Recommendation:

James River Coal (JRCC) is a terminal short. The company is possibly the worst decent sized publicly traded coal miner in the U.S. It looks cheap to quants, trading for 4-5x 2010 EBITDA. However, it will be hit by contract expirations that will essentially wipe out all earnings power starting in late 2011. Beyond that, the firm is likely to destroy shareholder value for the foreseeable future.

James River has the following characteristics:

• Nearly all production from Central Appalachia, which faces tremendous headwinds
• Under-invested in asset base
• Rapidly falling production
• Highest cost structure in basin
• Nearly zero metallurgical coal exposure
• Highest cost inflation in basin (due to poor geology and underinvestment in asset base)
• Gigantic open contract position for 201l. Near zero committed production for beyond 2011

Quick Tutorial on Central Appalachia:

Central Appalachia (CAPP) is the oldest coal mining region in the U.S. Coal has been mined here since the colonial days. However, it also resides near the top of the U.S. and global cost curve.

In recent years, regional production has been declining as costs become more and more uncompetitive with other U.S. basins. Geology was historically the main contributor, as reserves in the basin are already heavily depleted and miners are accessing more complex/deeper/higher strip ratio reserves every year. However, in this environment, many companies are kept afloat by earning extraordinary margins on metallurgical coal.

CAPP's decline has accelerated in the last few years because:

1. Very low natural gas prices, which prices CAPP coal out of the market
2. Labor shortages/falling productivity (the average CAPP miner is over 50 years old)
3. Recently enacted laws relating primarily to safety following high profile mine accidents in recent years (Aracoma, Sago, etc). These fell especially hard on small mining companies.
4. Much more MSHA regulation enforcement following the Upper Big Branch mine disaster in Apr 2009. Many more citations, frequent mine visits, mine shutdowns that destroy productivity.
5. A post-Bush militant EPA that makes it very difficult to secure permits.
6. A large CAPP inventory overhang heading into the recession. This is still around today but to a much lesser extent

As a result, the mines in this region are becoming less competitive, and will likely experience falling production and margins in the long run.

James River Company History:

James River pretty much exemplifies the troubles of Central Appalachia.

Notice something weird with 2009 and 2010? Here is what happened.

The company actually went bankrupt in the early 2000's and emerged in 2004 at $40 per share. However, JRCC was still overlevered, and even back then it was a very marginal miner. Prior to bankruptcy, it underinvested in its mines to conserve cash flow, which of course made it even less competitive versus peers.

The company struggled from 2004 to 2007, when it lost money every single year. By 2007, the company was in deep trouble and on the brink of bankruptcy due to perennial losses, negative free cash flow, and an increasingly levered balance sheet. The stock fell to below $5.

Without further options, the management decided to take a huge gamble. At that point, it was so uncompetitive that if it had sold all of its coal at market prices, it would guarantee bankruptcy. Besides, utilities were reluctant to contract with a company that might go BK. So it headed into 2008 with an unusually large uncommitted position, especially for H2 2008 and the years beyond.

This gamble paid off in a spectacular manner. In mid 2008, CAPP thermal coal prices nearly tripled, to a high of $145

As a result, it signed some incredibly profitable contracts that locked in some of its late 2008 production, a large portion of its 2009, 2010, and 2011 production, plus a very small portion of 2012 production. Many of these tons were sold at over $100 per ton. So as coal prices fell from $145 to $50, James River was unscathed and in fact produced record profits and free cash flow. It was even able to ramp up investment in its mine portfolio.

Nevertheless, these years were not enough to turn around its legacy of uncompetitiveness and high costs. Production fell rapidly from 2007 to 2010 -- not because James River didn't want to mine coal -- but because its costs were so high that every uncontracted ton it sold lost money.

James River has structurally disadvantaged mines with poorer geology that have been underinvested in for decades due to the firm's chronic debt burden. I do not believe the company can fix this.

To get a sense of James River's cost position, I present the following exhibit:

The costs are per ton COGS or cash costs, depending on firm. They are not 100% comparable but pretty close.

Notes:

ANR's late 2009 and 2010 numbers were derived from partial disclosures
ICO's costs/trend includes some distortion from its small Illinois Basin and Northern Appalachia production, because it changed the way it reports numbers in 2008. The absolute costs are not comparable, but the trend is.

