Description

Peabody Coal (“BTU”) is one of the more interesting speculative stocks I have seen in a while.  It offers 200-1,500% upside with a 70-90%+ probability.  Offset by 50-90% downside at a 10-30% probability.  Expected value is more like 2-3/share offering dramatic upside from today’s level of $.85/share.  This is obviously a smaller cap and more suitable for smaller funds but trading liquidity isn't horrible.  Given the binary outcome and upside, a small position can matter for even larger funds.

Backdrop:  Peabody Coal is a metallurgical (Met) and Thermal coal miner based in St. Louis.  It’s main assets are in the following basins:  Australia, Powder River Basin and Illinois.  It’s assets sit on various parts of the cost curve in those two grades.  It has a Crown Jewel asset in Australia called Wilpingjong.  This is a 5500 thermal coal producer with cash costs at the bottom decile world wide.  This asset would like obtain a cash bid even in today’s world.  Whereas the rest would probably not raise much capital after legacy liability issues..  While this may sound horrendous – it actually works to the benefit of the equity (follow).  

For BTU, it has two markets.  International seaborne and U.S. domestic. 

Key players Thermal seaborne:  Indonesia/Australia/US/Colombia are exporters.  India, Europe, Korea, Japan are importers.

Key players Met seaborne:  Indonesia/Australia/US/Colombia are exporters.  India (largest), China, Europe, Korea, Japan are importers.

The seaborne coal market is over-supplied in both grades with prices trading well below the cash costs of the marginal supplier.  As a result, 5-10% of supply has been shut for both grades.  Should we fully recover economically and steel making wise, we would likely see a surge in prices over the cost curve.  ($65/ton seaborne thermal and $140/ton.)  Historically, you would see a spike well over the marginal producers price for some time as you recover.  Met coal is one of the more volatile commodities in the world. 

Seaborne met:  China demand has roared back as steel making is near records.  They are currently in a small battle with Australia and are weaponizing met coal to influence a trade war.  As a result, they are not importing met.  Local prices of met are $200 per ton (reflecting a decided shortage) whereas spot seaborne met is $110/ton.  The longer they hold off the greater the arb between local/international prices will grow and the greater their need will be once they give in.  It is expected that this will end in early 2021 as new import licenses will renew.  Just as important, India’s economy is embroiled with covid and demand is down sharply.  However, it is starting to re-open and will need to replenish its inventories on top of its on-going demand.  Should these two demand factors hit at once, we could see a sharp rally in price given the curtailed supply.  Futures on seaborne coal are $140/ton starting in early 2021.  We are clearly on trough here with green shoots to a recovery in 2021 – especially 2H were many will hopefully be inoculated.

Seaborne thermal:  prices are moving up off trough and closer to $60/ton versus the $65/ton cost curve position.  This reflects the considerable capacity reduction and the fact that electricity demand has been fairly resilient.  I would describe market conditions as moving off trough.  The recovery is a bit more advanced than in Met.

US thermal:  there has been a lot of discussion about how Natural Gas prices are set to recover sharply this winter.  This has been driven by the following factors.  1)  Decided drop in the amount of associated gas in oil wells (~25%+) 2)  Absolutely no effort on the part of producers to replace declining production as they are off the cost curve and the explosion in the cost of capital for drillers 3)  Accelerating exports of natural gas via LNG terminals.  4)  Continued demand expansion as gas is a cheap form of energy and greener than coal.  At the same time, coal production has imploded as well for many of the same reasons but with green efforts accelerating the pace.  There is a growing chance that US natural gas prices are far higher than anticipated in 2021.  The supply response to higher gas has been destroyed due to years of false starts.  This can be seen in the stock prices of the E&Ps where the pulse rate has moved from 50bpm to 51bpm despite potentially being on the cusp of a more lengthy recovery.  As a result, this means that US thermal coal prices could move off their trough and surprise far more dramatically to the upside.  BTU’s PRB coal goes into the money at $2.5-2.75.   If gas prices average average $3.5/mcf in 21 – production volumes and pricing could surge adding hundreds of million of cashflow.bo

Long-story short:  conditions in all of BTU’s major markets are on trough and potentially poised to improve in a meaningful way.  However, I would warn you that the rally in thermal coal prices and EBITDA/EPS will likely be met with complete skepticism and multiple compression as the terminal value is in doubt due to green efforts.  This is despite most forecasts projecting growing global demand for seaborne thermal as Emerging Markets need the cheap source of energy.  While met coal terminal value is far less in question, it is dirtied by affiliation with the thermal and probably will not see much multiple expansion.  I mention all of this to set expectations low. 

How is BTU doing in all of this?  They cut a bunch of costs and produced $95mm of EBITDA in 3Q on trough conditions.  Pricing have eked up beyond the average price in 3q and the company has additional cost cuts underway.  As such, EBITDA seems set to improve still.  This places a floor run-rate (for now at $400mm+) which would cover interest expense and the reduced capex of $175mm.  should prices bounce to just over the cost curve EBITDA could move up to $600-800mm.  there is a lot of torque to price here.  A rally in EBITDA would be sheltered by large NOLs.

BTU Stock:  Fortunately, very little of the first 100-300% of the rally in BTU stock requires a rally in market conditions or multiple expansion.  Merely solving the solvency questions that loom will create a 100-400% rally.  However, if the solvency issue is successfully resolved and a market recovery takes place, this stock could move up to $10/share >1,000%.  If the board is able to solve the solvency issues without a the $150mm paydown the creditors are requesting, this could create another 100-500% upside as the board uses that cash to buy back debt at a decided discount. 

