Description

Cheap Option/Insurance on Potential China Hard Landing and Tight Credit Spreads

• Coal and copper company extremely sensitive to China’s economy.
• Risk/reward of CDS trade is extremely favorable with very limited downside and large upside over the next few months.
• Coal business (over 58% of YTD gross margin) may not be profitable at current market prices.
• Markets have not factored in the over 33% fall in met coal prices over the last three months.
• Calling leverage covenant bonds, management’s stated intentions and history of making acquisitions, along with a likely recent purchase of 3% of Fortescue, all point to a major acquisition down the pike.
• Large projects that cannot easily be slowed and have significant capex commitments make TCK significantly more leveraged than it appears.
• Copper seems to be supported by market speculators and could be due for a major fall.

Cheapest Option Is a Hard Landing in China:

Since the thesis on the potential for a Chinese hard landing is well known, I will not discuss it in detail here. Those interested in further information can take a look at presentations by Jim Chanos, available at http://www.youtube.com/watch?v=99HNFCn5RP8. This clip on China’s overbuilding is also very good: http://www.youtube.com/watch?v=rPILhiTJv7E. While both these videos are old, the thesis has remained largely unchanged. The only change over time is that instead of considering if or when it will happen, the situation is unfolding now.

While the bearish case on China has proven to be great analysis, most of the stories within this scenario have been played out and no longer appear to present the great risk/reward for short sellers that they once did. The Chinese stock market is trading near the financial crisis lows. Global miners, iron ore and coal companies, are trading well off their highs and could be risky shorts from here if we have hit bottom in the cycle.

Enter the TCK CDS trade: 

At the end of July, Teck Resources issued bonds with various maturities, including a 2018 maturity with a yield of only 2.5 percent; incredibly this bond now trades slightly above par. That is right: a company involved in one of the most volatile, low-quality commodity businesses [coal], an acquisitive issuer with a large amount of planned growth capex, is trading with a credit spread of just 2%and CDS trades at 200 basis points. We believe this is possibly the lowest or very near the lowest this could possibly go. The astonishing thing is that these incredibly tight credit spreads have come at a time of distress in TCK’s business. Essentially if this distress is not immediately alleviated, credit spreads should widen dramatically. On the flip side, if coal prices rebound, we do not believe credit spreads should decrease materially. The result is that over the next three to twelve months, if credit spreads can widen to 600 basis points (a conservative estimate in our view), you could triple your money with a minimal loss (assuming spreads remain where they are). Using the five-year CDS the reward versus risk ratio is eight to thirty-eight, depending on the duration of the trade (three to twelve months). We believe this is possible because of an extremely loose credit market that was brought about by low interest rates, a low volume market (the VIX is below 16), and a market that is still bullish on commodities, even mining and especially international commodities (TCK is a Canadian company). Clearly markets are not factoring in the recent fall in coal prices and are pricing in an immediate rebound. Even if coal prices do rebound, credit spreads may still widen if TCK makes an acquisition (see below).

Weak Coal Markets:

Coal has accounted for over 58% of TCK’s gross profit for 1H 2012. The benchmark met coal price tumbled from $225/MT in 3Q to $175/MT in 4Q. Things have gone from bad to worse as even this seemingly low met coal price (the benchmark is a bargained price not a public market transaction) can’t be held as spot market transactions have been done below $150/MT. Due to differences in quality (benchmark is the highest quality) and location (the benchmark is at the port in Asia), TCK’s coal sells for an average discount to benchmark of $20/ MT. In a weak market, we would expect that discount to rise, which is exactly what we are seeing now. Additionally, the port and ocean freight charges are $15-$20/MT, so the price TCK would receive for their coal is likely below their estimated $110-$115/MT in costs (2Q came in at $114/ MT). This is just gross profit and excludes SG&A and capex. Maintenance capex alone comes in at over $15/MT. Additionally, while TCK has thus far been able to avoid the geological problems that have hurt other miners, the company has run into some labor issues. There is a shortage of labor in western Canada due to the commodity boom, and TCK has been hit with strikes at mines in the past that have increased costs. We have also witnessed labor gradually degraded the economics of coal mining in Australia and have noted some similarities between the markets. Weather can also hurt results and drive up costs.

Another beauty of betting against met coal and copper is that it feeds directly into China’s property bubble. If China bulls are right, and the country is able to shift to a more consumer- and consumption-oriented economy, building and infrastructure spending will still slow and hurt the producers of those related commodities.

