Coal

[Tommy]

$WLB - Coal Without The Risk

Jhttp://seekingalpha.com/article/1585562-coal-without-the-risk?source=email_authors_alerts&ifp=0

Recently, I haven't been pointing out any near-term buying opportunities in the coal sector. Natural gas has been heading the wrong way, and simultaneously we've seen other significant emerging threats to the sector including a potential political drive to punish coal.

With these headwinds and coal companies carrying significant debt loads, it gets too risky to try and bet on a cyclical turnaround in coal. However, there might be a chance to get coal exposure with much lower risk and at a sensible valuation. The company I'll be talking about today, might be that chance.

Westmoreland Coal (WLB)

Westmoreland coal is a medium-sized coal company operating 6 surface mines in Montana, Wyoming, North Dakota, and Texas. The map below, from a company presentation, shows how these are positioned.

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Additionally, also shown in the map (in green), WLB operates a 2-unit coal-fired power plant with a 230MW capacity.

WLB's uniqueness starts here. With all mines being surface mines, low mining costs are already a certainty. Coal from these Western and PRB (Powder River Basin) locations is significantly cheaper on a per BTU basis. It's thus much less vulnerable to substitution by natural gas. The following chart from the same presentation tells us how it's positioned, cost-wise, versus other sources of U.S. coal:

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It's thus no surprise that WLB didn't suffer tremendously from natural gas substitution. After all, even in the darkest days of cheap natural gas during 2012, Wesmoreland's coal was still competitive:

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Westmoreland's competitiveness and stability doesn't end with per BTU cheapness, though. A further factor helping WLB happens due to WLB's mines' location, ensuring further cost advantages:

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One of WLB's mines has a significant shortened route to its main customers through rail. Another has the customers nearby and can service them with trucks, and finally 4 of the mines actually have the customers at mine-mouth, where these are fed through conveyor belt. Transportation costs are the main problem that PRB coal producers face, and for the most part WLB has these completely covered.

Finally, WLB's main customers are tied to it through long-term cost-plus or cost-indexed contracts. Cost competitiveness and these contracts ensure a rather low earnings volatility and low risk. Quite unlike most other coal operators.

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What does this all mean?

Overall, it all means a much more stable financial performance. Less risk, and revenue/EBITDA charts heading the right way, up and left.

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Even during 2013, in spite of an unfortunate event at one of WLB's plants, WLB kept its 2013 EBITDA guidance at $110-$120 million (what follows is from WLB's Q2 2013 earnings report):

"Unfortunately, Unit 4 at the Colstrip plant experienced a major equipment failure on July 1st and this unit is estimated to be down for at least 6 months. We anticipate that this will negatively impact our EBITDA in the second half of the year, but still expect 2013 EBITDA to fall in the range between $112 and $120 million, consistent with the guidance given last quarter. Our ability to maintain our guidance is, in part, due to the limited downside provided by our cost recovery business model."

This stable and cash-generative performance, on the other hand, is allowing WLB to quickly pay down its indebtedness, further reducing risk.

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Indeed, at the end of Q2 2013, WLB had already brought its net debt/EBITDA ratio down to just 2.5 times.

What does this all cost?

This brings us to another crucial matter. How much does this interestingly positive coal performance cost to an investor? It turns out it's massively cheap, when compared both to coal, and non-coal, companies.

WLB has a market capitalization of $184.3 million (at $12.71 per share). It carries net debt as of Q2 2013 of $299.6 million. This gives WLB an enterprise value of $483.9 million. At the midpoint of 2013 EBITDA guidance, the EV/EBITDA is thus a low 4.2 times. 4.2 times EV/EBITDA is low on absolute terms and relatively, when compared with other much riskier coal plays such as Arch Coal (ACI).

This profitability and cash generation is overshadowed by a high price/earnings ratio, due to WLB not yet being bottom-line profitable. Profitability is hindered by the debt load and resulting high interest costs. Given the high interest costs and falling leverage, it would seem possible for WLB to refinance these liabilities at a lower cost, with an immediate positive impact to profitability. Either way, in 2014 consensus estimates point towards an EPS of $1.01, giving it a 2014 P/E of 12.6.

Still, the very low EV/EBITDA is the main reason to believe WLB is very cheap from a valuation standpoint. Deleveraging will help both bottom-line profitability and equity, as it's likely that the EV/EBITDA won't trade much lower than where it stands now, so any deleverage is likely to be compensated by equity trading higher.

Acquisition

As a tribute to WLB's management, WLB undertook an acquisition - but it didn't do so during a market peak, like Arch Coal did when acquiring ICG. Instead, WLB acquired the Kemmerer mine for $179 million during one of the warmest winters on record. This allowed WLB to add another mine following its operating model (customer at mine-mouth) for a very sensible price, leading to a low EV/EBITDA acquisition multiple.

The Kemmerer mine added $43 million to WLB's 2012 EBITDA, so the effective EV/EBITDA multiple on the acquisition was also 4.2 times. Meanwhile, WLB has been able to produce measurable improvements in this acquired mine.

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The main problem

Not everything regarding WLB smells like roses, though. As always, there are some potential problems. The main problem regarding WLB rests on post-retirement pensions and health promises. These are recognized in the balance sheet, but lead to an ugly negative shareholder equity position of -$281.6 million.

This equity position can delay both a cheaper refinancing of WLB's debt and dividends. This is the one thing that's not to like regarding WLB.

Conclusion

Westmoreland Coal represents a very interesting operating model in the coal space. It's a low cost producer of sub-bituminous and lignite coal with added transport advantages, together with long-term contracts ensuring lower earnings volatility.

This lower-risk coal producer is available for a very low valuation, just 4.2 times EV/EBITDA. It thus represents a better way to get coal exposure than the other more-speculative coal producers.

There are also signs of a competent management team, in that it undertook an acquisition at the right timing, instead of the usual "buy at the peak" that's so common to see. This gives added confidence to an investor in WLB.

On the negative side, WLB still carries significant retirement and health-benefit liabilities and those lead to it having negative shareholder equity, which is never pretty and might make it harder for present shareholders to reap benefits in the short term.

All in all, WLB seems like an excellent buy, especially for those seeking coal exposure after the sector has been so punished.