Description

We recommend a long position in Warrior Met Coal (HCC) due to several catalysts unfolding in real time which the market is overlooking due to skepticism about long term met coal prices.

In a nutshell:

Profiting from high met coal prices, HCC until the end of the year will have ~65% of its current EV in cash, while at the same time a) management has already announced it will return excess cash to shareholders & reconsider how to do that once it has used up its NOLs (likely to happen until Q3/Q4), and b) the company has a strong track record of returning large chunks of cash to shareholders - returns reached high double-digit %s of the then current market cap during past years.

But wait…this is not just a “too much cash soon to be returned story” – on top of this, there are more catalysts which the market is ignoring and which we believe will help the stock: After a ~2y long strike which strongly impacted production volumes, HCC reached an unconditional offer from the union to return to work in March. In addition, HCC managed to fix operational issues at their main Terminal in May which had lowered sales volumes. In combination these two factors will mean return to normal production and sales volume (exp. To be +>30% vs 2022) flowing through Q3/Q4 statements.

Taking these short-term considerations together, we see a dividend yield of >35% until E2024 even in a base scenario (assuming modest coal prices of ~180USD/ton vs current prices of ~230USD/ton; *and* assuming no re-rating of the stock).

Now you say “sure, but what happens if prices indeed DO crash again”? In a super-bear like scenario (ie a 2^nd Covid/major recession) when coal prices crashed to about 113USD/ton (ouch!) equity could also crash to around 19USD/share– but to prices where share price and cash/share would roughly equal, and that for a US-listed company with little debt (and no pension obligation). I.e.: while prices might dip that low, it’s unlikely they’d stay there for very long. In addition, in that case the company could still comfortably return excess cash corresponding to ~30% of market cap at that low price. On top of this, take into account that large multinationals like Glencore are currently actively hunting for met coal assets, and again you end up with is a scenario that is unlikely to persist for very long.

Finally, on top of the dividend yield, you get a free call-option thrown in: On the longer term, the investment presents further significant upside due HCC’s ongoing development of a new world class met coal mine (Blue Creek) which once full running would increase production by >60% and significantly enhance margins (mouth-watering cash cost/tons of ~70USD/ton vs average of ~100uSD/ton now)– which as we speak could be paid for completely with cash in the bank even _after_ returning large chunks to shareholders. In the mid-price scenario of a coal price of 180USD/ton Blue Creek would add another >30 USD/share once running fully (first mining is scheduled to start in Q3 2024 already – but really relevant production not expected to start before Q2 2026).

Details:

HCC has been written up before by rhubarb in 2017, and I recommend you read the write-up for further background. For that reason, I will keep the background on the company short.

