Forget Walter Energy's Earnings Beat, Play for a Bigger Prize!
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Wednesday after the close, pure-play coking coal producer Walter Energy (NYSE: WLT) beat 2nd quarter earnings estimates and held a conference call Thursday morning expressing cautiously optimistic commentary on premium hard coking coal markets over the intermediate-to-longer term. Key takeaways from the call are that the Company's production is running smoothly, sales guidance for the year remains intact, realized prices are strong and costs are well contained. Compared to select U.S. peers, Walter's performance is looking really good.
Foolish investors need to look beyond earnings and focus on a much bigger prize, the takeout of Walter by a global mining company. Speculation of a takeout has been around for years, but there are major differences this time around. First and foremost, Walter Energy's stock is down ~75% from last year's high. Global mining companies like Rio Tinto, Vale, BHP (NYSE: BHP), Anglo American and Teck Resources, (NYSE: TCK) would be foolish not to take a close look at Walter. And in fact each of these companies and others have looked at Walter. Last September news that Anglo was prepared to pay $120 per share for Walter drove the stock up 20% in a single day.
There are reasons why Walter hasn't already been acquired. Walter's stock traded as high as $141 per share last year, a price at which it wasn't a compelling target. Before acquiring Canada's Western Coal, Walter had all of its production coming from a single mining complex in Alabama. And, Walter's mines are deep and gassy, meaning that mining conditions are tough and production shortfall relatively common. Still, with the stock price at about $36 and the Enterprise Value, "EV" about $4.4 billion, Walter is easily digestible for a number of majors. Importantly, the majors have ready access to incredibly cheap debt financing. Teck Resources just issued over $1 billion in new corporate bonds, some of which that have a 2.5% fixed coupon for 6 years. That's hardly different from FREE MONEY!
With green field coking coal projects increasingly difficult to get off the ground and the timing and costs hard to quantify, Walter's run-rate of 12 million tons must be looking quite tasty. Countries hoping to become global coking coal exporters include Mongolia, Mozambique, Colombia and Indonesia but political, environmental and infrastructure challenges have stalled ambitious plans. In Mongolia a massive coking coal reserve at Tavan Tolgoi was expected to be producing 15 million metric tonnes per year of premium coking coal by 2015. Ongoing delays have pushed back the date by at least 3 years, with no resolution to political paralysis in sight. Availability of skilled labor and equipment as well as rail and port capacity in emerging coking coal countries is nearing impossible to obtain for projects that won't see first coal for 4-5 years.
Even in the most mature and well established coking coal basins supply and cost constraints are a growing problem. Australia, by far the largest exporter of high quality coking coal, has experienced two "100-yr floods" in the past four years. BHP, the largest exporter of coking coal in the world, experienced an 18-month labor strike involving more than 3,000 workers. Cost inflation has been running at 15% per year in the 5 years through 2011.
All of this leads to an almost inescapable conclusion. Today it's better to buy than to build. It's far less risky to acquire producing assets than to try develop new assets. Diversification is the name of the game for both producers and customers. At no time in recent history has the buy vs. build proposition been so clear. Insanely cheap debt financing costs and very low target valuations make acquiring growth an absolute necessity. Acquiring Walter Energy is an inexpensive, long-dated call option on premium hard coking coal prices. It's a way to get more exposure to Asia's demand for coking coal without emerging market risk and without doubling down on over-priced Australian assets.
What does a global miner get from an acquisition of Walter? Instant geographic diversification, coking coal production of up to 20 million tons by 2020 and operations in the already emerged countries of the U.S. and Canada. Putting 20 million tons in perspective, any global miner that already has some coking coal exposure would leap to the 2nd largest producer in the world by acquiring Walter. Teck or Anglo would likely unseat BHP as the top producer by the end of the decade.
Foolish investors who are following the coal and iron ore markets know that these stocks are out of favor. Underlying prices of these and other commodities have traded down significantly. But at some point this year or next, it remains likely that demand from Europe and China, India and Brazil, Japan and Korea will pick up as global GDP growth rebounds to a healthy 3%-4%. Smart management teams will have learned from last year's disastrous coal acquisitions, executed at the top of the market. Deals like Alpha Natural Resources, (NYSE: ANR) acquisition of troubled Massey Energy and Arch Coal's, (NYSE: ACI) acquisition of International Coal. The smart money looks to buy assets when they are cheap, not rich. Walter's stock, off 75% from last year's high, is too cheap to ignore.
MockingJay2011 is long WLT stock through Call Options. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
