Description

Walter Energy Secured Notes – 101.5/102

March 2014

Walter Energy’s 1^st lien secured notes (the “Notes”) due 2019, while notionally ‘boring’ – offer excellent downside protection, substantial current yield and asymmetric / home-run upside in the event of a strategic transaction (which has been rumored in the past at stock prices >$100).  More importantly, a near-term financing should improve the Notes’ relative lie, quell liquidity-driven concerns and send notes higher.

Notes are off 8/9 points from the highs in December, and while China has slowed, driving met coal pricing towards record lows; much of the decline has been self-inflicted.  Specifically, the FQ4 earnings call somehow offered vague, yet all-encompassing (secured / unsecured / convert) guidance regarding financing.

Backing up for a second; Walter’s 2011 purchase of Western Coal is eclipsed only by the decision to finance said purchase with low-cost, covenant-heavy bank debt.  Bank debt-driven covenant pressures have resulted in five amendments and driven much / all of the last 18 months’ capital markets activity.  Walter now needs money to paydown the bank debt, given upcoming amortization (Term Loan A) and covenant (Term Loan B) issues.

The Notes benefit from a meaningful, current junior capital cushion – but as we’ll discuss, I think that cushion grows alongside a near-term financing.

Fundamentally; Legacy Jim Walter mines have significant long-lived reserves, lead the US in cost efficiency and produce some of the world’s finest coking coal.  These assets (Blue Creek) effectively ‘cover’ you through current levels ($1.6bn net secured debt), leaving everything else (Western, Coking & Gas) for free.  These assets have reportedly attracted suitors at much higher levels (see Audley Capital’s 2011 / 2013 commentary) and should continue to maintain that strategic relevance, either in a restructuring or normalized / turnaround scenario.

Business Overview

I’ll qualify my lack of specific ‘edge’ regarding coal, certainly relative to the vast bodies of coal research (sell-side, Platts, etc.).  Coal is about as out-of-favor as any industry I can think of (maybe for-profit education?), given well-documented issues like environmental concerns (more applicable for Thermal), Chinese demand slowing, Australian supply & competitive forces and perhaps the eventual tapping of supply in Russia.

Walter produces metallurgical (Met) or coking coal.  Specifically, this coal is used alongside Iron Ore in the production of steel.  Demand for steel, of course, is cyclical – and increasingly driven by China.  Chinas has slowed while Europe has improved – so overall demand has been slightly improved (up 2% in 2013).  More troubling, however has been the resumption of Australian-led supply, which has soaked up much of the growth in demand.

Despite these issues, Walter is still relevant and was recently still profitable.  Buyers often specify grading or quality standards (porousness, CSR, volatility levels) and Walter’s Blue Creek coal is well-known worldwide for producing excellent steel.  These legacy mines also benefit from low transportation costs, given a direct link to the Port of Mobile.  As a reference point, the Company breaks out results by division; US EBITDA (effectively Blue Creek) is consistently profitable, relative to losses in Canada / UK, which have much higher costs, and are all but shut down in this environment.  I can elaborate in Q&A, but one can model mine-level economics for Blue Creek.  Given certain conservative / reasonable assumptiosn regarding pricing, costs, volumes, capex, etc., I believe these mines cover you through the Notes' attachment point.  So again; best house (highest quality domestic product) on a bad block (Met versus Thermal) within a troubled community (Detroit / Central California?).

The business is comically sensitive to Met coal prices.  At spot rates ($110), Walter probably burns $0-50mm in EBITDA, with another $370mm in fixed charges (capex and cash interest).  Street estimates for $240mm of 2014E EBITDA are quite likely stale relative to spot pricing.  Just three years ago, the business printed $862mm of EBITDA, while met pricing was closer to $230.  I estimate each $10 swing in Met pricing drives ~$80mm of EBITDA 

Capital Structure

Any view regarding the stock will inextricably be linked to a more fundamental view on coal supply & demand.  I would note, however, the stock’s significant underperformance versus other US coal peers (Arch & Alpha) has been largely financing-driven.  Walter has $1.8bn of secured and $0.95bn of unsecured debt.  If you track the Company’s capital structure, over time – you’ll be amazed as to how poorly their foray into the leveraged finance market has gone.  They’ve since, continually worked to de-risk and term out the capital structure, through unsecured bond issuances in Nov 2012, March 2013 and finally the Notes’ issuance in Oct 2013.

For reference, Walter’s current capitalization is laid out below:

The Notes offer the most unique position in the capital structure; sharing security with the bank debt, but lacking maintenance covenants.  This sharing of collateral provides, by far, the cleanest attachment point (in front of unsecured claims, which can be messy with coal filings – although to be fair Walter is squeaky clean compared with two recent coal bankruptcies, Trinity and / or Patriot).

The Company has likely learned their lessons from previously poor financing decisions.  Their assets are top-notch, yet their balance sheet bottom-rung.  Meaning they need more flexible junior capital to ride out the storm.  Unsecured debt is a non-starter given secondary yields.  The same goes for equity; management is unlikely to issue meaningful equity at these levels.

Meaning, I think Walter will look to second lien notes to solve these problems.  Management may also issue additional Notes or convertible debt, but I think the vast majority of any financing will come via new second lien notes.  These new second lien notes, while no doubt carrying healthy rates; will provide incremental support for the Notes, liquefy the balance sheet and calm the collective capital markets.

Event Path / Returns

Given Company commentary and recent SEC filings, a financing should come sooner rather than later.  While pricing, of course, is TBD; 11-13% second lien notes are more likely than not.  The creation of this class (which will be priced to move) will further highlight the Notes’ relative attractiveness.

I believe the Company needs at least $500mm to paydown the Term Loan A (heavy amort in 2015), appease Term Loan B lenders (who have maintenance covenants and pro rata paydown requirements, driving consent fees) and raise a bit more liquidity (bridging to asset sales).

Near-term, the bull case would involve an all second lien / convertible financing.  In this scenario, I see 7-9 points of near-term upside.  These Notes should trade closer to Arch or Alpha; both of whom have worse assets yet better capital structures.  The base case involves a first / second lien financing, driving 3-5 points of near-term upside.

The bear case would involve no financing; however, I see too much value to ‘let things go’ over a couple hundred basis points.  Insiders have invested meaningful capital at much higher levels ($6mm of stock between 2011 and 2013 at ~$33), and don’t want to sell at these levels.  I’m not sure that the bank lenders (largely CLOs, this has never traded <95) want to own these assets, they want a comprehensive solution.

Medium-term, once financing concerns are addressed, the Company needs to perform operationally (FQ3 / FQ4 results were actually solid, albeit over-shadowed by the balance sheet).  At $110 coking coal, Walter’s only operational assets are in Blue Creek – driving negligible / negative EBITDA, and 90% of the US coal industry is underwater.  While I’m no coal expert – these pricing levels do seem unsustainable, certainly relative to the marginal cost of production (estimated ~$160 in the US) or industry forecasts.

Longer-term, the Company should be attractive for a larger commodity trader or steel producer.  Prior reports have mentioned BHP Billiton, Glencore and CSN.  Recall these notes are call-protected through October 2016.  A more strategic transaction would have home-run potential.

This idea is admittedly boring when compared with typical VIC content, but this is a big, liquid capital structure with substantial current yield and discrete near-term catalysts.

Medium & longer-term events are less tangible, but offer much more upside.  If / when a recovery in met coal pricing becomes more apparent, the stock will have tremendous upside (see YTD down 46%, LTM down 70%, off an amazing 94% from the peak of April 2011).

Catalyst