Description

Peabody Energy Term Loan

We believe Peabody’s term loan represent attractive risk/reward skew, yielding 19% to maturity with net leverage of 1.5x (face) and 0.3x (price adjusted). Phrased differently, Peabody’s term loan offers almost 20% yield with 84 cents of market value sitting in cash on balance sheet while the company is expected to generate more than $60mm of free cash flow in 2020.

Peabody is a diversified coal producer with metallurgical and thermal coal operations in the United States and Australia. While the market has inaccurately characterized Peabody as a secularly declining thermal coal producer, we believe Peabody owns trophy assets in both metallurgical and thermal coal that have significant earnings power and generate cash even in a depressed commodity price environment. We believe lenders are covered by the underlying asset value of the company, even in a prolonged downturn, due to the cash on balance sheet and competitiveness of Peabody’s Australian thermal coal assets (which sit in the first quartile of the global cost curve).

First, we believe Peabody’s US thermal coal business is a best in class asset that generates significant cash flow.

Peabody operates in three thermal coal basins in the United States – Illinois (ILB), Uintah, and Powder River (PRB). The mines in the ILB and Uintah are mid-tier at best, and we do not assign meaningful value to those assets.

Peabody’s PRB assets, by contrast, represent the largest coal mines in the United States, producing more than 100mm tons of coal per year at mine-level costs below $0.75/MMBtu. We believe these mines are the most competitively advantaged thermal coal mines in the United States, especially in an era of low natural gas prices.

In 2019, Peabody and Arch Coal announced the formation of a JV, where Peabody would take operational control and 66.5% ownership of an entity containing Peabody’s and Arch’s PRB mines. This creates significant value for both companies, primarily because the two largest mines in the portfolio (Peabody’s North Antelope Rochelle and Arch’s Black Thunder) share a property line. The JV creates one super-mine, one that produced almost 200mm tons of coal in 2018, and drives the lion’s share of an estimated $820mm net present value of synergies. While the FTC announced in February 2020 that it was challenging the venture, Arch has a history of successfully beating those challenges for PRB activity and both companies (along with industry experts) believe the FTC’s arguments to be weak.

Peabody’s PRB operations are substantially de-risked for 2020, with 96mm tons contracted at an average price of $11.13 as of 4Q19 earnings. Cost guidance of $9.70/ton implies contribution margins of $1.43, or ~$140mm of contracted EBITDA. At a 3x multiple, PRB operations represent ~$400mm of asset value, with another ~$550mm of value from expected JV synergies.

Second, Peabody’s Australian thermal coal business is in the top quartile globally.

Peabody’s Australian thermal coal business runs bottom of the cost curve mines feeding a growing demand for coal in South Asia, with the International Energy Agency estimating in December 2019 that regional coal demand will grow more than 5% per year through 2024 off of a ~200mm ton base, driven by new coal plants coming online in Indonesia and Vietnam to feed industrialization and economic development. Further out, the IEA estimates coal demand in the region will double to 400mm tons by 2040.

In the face of this demand growth, Indonesia – the largest exporter of thermal coal – announced a 10% production quota reduction for mines in 2020 (60mm tons lower YoY) while Indonesian domestic demand is expected to increase 12% (~17mm tons higher YoY). The net effect is a ~80mm ton decline in exports from Indonesia, while regional coal demand is expected to grow ~10mm tons.

This ~90mm gap is a substantial driver of expected improvements in Newcastle benchmark coal pricing, and the broader supply/demand backdrop gives us confidence in the demand for Peabody’s Australian thermal coal.

At a more granular level, Peabody sells in US dollars but expenses in Aussie dollars, and thus is a beneficiary of the trending decline of the Aussie dollar against the US dollar. With oil prices near record lows, the company also benefits from lower diesel prices for the industrial equipment at its mines.

Peabody has priced ~3mm tons (of ~19mm expected production) for 2020 at average price of $65/ton with expected operating costs of ~$32/ton. The resulting ~$625mm of EBITDA, at a 5x multiple, represents more than $3,000mm of asset value.

Third, we believe Peabody’s metallurgical coal portfolio has two crown jewels.

Peabody’s management has publicly stated their metallurgical coal portfolio is mid-tier at best. The company has struggled with the aftermath of a fire at its North Goonyella mine and has seen earnings from this segment decline alongside metallurgical coal prices throughout 2019.

We believe that there are two crown jewel assets in this segment, however, that are capable of generating cash across the cycle. These assets are the North Goonyella mine in Australia and the Shoal Creek mine in Alabama.

North Goonyella, despite its recent troubles, is a benchmark metallurgical coal – premium quality and highly desired by steel mills. While the fire has eliminated mining potential in some of the North Goonyella reserve, Peabody controls ~80mm tons of reserves in two separate, unaffected sections of the mine that can be economically accessed with additional development work. In the event that Peabody decides to develop these sections, we believe North Goonyella can return to a 2mm ton / yr production profile at ~$95/ton costs, implying ~$130mm of EBITDA at metallurgical coal pricing of ~$160/ton. At a 3x multiple, this implies ~$400mm of asset value before redevelopment costs The company has refused to provide estimates of redevelopment costs, but we suspect they are substantial. We look to Arch’s development of Leer South and Warrior’s development of Blue Creek as potential comps, which imply an average cost of ~$130mm per 1mm ton of production. We believe that restarting North Goonyella would have a cost advantage versus those two greenfield projects given its existing infrastructure. At a 25% haircut (~$100mm development per 1mm ton production), redevelopment costs of ~$200mm would imply an adjusted asset value of $200mm.

Alternatively, Peabody could sell the reserves to another operator. We note that BHP has mines surrounding North Goonyella and would be a natural buyer of the asset. Reserve transactions are hard to get public data on, but if we use Arch’s October 2019 purchase of a 25mm ton reserve block from Blackhawk for ~$50mm, the $2.50/ton value on 80mm ton reserve at Goonyella implies $200mm of asset value.

The second metallurgical crown jewel is Shoal Creek, an Alabama mine that Peabody acquired in December 2018 for $387mm. Shoal Creek produces ~2mm tons at a ~$80/ton cost structure, or ~$160mm of EBITDA at $160/ton metallurgical coal pricing and ~$500mm of asset value at a 3x multiple.

We believe pricing of $160 or higher is supported by average pricing over the last decade of ~$180, depletion of low-cost Chinese metallurgical coals mines which are driving that country’s domestic costs higher (and thus pushing up the indifference point of domestic production versus buying off seaborne market), and a shrinking supply of seaborne metallurgical coal as producers have failed to adequately invest in new capacity over the last several years.

Putting all the pieces together.

Despite its label as a declining thermal coal producer, we believe Peabody owns and operates thriving businesses with long-term earnings power, which are beneficiaries of strong growth in demand for thermal coal in Asia and an increasing global demand for metallurgical coal. Even at depressed commodity prices, analyst consensus is that Peabody will generate more than $60mm in free cash flow in 2020. There are few opportunities to earn a 19% yield with a creation value of near zero net debt on a business with world-class underlying assets.

Catalyst

Asian thermal coal demand growth

Met coal price recovery