• HCC is a pure-play met coal producer with a prod. Capacity of ~7.3m tons, great access to relevant international markets, a very competitive and flexible cost structure, low debt, and no pension obligations.
  • HCC is a pure-play met coal producer – and as an investor (and as a fan of the energy transition!) that’s the coal you should like!
    • HCC is a US based miner solely dedicated to the production of high-quality so-called metallurgical coal (or “met coal” in short) for the global seaborne market. Quality of the coal has direct impact on how close the actually realized price per ton sold is to the relevant underlying index, and HCC’s assets provide very high quality with price realizations normally around 98% of index prices.
    • The largest demand for met coal comes from international steelmakers (see below), and HCC’s location with proximity to a terminal in Mobile/Alabama plus good connections to railroad transportation to the port puts them into a prime spot to serve them quickly: Nearly all their coal goes to international markets (’22: >61% Europe, rest divided roughly equally between Asia and S America). This distance and shipping time advantage also results in higher margins compared to peers.
    • While there are many different types of coal, as an investor you really need to only know the distinction between two: Thermal coal and met coal. Their primary usage, and hence their main customers and relevant industry dynamics differ strongly: Thermal coal is manly used in power plants. Due to the increasing pressure to make our energy cleaner, more and more power plants switch to gas, and as a result, the global market for thermal coal is expected to shrink at LSD. Also, cash margins per ton sold are normally much lower compared to met coal.
    • Met coal on the other hand due to its high energy content still is one of the main ingredients for producing steel in a production process called blast-furnace (BF) which accounts for ~70% of global steel. Steel mostly goes into buildings and infrastructure, and as such will be essential also to drive the energy transition. Due to its importance in steel, the demand for met coal ir projected to grow by LSD.
  • HCC has a flexible cost structure which varies with coal prices (but is capped), and which keeps it profitable through the cycle.
    • HCC has “variabilized” its cost structure: royalties are calculated as a percentage of the price realized and therefore increase or decrease with changes in prices. In addition, HCC can adjust its usage of continuous miner units in response to pricing. This variable cost structure dramatically lowers cash cost of sales if realized price falls, while being effectively capped in higher price environments.
    • As a results, HCC managed to realize positive FCCs even through the depths of covid when prices hit lows like the 113USD/ton in 2020, because also the cost per ton sold dropped to ~92 USD/ton (vs ~100 USD/ton during normal times and 132 USD/ton in 2022 when prices shot to the sky). That also means that they can still pay for running their operations during times of havoc.
  • HCC has low debt & no pension obligations.
    • HCC currently has debt/equity ratio of ~20% (vs >80% in 2017), and no pension obligations to workers unlike peers.
• HCC has the main effects of the strike & op. issues behind itself which means they can return to normal production and sales volumes (expected >+30% tons sold this year vs 2022)
  • The Strike: In April ’21, the miners of HCC started a strike (which turned into the longest strike in US mining history), since they had lost many benefits they had had with HCC’s previous (and bankrupt) company Walter Energy. Extra costs of the strike were small (~40mUSD) – but the real effect of the strike for HCC were a loss in volume during the time of all-time met coal prices (2021 tons produced dropped by ~30% vs 2020). Fast-forward March 2023: HCC reached an unconditional offer from the union to return to work, and the process to return workers to work (health checks, etc) started then. So, this issue is closed. What is still open: ~2 weeks ago, it was ruled that during the strike HCC had violated labor law by failing to bargain in good faith. As of now, the consequences of this violation are unclear since the data on similar situations is thin. Nevertheless, market reaction after the announcement was cool despite the fact that the strike had caught national attention before with large media outlets reporting on it.
  • Operational issues: Throughout 2022, HCC was plagued by issues at their Terminal, which resulted in an all-time low of ton sold of 5.1m tons (average is ~6.5m tons). The main issues got fixed earlier this year, and while HCC expects that the maintenance needs more and ongoing attention, HCC has already increased its guideline for tons sold in 2023 to ~6.7m tons with the majority of this flowing through Q2/Q3 financials.
• They walk the talk: Management has a successful track-record of returning large amounts of excess cash to shareholders
  • During 2017-2019, the cash returns hit 12%, 38% and a whopping ~50% of the median market caps of the respective year.
    • As this sub-headline says: Mgm’t has proven it does return excess cash. In past years, these returns were a mix of regular and special dividends and stock buybacks, but dividends were clearly favored (2017: no buybacks, 2018: ~10% of the total cash returned, 2019: 5%). Even during the “crisis years” (covid+strike), HCC returned some cash through a small dividend, but without share buybacks. Part of the reasons are the NOLs:
  • Management is set to recalibrate cash returns by Q3/Q4 once they have used up all their NOLs
    • As part of Walter Energy’s bankruptcy (=HCC’s predecessor), HCC was able to bring over $2.2b of NOLs in 2017 to minimize its cash taxes. A funny part of tax code (Section 382 limitation) states that changes in ownership can restrict your usage of NOLs. And since sharebuybacks constitute a change in ownership, HCC decided to err on the side of caution and not do buybacks.
    • Mgm’t also already declared that the remaining NOLs will be used up latest by end of this year and then trigger a re-evaluation as to how to best return excess cash, and how big a role share buyback, and/or dividends should play.
• Valuation
  • Coal prices matter – but not as much as you might think
    • Three scenarios: One where prices hit lows similar to covid again (110USD/ton), a mid-scenario of 180USD/ton which corresponds to the 10y average met coal had hit before the price craze of 2022 and 2023 when coal prices reached highs above 480USD/tons and stayed well above 300USD/ton (i.e. long-term averages by now have moved higher), and a high(er) scenario where we do assume averages move higher to around 220USD/ton.
    • For all scenarios, I also assume margins will resemble realized margins of the past at the respective price points, and normal sales volume of 7m tons corresponding to sales volumes achieved under normal conditions (ie no op. issues, but still below 7.2m tons sold in 2019 before the op. issues hit). Also, for the remainder of 2023 I’ve used the high end of mgm’t guidance for CapEx of the 480mUSD, where the largest part is for investment on Blue Creek & discretionary spending (~345mUSD in high end scenario). Whereas CapEx to keep mines running in the high end is around 105m USD plus ~30mUSD of mine development costs.
    • In the low scenario (assuming NTM EV/EBITDA multiples stay at the average of past years of ~3,7), we’d look at an EBITDA of ~94m and a share price of ~19USD – vs ~18USD/share in the bank. After paying for their ops (~105mUSD), and even after completely taking out the whole remaining sum of 430mUSD at once to develop their new mine Blue Creek (highly conservative assumption - more on this below), and keeping ~200mUSD in cash in the bank (their historic number during past years of high cash returns; also confirmed again during last earnings call: 250m USD liquidity as long-term goal & they currently have >100m USD available under ABL facility), HCC would have >350m USD (or 6,8USD/share at a share price of 19USD) excess cash to return. So in this case, the share would very likely even get picked up by simple technical stock screeners, and I therefore consider this situation to be unlikely or at least not very persistent. Also, currently large strategic buyers like Glencore are looking to improve their exposure to the “good” met coal, and so persistently depressed prices would likely lead to becoming a take-over candidate.  Therefore, I consider this scenario to be unlikely to persist for long.
    • In the mid- (and high) scenario we look at >510m USD EBITDA (~625mUSD EBITDA), and there comes even more excess cash: Again after taking out the 105mUSD for operating their mines, assuming the remaining 430mUSD for BlueCreek will be paid at once and that ~200mUSD will stay as cash in the bank, excess cash goes to ~760mUSD or ~15USD/share (>870mUSD, ~17USD/share. All this assumes that excess cash primarily gets returned as dividends/special dividends as has happened in the past.
  • Add. long-term add. upside: Blue Creek project once running fully (CM start already in Q3 2024, but longwall start exp. Q2 2026) will increase production by >60% at sign. better margins, resulting in >30USD/share extra value in mid-case scenario
    • Currently, HCC is developing a new mine, Blue Creek (BC) one of the last remaining large-scale, untapped premium met coal reserves in the U.S.
    • With the 1^st longwall, BC will help to increase HCC’s production capacity to ~11m tons (from currently ~7.2m t), and to ~16m tons with the second longwall. In addition, the economics of this mine will be world-class: Cash cost/ton are projected to be around 70USD/ton vs HCC’s average of ~100USD/ton which will put BC very solidly in the top 15% of the global production curve.
    • Until Q12023, BC was set to cost about 700mUSD in total, to be spent over 2021-2026, and mgm’t has increased the original estimate (done in 2021) of the project cost to ~830m USD, citing project scope changes that should result in lower operating costs, increased flexibility to manage risk and the availability of multichannel transportation methods.  After 2023, HCC will already have spent >300mUSD. Note: On the question “How will they stage the investment for the remaining ~ 430mUSD?” I used a very conservative approach and simply assumed in all cash-return scenarios that the remaining 430mUSD are ”blocked” right away and not staged and/or earned as part of the cash flow from future years, and can’t be distributed. Importantly, this also assumes that HCC will finance the project solely via their cash in the bank while in reality they currently are checking alternate ways of financing it, e.g. via equipment leases.
    • Currently, the project is on track, and first mining is scheduled for Q2/Q3 2024.