Solvency questions:  BTU stock has been plagued by looming covenant breach in 4q-19 at the RBL.  BTU’s capital structure is fairly simple. There are four main instruments that are all secured and pari passu.  The company is flush with 770mm of cash and a little extra liquidity via A/R securitization.  The company announced on 11/9 that it had made an agreement with the surety bonds that it would pay the $75mm now + $25mm/year + a small FCF sharing arrangement in exchange for no triggers through 2025.  This is a HUGE development for the whole capital structure/equity because surety bonds can trigger a bankruptcy out of nowhere if they decide to move on.  However, the sureties require that the company extend out its maturity schedule to the same point – 2025.  To effectuate an extension, the company created an unrestricted subsidiary and intends (or already has) to place Wilpinjong in that subsidiary.  The company has then offered the following package to the RBL/2022 group.  15% haircut, Exchange 50% of the RBL and 2022 bonds into debt that sits at the Wilpingjong sub (with 1L guarantees at Legacy Co) with an aggressive FCF sweep structure (75%).  Due to the high FCF generation of the Wilpinjong asset in any market condition, this should drive rapid repayment of this debt.  The other 50% of the RBL and 2022 notes will sit at the legacy company.  The note holders are accepting this structure but reportedly asking for 1)  Par exchange  2)  $150mm paydown at par 3)  FCF sweep mechanism at the notes stuck at legacy company. As a result of this superior position, the 2022 notes trade at 40% versus the 2025 notes at 30%.  This reflects the likelihood that the 2022 notes exchange into a far more favorable position.  If you assume that the Wilpinjong notes trade at 80% and the notes stuck at Legacy trade at 30%.  The company’s offer creates a recovery of 55%.  The bondholder request for a $150mm paydown would add another 21% recovery and a FCF sweep mechanism might add another 5%-10% as the legacy co notes would trade at 40-50%.  As such, the offer from the company creates a 45-60% recovery while bond holders are asking for up to 85-95%.

What are RBL/2022 alternatives?  They could reject the offer and force a filing.  This brings up a multitude of issues.  To start, the surety bonds would draw their $250mm of L/C’s - priming the group and dramatically increasing the exposure for the RBL group.  The RBL group would rather eat cat food than let this happen.  Further, the bankruptcy would add another $50-100mm of debt to the estate.  The RBL and 2022 notes would not enjoy a priming position offered by the Company.  They would have to equitize a portion of their position and take over the equity.  While the company has $800mm of cash, the $100mm of BK fees and $250mm of securitization would limit the amount of cash pay down the lenders could extract.  Minimum liquidity is ~$500mm.  Perhaps they could take out $150mm of cash to spread across the debt balance which will have ballooned to $1.8bn+ with the surety draw.  Lastly, the RBL/2022 notes should fear the presence of Elliot in the equity.  Should market conditions recovery during bankruptcy and EBITDA surges to $800mm, the company will 1.1x net leveraged and spewing cash.  This could lead to the creation of an equity committee and more complications for the creditors.  Also – this is why bankruptcy SHOULD NOT drive the stock below $0.5/share but I suspect it could go to $0.20-0.30/share.  This is truly an equity that has optionality even in bankruptcy. 

Putting aside the equity committee.  What would be next for the new equity holders of BTU?  The RBL/Noteholders would then be listed as the owners of a coal company which in the new ESG world isn’t great.  Since they would probably not want to sit on the board, they would hand over the keys to a professional board who might not fully listen to their instructions.  (I have a lot of experience with this and board members think they know better >80% of the time.)  They could sell Wilpinjong and dividend out this cash but the other assets would be unlikely to get a bid that exceeds liabilities.  In this scenario, the FCF generation would be meek and the trading prices of the new securities would be horrendous.  This is not a favorable outcome in my opinion – even as an agnostic potential investor in the 2022 notes.  However, the holders are all big banks and par holders that detest equitization.  I could also see how the RBL might get all of the excess cash to continue to provide L/C’s and a modest RBL position.  As such, the 2022 might not see any of the excess cash.   The company is offering them a chance to accelerate their pay down at the expense of their other holders via the Wilpinjong subsidiary.  If the company fails in 2025, they are in a far better position and probably mostly out of 50% of their position at Wilpinjong and enjoyed 4 years of coupons at legacyco notes.  At which point, they can reassess solvency questions.  In a nutshell, the RBL/2022 notes would be insane not to take the offer and Elliot has the capacity to meet their request if they prove recalcitrant.  As such, I think there is a very high probability this works out.

What could this be worth if they can settle the solvency questions?  At $380mm run-rate, the company is 2.3x net leveraged and the stock is 2.5x TEV/EBITDA with massive optionality should coal bounce back.  I suspect the stock bounces to $3/share on the news.  This is $300mm market cap and creates the company at 3.0x EBITDA.  However, should the company be moving toward $800mm of EBITDA, $10/share is 2.3x TEV/EBITDA.  In addition, should the company be able to get a deal done without a pay-down and use $150mm of cash to reduce debt at prevailing prices of 30-40%.  This could create an additional $3-4/share of value.  The easy trade here is to anticipate that they can come to terms.  The coal price recovery is a bit less certain – but I would argue more likely than not.  Hope this helps.

Catalyst

settlement of solvency questions in 4q2020.  Rally in thermal/met coal as economies re-open.