Description

Westshore Terminals Investment Corp. is perceived to be a steady, dividend-paying asset, and is held by a relatively conservative, sleepy, and yield-oriented investor base.  Sell-side models naively assume volumes through the port remain steady into perpetuity with modest annual price increases/escalators (which are currently structured into the contracts).   However, Westshore’s profitability is largely dependent (2/3rds of their volume) on a single large, strong, and well-resourced customer, Teck Resources. Teck has been locked in an onerous and uneconomic contract for an extended period of time (a 10-year contract signed in 2011 during a dramatically different commodity backdrop) -- that contract is set to expire in March of 2021.  Additionally, Teck has been frustrated with the operational execution at the port (i.e., Westshore has been underperforming loading targets, etc). The combination of the historical negotiating leverage exerted against Teck by Westshore during peak commodity markets coupled with the aforementioned recent operational missteps by Westshore has caused Teck to deem it “strategically imperative” to control their own logistics infrastructure.  As a result, Teck has begun spending capital ($85mm board approved this year out of a total ~$220mm capex project) to expand its own port, Neptune (which sits near Westshore in the same harbor) to prepare for the post-contract termination world. The below link illustrates the engineering schematics of the expansion (a hard copy of the updated document, with permits, can be obtained by contacting the Port of Vancouver directly).

https://www.portvancouver.com/wp-content/uploads/2015/03/2013-01-23-project-permit-signed-with-plans-and-schedule-neptune-coal-capacity-pp-2012-066.pdf

Further exacerbating the problem for Westshore, their remaining volumes are also at risk, as the remaining 1/3rd of volume consists of high cost US thermal Producers, who are swing producers to the ROW (and thus, unable to export volumes profitably throughout all phases of the commodity cycle – i.e., with thermal coal below ~$75 per ton).  Cloud Peak alone represents half of the non-Teck tonnage and their “take-or-pay” contract is set to expire in 2020. Cloud Peak is unlikely to agree to similar terms upon contract expiration, given the balance sheet risk the current arrangement has posed.

·         For instance, Cloud Peak almost went bankrupt in 2015 when coal prices came under pressure -- as an aside, see below for a chart of Westshore’s stock back in 2015 when investors were concerned Cloud Peak, who represented only ~13% of Westshore’s volumes, might go bankrupt and potentially reject the contract in Chapter 11.  

Ultimately, we see downside in excess of 70% as the investment community digests the reality of the post-March 2021 FCF at Westshore as well as the appropriate multiple to assign to the remaining cash flow (e.g., Cloud Peak bonds trade with a 10.8% yield relative to Teck’s, which yield 4.5%).  Furthermore, there are scenarios were Westshore is a completely stranded port.

Background:

Westshore operates a terminal on land leased from the Vancouver Fraser Port Authority (“VFPA”) located approximately 30 kilometers south of Vancouver – it’s the largest coal loading facility on the west coast of the Americas.  Teck is Westshore’s largest customer, accounting for approximately two-thirds of total throughput, or 19mm tons. Its other customers include US producers who collectively account for ~11mm tons. Following a capex project, which is expected to be complete by early 2019 (and increases capacity by ~2mm tons), total throughput capacity will be ~35mm tons and Westshore anticipates filling the remaining ~4mm tons of capacity with volumes from a greenfield project (which is expected to be up and running in 2020).

Westshore operates the Terminal on a throughput basis and is paid a handling charge by its customers when the coal is loaded on a ship. While market conditions may affect the competitiveness of Westshore’s customers and therefore, the volume of coal handled by Westshore, Westshore secured long duration (10-year) take-or-pay contracts with its main customers during robust times for global commodity markets – as a result, Westshore’s revenue has been highly predictive.  Meanwhile, Westshore’s cost structure is primarily fixed cost, so maintaining volume throughputs and charge rates is extremely important to sustaining the ports profitability/FCF. Importantly, we do not see the potential for any other customers in the area to fill any excess Westshore capacity in the event Teck were to divert coal away from Westshore (i.e., there really aren’t any others) and Teck is not expanding coal production. Furthermore, there are no alternative uses for the port (which wouldn’t require substantial capex and thus, completely disrupt the ports economics).

Is this all a Negotiation by Teck?

Perhaps.  Although Teck notes a strategic desire to control its own logistic infrastructure when discussing the capex rationale, it is entirely conceivable that Teck is simply attempting to restrike the existing contract.  To the extent that is the case, we believe that it’s highly likely that we see a near-term catalyst (as the new deal will need to be inked before Teck spends capital to expand its own port). To that point, we find Teck’s commentary on its recent earnings call revealing:

Analyst:  And just to focus on Neptune, you are going to spend CAD85 million there this year, is that a capacity expansion that you're undertaking?

Donald Lindsay (Teck CEO):  Yes.

Analyst:  By how much?

Ronald Millos (Teck CFO):  The target is to be in excess of 18.5 million tons per annum for something around 20 million tons of capacity once the expansion is finished.

Analyst: “So how is that going to impact how you direct your coal transport out of BC then? How much will go through Westshore and how much will go through Neptune?

Donald Lindsay (Teck CEO):  “Well, we have our contract with Westshore until March of 2021 of 19 million tons and will clearly honor the contract.”

Consensus:

As mentioned above, consensus models assume that modest annual price escalators continue into perpetuity, existing contracts are reset at the same economics, and a 4mm ton greenfield project comes online to fill the open 4mm tons of Westshore capacity (I haven’t attempted to quantify the risk that this project ultimately doesn’t come to fruition) to bridge to ~220mm of fully ramped EBITDA, which translates to ~150mm of FCF (as capex reverts to maintenance capex of ~15-20mm annually following completion of the 2mm ton expansion in 2019), or a 12% FCF yield in 2020.

