Description

Warrior met coal (HCC) is a fantastic risk/reward due to its 1) high quality assets, 2) great balance sheet, and 3) undemanding valuation. 

The opportunity exists due to the recent sell-off in global mining shares, skepticism about long term met coal prices, and because HCC carries the stigma of the bankrupt Walter Energy, HCC’s predecessor. 

Overview:

HCC owns and operates two highly productive underground mines located in Alabama with an annual production capacity of 7.3mm metric tons.  These two assets were formerly the “crown jewels” of Walter Energy.  As a strategy to maximize value for creditors, the two mines were separated from Walter’s otherwise toxic estate and moved into a newly created shell company via a 363 sale.  Importantly, nearly all of the legacy liabilities ($4.8b of debt, OPEB, pension, etc.) were left behind in “BadCo,” along with a mish mash of less desirable assets.  HCC was also able to bring over $2.2b of NOLs (with some restrictions) which will minimize its cash taxes over the next 5 years.  Management appear to be sound operators and were not responsible for the sins of the past. 

I think the quality of HCC’s assets is an underappreciated part of the story.  They are special for several reasons.  First, the quality of the coal is exceptional.  HCC achieves the 3^rd highest revenue/ton out of 170 met coal mines (worldwide) selling into the seaborne market.  To further this point, HCC’s U.S. peers (Arch, Alpha, Contura, Ramaco, Blackhawk, etc.) realize ~15% lower prices per ton on average due to lower quality coal.  Second, HCC’s geology is accommodative.  Thick coal seams (~6’) allow for a low-cost longwall mining method (most peers use continuous mining method, which is less efficient).  Third, HCC benefits from logistical advantages vs. the comp set.  HCC has multiple transportation options (direct access to CSX, wholly owned barge loadout facility) and is located with relative proximity to the Port of Mobile. 

These three advantages allow for netbacks at the mine that are firmly in the 2^nd quartile (~33^rd percentile) of the global met coal cash margin curve.  This gives HCC the right to make a healthy cash margin through the cycle.  In addition, HCC has done a nice job using the (formerly) tough coal environment as leverage to “variablize” their cost structure to reduce margin volatility when benchmark prices are weak.  For example the new CBA (collective bargaining agreement) ties bonus incentives and hourly wage increases to HCC (hard coking coal) benchmark prices.  HCC’s logistic contracts (rail, port, and barge) are also far more flexible than pre bankruptcy.  This has substantially reduced the breakeven price that HCC can bear before burning cash at the parent level.

Macro backdrop:

Met coal is used as an input in the production of steel in a blast furnace.  This production method accounts for 1.2b of the 1.6b MTs of crude steel produced worldwide each year.  The other .4b MTs of steel are produced using an electric arc furnace, which does not use met coal.  In the past five years blasts furnace production has increased by a 2.6% CAGR.  Over the next five years, blast furnace production growth (and therefore met coal demand) is projected (by Wood Mackenzie) to moderate to 0-1% CAGR as China (17% of met coal imports) takes its foot off the gas a bit, offset by modest growth in the rest of the world. 

On the supply side, the met coal industry has been starved of capital over the past several years as prices declined to levels not previously thought possible (which put the entire U.S. met coal industry into bankruptcy).  As a consequence, a number of higher cost mines have closed for good and very few growth projects are underway worldwide.  Additionally, China has been making efforts to rationalize its coal capacity (both met and thermal) for both environmental and economic reasons.  They have achieved this by closing higher cost mines and limiting working days for the industry.  This healthy backdrop should help keep the market in balance. 

Normal met coal prices:

The most important assumption required to value HCC is the “normal” price of met coal.  This is a difficult exercise because the benchmark is incredibly volatile and is prone to spikes due to supply shocks.  In fact, the trailing ten year average benchmark settlement was $189/mt, but ranged from mid $70s to $350+.  However, commodity prices tend to gravitate towards a level where high cost producers break even.  If the price gets too low, these high cost players exit the market and create a shortage – which drives prices back up. 