TCK Potentially on the Hunt for Acquisition:

Teck Resources has a history of acquisitions. TCK’s $14 billion ($9.8 billion funded by debt) purchase of Fording Canadian Coal in July 2008 nearly put the company into bankruptcy in the ensuing financial crisis.  . TCK has stated openly that it is an acquisitive company, and for the past five years it has been trying to buy its way into the iron ore business. Iron ore is considered to be a weaker business than coal or copper because iron ore is more abundant. On February 13, rumors that TCK had purchased 3% of Fortescue were reported. TCK will not comment on the validity of these rumors.

We may have gotten our smoking gun on July 30, when TCK redeemed several series of high interest rate bonds. At first glance, this looks logical, but the true motive for the redemption may have been obscured. While the bonds were high interest, the call prices were extremely high. TCK took a $202 million charge on a $659.2 million principal repurchase, according to a company press release. TCK could have waited until the call prices dropped over the next year. The decision to proceed with the bond purchase looks at best to be a break-even transaction for TCK. The company likely would have been better off waiting because they could still have raised debt to repurchase the bonds under the premise that they would be waiting to do so. These bonds contained a leverage covenant that would have restricted TCK’s ability to make an acquisition; this was likely the motivation. TCK points to the bonds’ credit rating covenants, but if the credit rating were downgraded, the leverage covenant would kick in; of course, a major acquisition would almost certainly cause a downgrade.

TCK has net debt of just $3.38 billion, which is partially due to holding cash of 3.641 billion. The cash on hand makes it a lot easier for TCK to make an acquisition or embark on a large growth project. We are not sure that TCK has a particular target in mind; our best guess is that the company is keeping their options open and will act opportunistically. While it is unclear if an acquisition by TCK would hurt equity holders, it almost certainly would hurt debt holders. It is worth noting that with the fall in iron ore prices, Fortescue has experienced some turbulence and has already been forced to cut over $1 billion in capex. TCK takes a long-term approach to acquisitions, putting an estimate on the long-term price of a commodity and using that to determine the earnings and value of a company, rather than assessing whether an acquisition is accretive by looking at current prices. This approach makes it more likely that the company would be a buyer when a commodity falls, as iron ore has recently.

Investors Incorrectly View Growth CAPEX as Flexible When It Is Very Similar to Debt:

TCK still has another $2 billion left in capex on existing growth projects. TCK also has a $5.5 billion copper project in Chile that they are considering pursuing. Investors believe that growth projects would be scaled back if business slows; this assumption is incorrect. Since 30% of costs are indirect and considering associated geological issues, it is a very costly maneuver to halt construction and leave a mine incomplete. Even in the financial crisis, TCK continued at least one growth project. While TCK’s debt is low, if growth capex is viewed as being similar to debt, this changes. If TCK goes through with the Chilean copper project, TCK would also pay out nearly $500 million a year in dividends.

Copper Prices Could Be the Next Shoe to Drop:

Met coal and iron ore have experienced dramatic price drops in the last few months. Meanwhile copper has held up extremely well and is trading within 5% of a 52 week high. To put this in perspective, consider that met coal is close to its $129/MT crisis low while copper at $3.74 is roughly three times its crisis low. The end demand of both commodities is extremely similar, and with a very high construction and new building component, China is clearly the main demand driver of both. We believe that the primary difference between met coal and copper is that one is traded and one is not. The met coal price is a pure price between producer and consumer; copper, however, is traded and that can lead to inflated prices caused by speculation. There have been reports that China’s copper stockpiles have increased 20% since July. Some stockpiles of copper are said to be so large that they are cracking warehouse floors. We do not consider ourselves to be copper experts, but it is clear to us that the chances of copper taking a major fall in price are elevated.

Conclusion:

The chance of a hard landing in China has increased, and investors would be wise to seek ways to protect themselves from this possibility. Credit default swaps on Teck Resources is a very attractive hedge, as prices do not seem to even reflect the recent reality, let alone the possibility of a bleak future. Some other global miners seem to also have similarly mispriced CDS; while we did not fully analyze all companies, we believe the possibility of an acquisition by TCK makes it the best choice of the group. 

Risks:

A quick rebound in met coal prices—an event we see as unlikely.

Credit spreads go below their already historically low rates.

We view this as a very low risk trade; the one negative is the possibility of a TCK bankruptcy, which we still see as relatively low, and therefore the end price of the CDS is likely to be zero. Since the ending price of the security is likely to be below the entry price, buying CDS on TCK may be considered more like speculation than investing.

Catalyst