Description

Description

The Westmoreland Coal (WLB) 8.75% Senior Secured Bonds provide an attractive yield (~10% current) supported by cash flow generated with long term contracts and a management team committed to utilizing cash flow over the next few years to de-lever the balance sheet.  In a post Trump-victory world, Coal is not as hated as it had been, with expectations that Trump will be less supportive of the EPA / Obama war on coal. WLB was somewhat of the poster child for the baby thrown out with the bathwater as its stock and bonds were obliterated over the last year and a half before rallying throughout this year and in particular, following the election. While many coal companies have struggled, and WLB was not without its own idiosyncratic challenges not to mention an over-levered balance sheet, WLB’s long term contracts and unique mine-mouth positioning should have left it more immune to movements in the price of coal and thus to some degree the market re-rating of the space. With Trump’s ascendance however, we believe there will be a gradual re-acceptance to some level of the investment merits of certain coal related companies, with WLB included. We like the seniority of the bonds coupled with a nice yield. As a hedge, a Bond long may be twinned with a partial short of the equity which has run up dramatically (~40% increase since the election / 300%+ YTD; Bonds for context are up about 10 points from 80% level pre-Election)

Business Overview – Long Term Contracts

“The confidence we have in our ability to execute is based on our unique model. It not only positions us as a low-cost fuel provider but protects us from much of the current pricing volatility in our space.” – CEO Kevin Paprzycki

WLB produces and sells thermal coal primarily to investment grade utility customers under long-term cost-protected contracts. Two thirds of its tons are contracted through 2020 with its average contract length exceeding 10 years (extension discussion on renewals are underway). Every contract has its own unique feature and WLB is not very disclosive regarding specific contracts but many of the contracts are cost plus or cost protected (cost protected contracts have various indices incorporated into the contract protect the margin; the cost plus contracts are deemed more favorable and secure by the company). In short, WLB has minimal coal market pricing exposure. The company produced 53 tons (company record) in 2015 with a similar range projected for 2016.

With the exception of two mines (out of 13 total), the company focuses on mine-mouth operations whereby the mines are adjacent to the Power Plant customer. The goal thus accomplished is to serve as the low-cost supplier of choice to WLB’s customer. This dynamic (low cost + long term contract + cost protected contracts) helps position WLB with a steady stream of fairly predictable cash flows and a natural competitive advantage over competing fuel sources for its customers. The below chart illustrates WLB’s cost advantage:

Capital Allocation – Transition out of Acquisition Mode & Debt Paydown

“I've said before that our objective for 2016 is to delever, delever, delever.”

“We also expect to delever throughout 2017 with the cash flow we generate from operations”

CEO Kevin Paprzycki

After several highly acquisitive years, the company has expressed a commitment to focus on its current holdings with cash flow directed primarily at de-levering the balance sheet. This is of course a benefit to the debt, specifically the bonds to the extent that the company either purchases bonds below par in the open market (has been discussed) or pays down the Term Loan which shares in the Sr Secured bond collateral.  

Valuation through the Bonds

YTD, the company has had strong performance with $84mm in Cash flow from operations, $31mm in Capex, implying ~$54mm in FCF. Full year Guidance is laid out below. The company expects similar if not higher numbers in 2017 (Q316 CC), supported of course by contract visibility. In order to properly analyze where we create the bonds, it is crucial to note that while secured, the bonds are not secured by all of the company’s assets. The Sr Secured bonds share a guarantor package with WLB’s Term/Revolving facility so for analytical purposes we view that as a single tranche. If the company sticks to its plan, the debt at Parent (i.e. primarily this debt package) ought to be gradually reduced in the coming years thereby de-risking a bond position.

We do not have broken out financials for the Guarantor group specifically to whose assets the bonds along with the bank facility are first in line but can nonetheless put together a reasonable profile based on company disclosure in its filings for the Restricted Group (which does include some non-Guarantor but Restricted entities with minimal debt). The Restricted Group debt was listed as $700.9mm as at 9/30/16. This includes 1) $350mm of 8.75% Sr Secured notes due 2022, 2) $325mm of TL due 2020) and 3) a plug of $26mm.

The Restricted Group generated Adjusted EBITDA of $85.2mm for the 9 months ending 9/30/16, or 47.6% of the total. Using that allocation as a proxy, we can attempt albeit imperfectly, to allocate full year guidance to the Restricted Group and see where we create the asset. While coal companies in recent years have traded at depressed levels, as we look at where we create this through the debt, we are comfortable given we think the long term contracts / price advantage the company offers warrants a premium and the ability to create this at a 15% yield to the debt (unlevered cash flows divided by the debt) is a compelling position should things go south and we become forced to own the asset outright through an unanticipated restructuring:

Summary

Putting it all together, we think WLB’s Senior Secured bonds provide an attractive yield with support from long term contracts and minimal exposure to the pricing fluctuations that impacts the majority of coal produces. WLB’s unique mine-mouth model positions the 10% current yield and 11.4% YTM as a compelling investment.

Catalyst

- Continued pay down of debt

- Continued execution in core operations / cash flow generation which will strengthen investor renewed confidence in the capital structure

-General continued re-rating of Coal if occurs will continue to benefit WLB securities