Most Westshore analysts appear to be unaware of Teck’s plans (they don’t tend to cover Teck) or gloss over the risk; however, one analyst does appear to have taken some notice and recently downgraded the stock while lowering his price target from 31 to 27 -- noting “Teck Resources’ plans to expand the Neptune coal terminal are likely the beginning of its transition to in-source a majority of its port requirements.”  I have a no idea how he arrives at 27, however, as we illustrate below, such an outcome would be disastrous for Westshore.

The Economics:

·         After price escalators have kicked in, Teck will be paying Westshore ~12.50 per ton on 19mm tons of current throughput, or ~240mm of revenue in 2020.  Meanwhile, although fully loaded costs are 5-5.50 per ton when operating at full utilization, our conversations suggest variable costs are only ~1-2 per ton, suggesting every 1mm tons of lost Teck volume is worth ~11mm of EBITDA (implying essentially ALL of Westshore’s EBITDA is at risk -- before any change in economics from Cloud Peak or other US producers -- if they were to lose all of Teck’s volumes).

Could Westshore lose all of Teck’s volume?  And, what would a negotiated solution look like?

The short answer is, yes – it’s possible.  And, Teck appears to have an axe to grind.

·         Neptune, Teck’s port, currently has capacity of ~12.5mm tons relative to current throughput of ~6mm tons (the fact that it’s not running at full capacity is an accident of history, the prior contracts, timing of prior Teck expansions, etc).  Given that Teck is already incurring the fixed costs associated with that capacity and it requires zero capital to ramp to 12.5mm tons, it’s reasonable to assume that absent Westshore restriking 6.5mm tons of Teck volume at Tecks variable costs (or 1-2 per ton), that 6.5mm of Teck tonnage and associated EBITDA will be lost, or ~70mm of EBITDA at a minimum (in a negotiated scenario – i.e., Westshore prices 6.5mm tons at 1-2 per ton).

·         Meanwhile, Teck can spend ~220mm of capex to increase capacity at Neptune to ~20mm tons, or an additional 8mm tons.  Presumably, Teck would incur additional fixed costs at the Port associated with the expansion, so we assume Teck’s costs per ton would be ~4 (relative to the 1-2 per ton variable costs on the first 6.5mm) when modeling the IRR Teck would expect on its 220mm capital (or a ~20-25% after-tax IRR, i.e. 12.50 Westshore rate less 4 of costs at Neptune, or 8.50 of savings * 8mm tons, tax-affected at 25%).  From our conversations with Teck, we believe that they would spend the capital unless Westshore were to renegotiate throughput rates on this tonnage to ~7 per ton (while that would only equate to an 8% after-tax IRR, again, Teck views it strategically important to control its logistics infrastructure and doesn’t want to get caught in a position in out-years during a potentially more robust commodity backdrop where Westshore is able to exert leverage again).   Thus, in a negotiated solution we believe Westshore would have to give up a minimum of $5.50 per ton on this 8mm tons, or another ~45mm of EBITDA.

What about the remaining ~5mm tons (of the 19mm that Teck currently exports through Westshore)?  Could Westshore just increase the price on those tons to close the shortfall?

·         We don’t believe so, hence we assume that the remaining 5mm tons is resigned at existing economics in negotiated scenario (to arrive at a blended rate of ~6.50 across all 19mm tons in a negotiated scenario), which may actually be very conservative given the many levers Teck has at its disposable.  For instance, Teck could just ship those tons further north to Ridley, which has plenty of excess capacity (although the rail costs would be higher in that scenario, Ridley rates would likely be substantially lower than 12.50, thus offsetting the incremental rail costs). Other possibilities include flexing their production profile – for instance, Teck is planning to close ~3mm tons of capacity (The Coal Mountain Operations in mid-2018 that currently ships through Westshore).  Meanwhile, they’ve been investigating a capacity expansion at Quintette (that would roughly offset the Coal Mountain tonnage) that would ship through Ridley.

Is Neptune an inferior port?

Our calls with industry professionals, the rails, etc. suggest that as of today, Neptune is actually a slightly inferior port.

·         However, importantly the equipment/capex associated with the 220mm expansion WILL solve the current issues at Neptune, which account for its deficiencies.  For instance, the engineering drawings illustrate that a new ship loader will be built, which will allow for loading of capesizes at Neptune (the current equipment only allows for loading of smaller vessesls).  

·         Furthermore, one of the reasons that Westshore is more efficient today is precisely because of Teck’s existence (i.e., one very large customer allows for more efficient port operations, creating more efficiencies for the rails, etc with respect to loading, unloading, etc).  As a result, many efficiencies that exist at Westshore today will flip in Neptune’s favor in the event that the Teck capex is spent.

·         Meanwhile, there are other pros and cons, that in our opinion all roughly offset each other – for instance rail traffic at Neptune will likely be modestly more congested, however, Neptune doesn’t have waves (given where it sits in the harbor) which limits loading at Westshore.

Conclusion:

Overall, in the event that Westshore chooses to negotiate with Teck, we believe a minimum of $110mm of EBITDA is at risk, bringing FCF to ~$70mm in 2021 (before any changes to the US producer contracts).  Put whatever multiple you want on that and it’s not hard to see that Westshore’s stock would likely decline in excess of 50% in a negotiated solution (and we’d expect an announcement to come within the next several quarters, as a negotiated solution would have to happen before Teck spends the capital).  Meanwhile, if Westshore fails to negotiate and allows Teck to spend the capital, the consequences could be devastating.

Catalyst

market recognition of westshore economics post contract termination