As you can see, JRCC is near the top of the region's cost curve and experienced the most cost inflation among its peers. A 3% spread versus the rest of the industry may not seem like a big deal, but CAPP mining is a relatively low margin industry and is extremely capital intensive. 3% compounded over a decade is a very big deal. Look at the way its costs migrated through time. In 2003-2004, it was sort of in the middle/low end of the pack, which makes sense given its thermal coal only portfolio. Look at the situation today. They are conclusively near the top.

The only miner with higher costs is ANR, but of course 1/3 of ANR's production is metallurgical and JRCC has almost zero metallurgical coal. In fact, most CAPP miners have a significant met exposure. Since met coal is much more expensive to produce usually, you would expect JRCC to have lower costs versus the basin, but obviously that's not the case. (This is also the reason that despite having costs towards the middle/lower end of the spectrum earlier in the decade, it had among the worst margins) Furthermore, JRCC has long claimed that it's idling "high cost" production, which would imply a slower cost inflation because of the positive mix shift. There is zero sign of that here.

Coal prices have recovered quite a bit since 2009, and CAPP thermal coal is trading for about $75 per ton on the prompt month (with a mild contango). With JRCC's costs approaching $70 per ton (Q3 costs were over $70), its production is at best very marginally EBITDA positive at market prices.

Resetting Contracts

The vast majority of JRCC's above market contracts will expire by the end of 2011. In fact, since 2008, it has barely sold any additional coal, because each additional ton it sells is barely profitable. In 2011, James River is taking another gamble. It is entering the year with about 30% of its tons unpriced, when peers are almost completely sold out. If coal prices do not appreciate, it faces a tough choice -- shut down mines, which may never come back online; or produce at a loss.

If by early 2012 nothing materializes (i.e. coal prices do not appreciate massively), it's essentially screwed

Remember James River has almost no metallurgical coal. In fact, it had zero metallurgical coal until very recently, when it opened/plans to open three very small mines to produce a total of 250K - 300K tons per year.

Here is a rough model I built to illustrate the crippling effect of resetting contracts and rapidly inflating costs. ILB = Illinois Basin. Because its contribution is small I am not going to spend a lot of time on it.

*EV has been adjusted for the face value of the converts, which is $172M. Converts are struck at $25.78 and carried on the BS at a $40M discount (obviously this helps limit upside as well). Interest is cash interest. The firm also has $150M senior debt due 2012. Assume zero cash taxes.

I've actually made some fairly generous assumptions:

• The small amount of metallurgical coal it produces sells for $200/Ton at the mine mouth, which corresponds to a benchmark hard coking coal price of over $300/Ton. In reality, subsiding floods in Australia may very well bring met coal back down. Met coal is over 1/4 of EBITDA despite accounting for 3% of production. Should met coal prices weaken, these EBITDA numbers are way too aggressive
• Cost inflation of "only" 8%, well below trend.
• Production flat, reversing a decade long trend of declines
• Thermal coal prices roughly to the curve at the mine mouth.

As you can see, even with these generous assumptions, EBITDA essentially collapses post 2011. In the long run, because the company's poor asset base, I expect EBITDA margins to continue to shrink.

The situation worsens dramatically for JRCC if I make more "realistic" assumptions. In particular, as we head into the summer, unless coal prices improve dramatically, JRCC will probably be forced to curtail production. Historically, when it curtails production, it has never brought them back online again. I suspect this will be the case once more if this scenario were to occur. Also, if cost inflation is higher than 8%, margins get eaten up pretty rapidly as well.

So essentially, the market is valuing the company at over 5x peak EBITDA. If this EBITDA was actually somewhat sustainable, that might be fair considering the extreme cyclicality and capital intensity of the industry. But I think it's grossly overpriced given this EBITDA is near an all time peak and very likely to decline.

Q4 Earnings Preview:

James River is one of the last coal companies to report. I think Q4 will be pretty ugly.

From what we know, the CAPP region was hit by high costs, low productivity, and poor rail service during the quarter. Arch and Alpha both pre-warned on these issues (which will probably affect Q1 as well) before the earnings season started. This is an exceedingly rare event -- for two miners to warn on poor shipments and costs

From the companies that have reported, I think only PCX didn't post record costs. MEE reported a shipment shortfall and record costs. ICO wasn't great and the stock was down over 7% on Thursday. JRCC was only down 1%.

JRCC, being the worst miner in the region... I wouldn't be surprised was affected by these issues, but to a greater extent. The March $21 puts are trading for $1.10. They look like a good risk/reward bet to me.