Description

We think a compelling investment opportunity exists in going long Massey Energy (MEE) and shorting Walter Energy (WLT) in equal dollar amounts. Both companies are large coal producers in Appalachia. I wrote this about a week ago but didn't get a chance to post until now.

Introduction

Please refer to these simple statistics for an intuitive feel of our thesis.

*Other liabilities include primarily reclamation costs, pension and other post-retirement benefits.
**Op costs exclude freight pass-through, black-lung taxes, so is slightly understated

Despite a very tough economy and a record inventory overhang, the past 12 months have been an excellent one for coal investors. Our coverage universe of U.S. coal miners has rebounded roughly 300% off their 2009 lows, with the Appalachian miners typically doing better than their Powder River Basin counterparts.

The savior of the coal industry has been phenomenal demand from Asia, especially for metallurgical coals, which are used in steelmaking. Indeed, metallurgical coal prices are soaring and the industry is eyeing the resulting fat margins with glee. Miners are talking up their metallurgical prospects to the investment community and are pressing ahead with mine expansions. In this environment, any company producing metallurgical coal is receiving a sizable premium from the market, as thermal coal demand is still in the dumps.
We believe this backdrop has created a very compelling long/short opportunity. Walter Energy is the purest large "met coal" story available in the U.S, and its stock has rallied over 500% since YE2008. We believe this rally is unwarranted given the other opportunities in the coal industry today.

Usually, investing in any commodity sector requires a strong fundamental view about future commodity prices. This case is different. Investors do not need a strong coal price view. We simply believe Walter has been overplayed due to its cachet as a "pure" metallurgical coal miner.

Our thesis is straightforward. Despite having a nearly equal enterprise value, Massey Energy produces much more metallurgical and thermal coal. This situation does not make sense in almost any operating environment, as operationally, Massey and Walter are similar companies. Massey is the biggest coal miner and coal reserve owner in Central Appalachia. Walter controls two very high quality mines in Southern Appalachia, a region with similar geology, costs, and long term issues as Central Appalachia.

Details in the Numbers

The biggest discrepancy between Massey and Walter shown above is the coal pricing per ton. On the surface, this indicates Walter mines superior quality coal. However, Massey sells its coal primarily at/near the mine-mouth, whereas Walter sells its coal at the port and incurs additional rail freight costs which are then passed onto customers. We estimate this cost at roughly $20 per ton. Therefore, on an "apples to apples" basis, Walter and Massey sell very similar quality coals, with Walter possessing a slight advantage, as some of Massey's 2010 production will be lower quality or "crossover" metallurgical coal.

On the other hand, the cost equation gives Walter an edge. Massey does not explicitly break its costs between thermal coals and metallurgical coals, though thermal coal mining costs are lower. For metallurgical coals, we believe Massey's per ton mining costs are $8 to $10 higher on an "apples to apples" basis.

This may seemingly give Walter a massive advantage, but this is not so. Today, newly contracted premium metallurgical coals can realize operating margins of over $60 per ton. We believe Massey's 40%-plus volume advantage easily outweighs Walter's production cost advantage. In fact, in almost any operating environment, Massey's much greater output would translate into higher firmwide profits. Only in very poor environments, such as the one prevailing in late 2008 and early 2009, does Walter's cost advantage come to the fore.

Growth Profile

One reason Walter is accorded a premium valuation is its growth profile. It has an expansion project that will increase its metallurgical coal output to 9.5 million tons annually in 2012 versus just under 8 million tons today. If the current environment persists, the extra output can translate into $120 million of additional operating income per year.

However, if the bullish environment persists, Massey has superior growth prospects. For example, in Q4 2009, Massey raised its 2010 CapEx guidance for a new Central Appalachian premium metallurgical coal mine with annual output of 1 million tons. This mine should open in late 2011. Furthermore, Massey recently lost 1 million tons of metallurgical output capacity due to a fire that destroyed a processing facility (Bandmill). This plant should be rebuilt by mid-2010. Management has publicly stated that its metallurgical output can exceed 14 million tons per year, conditions permitting, by July 2010.

