Description

In order to make significant returns from energy investments, one must take a contrarian approach: buy just as industry conditions turn for the better and sell when everyone thinks that there is no downside. This is why I am NOW very bullish on the coal industry.

Coal has long been considered to be oil's poor cousin. however, the supply/demand inbalance for fossil fuels bodes very well for coal firms at this time. After operating with the lowest contracted prices for thermal coal in over twenty years, the few firms still standing are lean,mean fuel machines. Provided that the price of oil remains above $25 per barrel in the latter half of 2001, coal contracts stand to be renewed at prices that are at least 25% higher than at present. This all falls directly to the bottom line, since coal mining carries high fixed costs and high variable profit margins. Add to forecast price increases the sharply rising utilization rates by utilities and the need for low cost domestic alternatives to oil and natural gas... the result is that the outlook for coal is now more attractive than at any point in the last quarter century.

Westmoreland Coal is the oldest publicly traded firm of its type in North America. In my view, it is also the best positioned firm to benefit from the increased demand and potential price increases. The company (and the industry in general) have kept a very low profile in recent years. Since the entire industry has been relegated to the proverbial coal-bin, no Wall Street coverage exists on Westmoreland. This will shortly change.

Last week, Westmoreland announced a blockbuster purchase of a highly profitable utility coal operation from Montana Power (who is divesting all power operations to focus on telecommunications). In addition, a smaller acquisition of an efficient and profitable utility coal operation from MDU Resources (announced last month) is in the final stages of due diligence.

When completed, these two purchases will serve to increase Westmorelands' annualized coal revenues by 775% in 2001. Profits from these two purchases (assuming that Westmoreland will have to pay junk bond interest financing costs of 14%) should propel the bottom line from a forecast loss of -$7.2 million for 2000 to a profit of $25.6 million ($1.60 per share)in 2001. Profits for 2002 may rise by a further 33% based on contracted volumes and hit $2.28 per share ($35.6 million). These forecasts assume no price increase whatsoever in thermal coal contracts. Should oil remain above $25 per barrel, these numbers will prove to be highly conservative.

Furthermore, utilities are interested in separating their capital intensive generating capacity and transmission operations from the customer base. This leads me to believe that more coal mining operations presently held by utilities are for sale.

Westmoreland is the industry's low cost producer. They have a total of 13 employees and are the most heavily levered to rising coal prices of any firm in North America. With its' new size, every $1 increase per tonne of contracted coal sold can add up to $2 per share to Westmoreland's bottom line.

1999 was a difficult year for the coal industry. Westmoreland produced 5.5 million tonnes of thermal coal and sold their output for roughly $8 per tonne. This was below breakeven, and subsequently, the company is forecast to lose $7.8 million this year. Management however, is both shrewd, value oriented and opportunistic. Rather than batten down the hatches, they have taken advantage of the buyer's market for coal operations.

For example, consider their most recent purchase of Montana Power's assets. In 1999, Montana Power mines generated revenue of $238 million and produced net profits of $36 million after tax. This represents a return on sales of 15%. Yet, at the bottom of the cycle, Westmoreland paid just $138 million. They will recover their entire purchase cost in less than four years.

As mentioned, Westmoreland is also wrapping up their due diligence on the MDU Resources "Knife River Mines". The cost is estimated to be between $25-$30 million, which will be in the five times earnings range.

Both acquisitions are unique, as the bulk of the coal produced is directly consumed by generators right on the mine site. This is known as "mine to mouth" operations. With mine to mouth generators, the utility becomes a captive client.

My pro-forma of the combined operations of Westmoreland, Montana Power and Knife River Mines for 2001 and 2002 are enclosed. Please note that I am assuming that an equity issue of up to 8 million shares will be required to complete the purchase, as will debt financing of roughly $130 million (at a cost of 14%). I have included these numbers in my pro-forma. Rothschilds of London will be handling the financing requirements for Westmoreland.

2001 Estimates

Revenue: $311 million.
Gross price per thermal tonne: $10.5O
Output: 29.6 million tonnes
Profit after tax: $25.6 million.
Profit per share: $1.60

P/E ratio is less than three times earnings.

Since the utilities that purchase coal from Westmoreland have committed to increasing their purchase volumes in 2002, let's consider the pro-forma estimate with constant pricing and increased volumes.

2002 Estimates

Revenue: $322 million
Gross Price per thermal tonne: $10.5
Output: 30.7 million tonnes
Profit after tax: $35.6 million
Profit per share: $2.28

The leverage to increased coal prices becomes evident once we price oil at $25 per barrel in 2001. Remember, with pricing increases, the fixed costs are basically unchanged, and the variable increase in revenue flows directly to the bottom line. The only difference would be in taxation, and Westmoreland has $200 million in unused tax pools to apply against future profits.

2002 Estimates with coal price increases based upon oil @$25 per barrel.

Revenue: $384 million
Gross Price per thermal tonne: $12.50
Output: 30.7 million tonnes
Profit after tax: $99.6 million.
Profit per share: $6.20

SHARE PRICE FORECAST

I assume that the market will pay six times peak earnings for coal operations. Should Westmoreland generate profits in the year 2002 of between $35.6 million to $99.6 million after tax (and using 16 million shares as the outstanding equity)... the shares would be fairly valued anywhere between $13 to $37. The range is quite wide, due to the heavy leverage of rising coal prices upon the bottom line. Coal prices have been as high as $20 per thermal tonne during the past ten years, and with oil at current levels, we may see coal prices surpass their ten year highs as well in the next twenty four months.

RISKS

The most significant risk will occur in late 2001. Should oil (in latter 2001) trade for less than $16 U.S. per barrel, Westmoreland's coal contracts would be repriced at break even or even unprofitable levels. This would be catastrophic for equity holders, as debt holders would likely trigger a debt for equity restructuring.

In summary, the coal sector is cheap, overlooked and poised for explosive gains in revenue and earnings during the next two years. With its' completed acquisitions, Westmoreland will undoubtedly prove out as the best positioned company for maximum capital gains. I would buy any coal firm now, but Westmoreland stands heads and tails above its' peer group.

Value investors should buy and hold for a minimum of three years. A $20 share value by 2004 would not be unrealistic, should my analysis prove correct.

Please note: Westmoreland presently has only 7.2 million shares outstanding, and less than $80 million of total long and short term debt. Most of this debt is in the form of coal pension heritage costs. I have added in the debt cost and a sizeable equity financing in my pro-formas. The company may adjust the amounts of debt or equity, but the bottom line should very much be the same once completed.

Catalyst

Westmoreland will benefit from a 775% near term increase in revenues from two highly profitable acquisitions. This massive increase in size and profit will attract both momentum investors and Wall Street coverage by the end of 2000. A potential for double digit increases in coal contracts may further pad the bottom line. Finally, as more utilities divest themselves of coal operations, Westmoreland may be able to further lever their top and bottom line through astute acquisitions.