How much of this volume will actually flow through the financials as sales? That is not clear yet. In the words of Walter Scheller, CEO during the last earnings call: “…we should start producing the tons in the middle of next year. But you have to remember, we have to build a preparation plant and have a way to get those tons to market. And we'll be working on that to try to figure out, are we better off to just stockpile that, clean it, take it to market immediately, which will have a higher cost on it because transportation will be significantly different than it will be once the transportation modes are completed.” Therefore, I assume that the main bulk of production will require the longwalls installed and running which is planned for mid-2026.

• • • So, how much is BC worth? While everything is progressing to plan at the moment, and markets might react positively already in 2024 through e.g. multiple expansion when the first step of mining is completed, and while HCC would have the cash to pay the remainder of the invest down straight away - a lot can happen between now and when actual production starts. I therefore above made the über-conservative assumption that the BC spend is “money thrown out the window” with zero value created. Once running, HCC estimates an NPV pf >1.5bnUSD, or >30USD/share for the mid-price scenario of 180USD/ton. So while this is not taken into the valuation given above, this sth to check out again once we’re in late 2024 – essentially, it’s a free call option.
    • A short add-on on project costs: During the last call, mgm’t announced the cost increases in the project. This caused some eyebrow raising in the call, also because while mgm’t claimed this would lead to better operational metrics, the business case of BC did not get upgraded by them. Some of you might remember a write up by zax382 end of 2021 on Algoma, a Canadian steel producer, which was so cheap “it couldn’t get cheaper”, and “will return a lot of cash soon…about to start a new very profitable project” – only that the project (funnily also estimated to be at ~700m at the beginning) went over time and over budget. So these overruns represent a very real risk.

 Risks

• Operating Issues at Terminal come back
• Process of workers returning to work stalls, bad outcome from ruling on labour law
• Met coal price volatility and people losing their nerves
• Project overruns for Blue Creek
• Technological disruption in the steel-making processes, replacing met coal as necessary ingredient
• “Combo risk”: While I think the company can handle these risks individually, one way to get creamed in commodities if risks combine, i.e. low commodity prices together with operational issues

Catalyst

• Use up of remaining NOLs and restructuring of cash return program (decided in Q3/Q4 or in 2024) / incr. high cash in the bank share vs EV
• Increased sales volume after work/op. issues are over and higher volumes start to flow through Q3/Q4 financials
• Ongoing cash flow generation
• Long-term, call-option: Add. >30USD/share in mid-term scenario once Blue Creek is fully operational and/or market starts to realize its potential.