris Cline who have already been paid handsomely with MEC’s money over the years, and 3) I’d avoid or limit shareholder communications.  As we’ve seen a couple weeks back FELP is paying out the maximum allowed under current lender agreements despite almost none of it going up to MEC.  And they’ve even recently created a respectable investor presentation as well as been quite communicative with the shareholder base despite their relatively small size.

This tells me MEC has one goal in mind: max out earnings at FELP, delever with the sweep, and go for the home run.  I don’t think MEC has any other viable option.  He could try “the CHK” and whisper about hiring some restructuring advisors and then buy up his debt on the cheap but I don’t get the sense that he wants to sell down assets to do this.  And given some of his recent comments in the press I imagine that any cash flow from his FELP investment could be the difference between being “the last man standing in coal” and being a subordinated unit bagholder.  

That now ties into why this isn’t some cruddy coal company and how they’ll max out earnings.  FELP is one of the lowest cost coal producers in the Illinois Basin.  If Trump were CEO he’d be saying “we have the best and lowest cost coal, everyone always says so.”  But he wouldn’t be far from the truth.  When adjusting for tons sold/produced in the 2Q or 2017, costs per ton were around $20.  Even with natural gas in the northeast at $2 or lower contracts on ILB coal are transacting around $35.  Unlike other coal benchmarks ILB coal has been unable to hold a bid with all the natural gas being trapped in the Marcellus.  Based on a quick comparison across the cost structure of other ILB producer’s, the marginal costs/ton are somewhere around $28-31 with Alliance and FELP controlling around half of the production.  $35 should be a reasonable trough pricing picture for ILB producers.  And given the troubles of some other ILB producers I think you should see some rationalization over the coming quarters as contracts roll off for higher cost producers in the basin.

The mines/complexes are as follows:  Deer Run (on fire but an 8Mt mine), Macoupin (2.5Mt), and Sugar Camp (12Mt), and Williamson (7Mt).  Without Deer Run they can do about 22Mt which they are currently maxing out.  But if you follow some of the recent developments around Deer Run it seems like they are making serious progress to restarting.  Based on the last conference call:

As we mentioned on our last quarterly call, MSHA accepted our plan to send personnel underground to evaluate and explore the underground workings at the Hillsboro mine. And on May 16th, mine rescue personnel breached the seals and entered the mine to evaluate the underground workings and equipment. We continue to have access to the underground workings of the Hillsboro mine at this time, and continue to monitor and evaluate existing conditions.

I think Deer Run will be key driver for this investment being a home run.  It doesn’t need to come back for this investment to have a nice margin of safety but it appears to me that MEC is heavily incentivized to get that mine back running.  Current guidance of $300mn of EBITDA is for 22Mt or roughly $13-14 EBITDA margins/ton.  5Mt out of Deer Run at $13 margins (Deer Run was the lowest cost mine at FELP but I’ll trim down margins a bit because who knows) should add north of $65 million of EBITDA.  That alone would bring the cash flow sweep under 50% with leverage around 3.9x. 

EBITDA                       $365mn

Interest                      $130mn

Capex ($3/ton)            $81mn

Excess cash flow          $154mn

Distributable cash flow  $77mn

DCF/common unit:        $0.96 (71% of annual MQD’s)

If FELP starts paying out $0.96/unit and earns close to $2/unit would it still be trading around $4?  That would seem fairly onerous given the arrears built into the common units. If Deer Run doesn't come back then we'd be waiting for ILB pricing to normalize.  An extra $5/ton would add more than enough EBITDA (an extra $100mn+?) to achieve a similar outcome.  In the meantime the situation looks like this:

I think Deer Run will be key driver for this investment being a home run.  It doesn’t need to come back for this investment to have a nice margin of safety but it appears to me that MEC is heavily incentivized to get that mine back running.  Current guidance of $300mn of EBITDA is for 22Mt or roughly $13-14 EBITDA margins/ton.  5Mt out of Deer Run at $13 margins (Deer Run was the lowest cost mine at FELP but I’ll trim down margins a bit because who knows) should add north of $65 million of EBITDA.  That alone would bring the cash flow sweep under 50% with leverage around 3.9x.

EBITDA                       $300mn

Interest                       $130mn

Capex ($3/ton)             $65mn

Excess cash flow          $105mn

Distributable cash flow  $26mn

DCF/common unit:       $0.33 (24% of annual MQD’s)

The $80mn being allocated towards open market repurchases of 1L's should allow FELP to delever into lower excess cash sweep tiers.  With two years of $300mn EBITDA and 75% cash flow sweeps leverage should fall under 4x, distributions paid out should tally around 16% of the current share price, and future annual distributions would step up to $0.65/unit even without an improvement in coal markets.  The big issue with this particular scenario is that it does almost nothing for MEC.  Roughly $1bn of 2L notes are at the MEC level costing over 11% of interest that were issued in connection with the FELP purchase. I'm not exactly sure that time will be on his side.

This brings up the possibility of dilution and ways MEC might affect FELP unit holders.  With the large arrears from unpaid MQD’s any equity issuance will be quite costly at current levels.  As such I think FELP would only issue common units to MEC because we’re looking at roughly 75% of the current share price owned in arrears be the end of 2017.  Why pay others when you can just pay it out to yourself?  And if MEC was injecting cash and acquiring new common units I think it would imply an intention to reduce leverage and pay arrears out to common units.  Plus if MEC had excess capital to be buying up common units I can only imagine coal conditions are a lot healthier and that would be a good thing for FELP.  Overall not something I worry about in the wee hours of the night.