Aside from this, we believe Massey's broad mine portfolio and vast reserves should provide opportunities to expand both thermal and metallurgical coal output in the long run. For example, in 2007-2008, Massey launched an extremely ambitious CapEx program designed to expand output to 50 million tons in five years. This led to over $730 million of capital spending in 2008. We have not seen any fruits of this investment, as Massey choked back production hard in response to the recession. We believe the firm is currently operating with slack capacity that can be brought on quickly if prices remain firm.

The Value of Massey's Thermal Coal Portfolio

Thus far we have only addressed the metallurgical side of the equation. However, based on current market valuations, investors are receiving Massey's very substantial thermal coal portfolio "for free".

Thermal coal demand fell over 10% in 2009 for three main reasons:

1)       Electricity demand dropped due to the recession

2)       Natural gas prices were very low, prompting utilities to switch to gas

3)       Export demand was down

Because producers did not cut production fast enough early in the year, a very large inventory bubble developed. This inventory overhang threatened to derail pricing and margins for the foreseeable future, though the situation is improving after a cold December and January.

Accordingly, the market believes that metallurgical coal markets essentially "decoupled" from the thermal markets. In other words, metallurgical mines will make boatloads of money, while thermal mines will struggle with low margins and poor cash flows.

We think this is wrong. Historically, metallurgical markets and thermal markets have had very strong linkages and pricing in the two markets is highly correlated. Though the current situation is highly unusual, we think this historical relationship will reassert itself. If metallurgical margins stay strong, thermal margins will follow, and vice versa.

There are two primary links. First, high quality thermal coals, sometimes with some further processing, can be easily sold into the metallurgical markets as lower grade metallurgical coals. Every major Appalachian miner is pursuing this prospect and it happens every cycle. Massey itself can probably sell several million tons of this product.

Second, certain thermal coals with poor metallurgical properties can be sold as "pulverized coal injection" or PCI coals. This product can be pulverized and injected into a furnace, directly displacing metallurgical coals. PCI coals usage has become much more widespread and optimum injection rates have increased in the last ten years, especially as the metallurgical coal market tightened and prices rose.

We believe these linkages are strengthening in today's environment. For example, CONSOL Energy (CNX) recently widely publicized that they sold high sulfur Northern Appalachian thermal coals into the Asian metallurgical market, which apparently has figured out a cost-efficient way to utilize it. As sulfur makes steel weak, it would have been unthinkable to sell this coal grade into the met market only a year ago.

The bottom line is that there is significant elasticity and arbitrage between the thermal and metallurgical markets. This leads to a high degree of correlation in pricing and profitability between thermal and metallurgical miners in the long run.

Other Considerations

Another issue to consider with Walter is that the bulk of its value is tied in only two large metallurgical coal mines located in very close proximity. Although these are very high quality properties, Walter has a degree of geological risk that Massey does not. If something were to happen with one of these mines, whether geological, regulatory, or operational, Walter would suffer greatly even if the issue is temporary.

Furthermore, readers must notice that Massey has substantially more gross debt than Walter. However, we do not view this to be a problem. Net debt stands currently at about $640 million. This is about 1.4x 2009 Adjusted EBITDA.

Lastly, we address the relative reserve positions of the two companies. U.S. coal companies typically do not trade on reserves, but it's a fair question to ask. Walter comes off worse here. Its recoverable reserves at JWR #4 and #7, the two metallurgical mines, combine at about 140 million tons, or about 18 years of production at current rates. After its planned expansion, the reserve-years fall to about 15 years. Massey currently holds about 1.5 billion tons of proven recoverable reserves, 1 billion of which are held at existing resource groups (near current mines and infrastructure). It has another 885 million tons of probable reserves. At an annual normalized run rate of 40 million tons, proven recoverable reserves held in existing resource groups can last 25 years. If including other reserves and probable reserves, the reserve-years expand by several more decades.

Conclusion

We think this trade makes sense in nearly any coal price environment. The only time that it might break down is if metallurgical coal prices fall dramatically, when Walter's lower costs would help it preserve margins better. Even in this unfavorable scenario, we think the trade's losses will be modest. We expect this trade to fare best in a robust economy, high coal price scenario. If this were to happen, Walter's cost advantage is felt much less strongly on margins and Massey's thermal coal operations would benefit from substantial operating leverage. In this scenario, we expect Massey to be a vastly more profitable company than Walter and the shares would respond accordingly.

Catalyst