I was able to track down data from Bernstein which showed that 1) the current 90^th percentile cash costs FOB (free on board) port for met coal is $92/mt (down substantially over past couple years), and 2) the met coal benchmark has historically traded (over 30 years) at ~140% of the 90^th percentile producer.  This premium makes sense primarily because most producers realize a meaningful discount to the benchmark.   Additionally, met coal is fairly capital intensive (~$10/ton maintenance capex) and so a premium would allow for capital recovery. 

Using this framework, we can build up to the normal price of met coal.  If you take the $92 cash costs of the marginal producer and multiply it by 140%, you get ~$129.  I would argue that one should increase the cash costs of the marginal producer to account for cyclicality to normalize for labor, equipment, and service costs that have all declined materially in the weak market.  As an analogy, look at how oil service costs in the U.S. reacted to a weak oil environment.  Even FX (which impacts competing producers in Australia and Canada) seems to be pro-cyclical and tied to the broader commodities cycle.  To be conservative, I am using $130, however I think one could make an argument that $135-140 is a reasonable mid-cycle price deck. 

As a smell check, Ramaco Resources (METC) is ramping up Elk Creek complex in Kentucky.  This is one of the only met coal capacity additions I’m aware of.  Once the mine reaches its full potential (2019ish) it will produce 2.7mm STs and require ~$130/mt benchmark prices to breakeven at the parent.  The math is as follows (on a per ton basis):  Starting with a $130 benchmark, deduct ~15% for coal quality (~$20), convert metric tons to short tons (~$10), deduct $30 for rail, $3 for port, $7 for sustaining capex and you are at $60 netback to the mine.  Once at scale (they are still building the infrastructure), METC will have mining costs in the high $50s (let’s call it $57).   That would leave $3/ton in profit at the mine x 2.7mm tons, but METC will have ~13mm of SG&A (~$4-5/ton).  Therefore, at a $130 benchmark price METC will be roughly breakeven on a cash basis and unprofitable on a GAAP basis (when accounting for depletion and other accruals).  And if you speak with them – they will put their asset quality up against any of their peers in Central Appalachia.  Therefore, if a brand new mine with solid geology in Central Appalachia needs ~$130 to be viable, it seems like a reasonably conservative assumption to use when valuing HCC.

Valuation:

On the IPO roadshow, management expressed confidence that they could produce north of their stated capacity of 8mm STs (7.3mm MTs) in good times.  To be conservative, I assume a normalized production of 7mm STs (6.3mm MTs).  At a $130 normalized met coal price and 7mm STs of production, HCC is cheap by any metric.  On my numbers, HCC generates roughly $200mm of EBITDA, $120 of EBIT, and $80mm of NOPAT.  The NPV of NOLs is ~$150 as currently restricted and I project HCC will end the year with ~160mm of net cash.  HCC has applied for a private letter ruling which would allow unrestricted access to NOLs.  I’ve done some work on this topic and put a 50% probability on a successful outcome, which would add $170mm of NPV.  Therefore I give HCC credit for ½ of that value as a non-operating asset ($85mm).   

At the current price of $16.92, using 53.5mm shares, the market cap is $905mm.  Therefore, $905-$150-$160-$85 (see above) = we are creating HCC at a $510 adj. EV.  This implies HCC is trading at 2.6x normalized EBITDA, 4.3x normalized EBIT and 6.4x normalized NOPAT.  That is way too cheap.  I value HCC at $25 (~47% upside), using a 12.5x NOPAT multiple and adjusting for all the above assumptions. 

Moreover, I am comfortable that the risk of permanent impairment here is low given HCC’s overcapitalized balance and high quality assets. 

Key Risks: 

-          Global recession hurts steel demand

-          Blast furnace capacity closures

-          Irrational Chinese behavior (on met supply side)

-          FX moves adversely shifts cost curve

-          Union strike

-          Mine collapse/fire

Catalyst

cash flow