A quick remark on why coal may or may not suck.  I’ve noticed a lot of attention towards some reorg coal names (Contura, Peabody, and others) but I can never get excited about them.  For starters their assets are a mix of good and average to below average assets.  None of them have purely great assets.  Or they’ve benefited tremendously from what has gone on with China rationalizing some of their capacity in 2016 or the tremendous rally we’ve seen in some export pricing.  You have a lot of low unlevered multiples but I think there is a reasonable if not high chance that we may be looking at a cyclical peak in some of these coal benchmarks.  I’d much rather own the low cost met producer at 5x trough than 10x after met has tripled off the lows.  If I’m going to deal with the headache of owning a commodity producer I’d at least like to know I have some optionality for the cycle to turn.  Domestic steam coal markets haven't turned yet.

FELP is a low multiple on what is almost certainly trough earnings and I think they have great assets even if one happens to be on fire.  It’ll be difficult for margins to shrink below $10/ton and based on more normalized environments that appears to dramatically underprice the full cycle earnings power.  They’re already maxing out their capacity so they only need pricing to normalize to grow earnings without Deer Run.  But if one gets Deer Run and pricing then it’ll be off to the races.

Why is ILB pricing so low? 

It’s primarily a glut of natural gas in the Northeast and multiple seasons of abnormally warm winters.  I don’t want to be the guy to predict the weather will be but if for some reason we finally get a cold snap you’ll see coal and nat gas inventories worked off and ILB will tick up.  In fact, in late 2016 we saw ILB creep up towards $40 as Marcellus gas went north of $3.  You don’t need to see any structural shifts away from nat gas turbines back towards coal fire plants.  You just need an extra frosty winter.  I don’t know what the odds are here but maybe 1/5 over the next few years?  In the meantime I can own a lowest cost producer at roughly 4x earnings even if we don’t get that cold winter. My nose might be off here but that smells mispriced.

Why the opportunity exists

As part of the restructuring, old FELP notes were exchanged into new notes that included a warrant kicker equal to 6 million common units.  The bonds pre-exchange had a nominal par value of $600mn and were mostly in the hands of high-yield mutual funds.  I calculated the total value received as part of the note swap as north of $700mn not including interest or the $20mn of warrants struck at $0.89 and expiring in 2027.  If you chart FELP from the day the new credit facilities and notes priced on March 15^th it’s been a straight path down.  I calculate the free float at around 10 million units or less.  The sudden inclusion of 6 million common units in the hands of high-yield mutual funds is certainly a fair amount of overhang.  And since the only way to exit that warrant is to exercise and sell common units in the open market I believe it’s had a considerable impact on the market price.  About 1.4 million common units were issued as part of warrant exercises per the last 10-Q.

You could also say “well it trades at a higher EV/EBITDA multiple than peers.”  To which I think that is misguided for a couple reasons that I hinted at higher.  1) FELP is already levered.  Will BTU (just as an example) take on 2-3x leverage anytime soon?  I highly doubt it.  Will BTU (again, just an example of the current coal space don’t yell at me about BTU) consistently trade with a high cost of equity capital?  I think that’s a reasonable thing to expect.  It's natural to see FELP trade a bit rich on unlevered metrics versus peers.  The cash flow returns to equity holders will drive returns as long as they stay within the confines of debt covenants and they’ve already worked through almost any situation that could have significantly diluted existing common unit holders.  I think that should speak volumes.  2) ILB coal pricing is still trading well below cycle averages which should be considered when normalizing out earnings at some unlevered and lower multiple peers. 3) A repeat of #1 but it’s already levered and the creditors are allowing them to pay out earnings based on reasonable leverage levels.  This isn’t a highly levered situation where you hope for a steady unlevered multiple while debt gets worked off because cash can't be paid out to equity holders.  You don’t have to hope that they’ll arbitrage an 6-10% cost of debt with 30-50% cost of equity capital.  The units are already situated to work when the positive operating leverage comes into play.

Where’s my margin of safety mental model

Let’s face it.  Stocks at 3-4x earnings have a habit of falling to 2x earnings.  Or maybe it’s just the stocks I buy at 3x earnings that have a habit of getting much cheaper.  At any rate it’s very difficult to know what the downside market price here is especially given the considerable warrant overhang.  I think the units can go lower but ultimately performance will be driven by their ability to maintain and grow earnings even in a depressed coal environment and the distributions that are paid out to unit holders.  It’s not often you can purchase a low-cost commodity producer at a low multiple of cyclically low earnings with a highly incentivized management team/share structure.  Situations like this are typically difficult to peg a worst-case downside scenario in but I can’t imagine a worse environment than FELP experienced in 2016.  Always possible but I would argue not probable. 

Risks

If something happens to one of their other mines it'll hurt.

Margins erode and they trip covenants again.

Murray Energy goes bankrupt and perception issues affect Foresight.  We've seen that with FELP notes the past week.  Nice one Bob.

Export prices have picked up and make up 20% of tons sold.  Should that roll over it would certainly be an extra headwind.

Another few years of warm winters.

Natural gas in Foresight's markets stays under $2 for a long, long time.

Catalyst

Reduction in leverage to < 4x

Resolution around Deer Run

Distribution growth