Walter Energy: Classic Turnaround Play or Value Trap?
Sean is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Shares of Walter Energy (NYSE: WLT) have been pummeled as of late. The metallurgical coal producer, one of the only pure plays in the industry, has not only been experiencing losses since 2012, but is now spooking investors of its long-term viability. In fact, one of the reasons for the stock’s 68% drop in share price so far this year was the announcement on June 14 that Walter Energy would not be moving forward with a planned $1.55 billion credit refinancing. The shares promptly fell as S&P also announced the firm was now on credit watch due to the announcement. Given all the blood that’s running in the streets here, might there be opportunity?
Canary in a coal mine?
With the possibility that a purchase of Walter Energy could be a falling knife in mind, what are the odds that Walter can return to some form of its former glory? Better than one might think. A pullback in an industry can often be a fantastic opportunity to purchase cheap shares in companies that have the ability to outlast the storm. Coal prices have sagged in recent years, for reasons ranging from a slowdown in Asia to a lack of breadth to the global economic recovery. As if sagging demand was not enough, Federal environmental regulators are not making things any easier for coal producers by increasing emissions standards for thermal coal's main customers. On top of all this increasingly tough competition from plentiful natural gas reserves in the United States means coal producers should keep their eyes on their canaries as they head to work each morning.
A Tale of Two Coal Markets
Despite all of these negatives, Foolish investors have several reasons to look past any sickly canaries. First, unlike most coal producers, Walter is solely a metallurgical coal producer as compared to a thermal coal producer. Thermal coal producers have been under pressure due to competition from natural gas as power generators switch to a cleaner, cheaper fuel. Metallurgical coal producers don’t have this issue, with low prices for metallurgical coal being caused by sagging demand that will inevitably return with global steel production.
This compares with the issue being faced by thermal coal: potentially being entirely replaced by natural gas. Many other coal producers are seeing the writing on the wall: Alpha Natural Resources (NYSE: ANR) which produces a mix of thermal (81% of output) and metallurgical coal (19% of output) recently announced a shift towards focusing more on metallurgical coal production. Holders of ANR will no doubt benefit in the future from this move, but any rebound in their metallurgical coal division will be diluted by the company's continued presence in the thermal coal markets. This is what makes Walter worth a look: Foolish Investors looking to place a bet on the dichotomy between the futures of these two coal markets have little to choose from when looking for a pure metallurgical play.
The only other publicly traded entity besides Walter Energy whose fortune is tied solely to the metallurgical coal industry is SunCoke Energy (NYSE: SXC). SunCoke operates on a contractual basis with what amounts to just two clients, ArcelorMittal and AK Steel, thus benefiting from the inherent stability that goes hand in hand with long-term clients. However this prevents SunCoke from benefiting in a large way from an eventual rebound in metallurgical coal prices. SunCoke Energy also leaves much to be desired in terms of valuation: It currently trades for just under 2 times book value. Even SunCoke's own recently spun-off Master Limited Partnership (MLP) SunCoke Energy Partners LP has only a steady 7% dividend to offer investors. Decent for a MLP dividend stock but hardly eye-catching if one wishes to earn above average returns betting on an eventual turnaround in metallurgical coal.
Deep Value and leveraged to the future of Metallurgical Coal
What about the possibility that Walter could go bankrupt? After all, if a company can’t survive long enough to enjoy an eventual recovery it makes little difference. Looking at Walter’s balance sheet, it’s clear that the company does have a high debt to asset ratio, with $5.9 billion in assets supporting $4.9 billion in liabilities. Such a high debt/asset ratio means Wall Street has reason to be concerned. However, a glance at the income statement and cash flow statements shows that for the three months ended March 31 the company lost approximately $50 million on a GAAP basis, but its actual cash losses from operations came to just $20 million. This is hardly critical to a company with $235 million in cash on hand at the end of the quarter.
By contrast, earnings last peaked in FY2010 when Walter earned a net profit of just under $400 million. While the company does carry a significant debt load, Walter Energy has no significant debt maturities until 2016 when a $750 million term loan comes due. This gives the company, and its major customers in the steel industry, a full three years to gain their footing.
The bottom line
While it’s clear that Walter Energy faces some headwinds, long-term investors might find shares of WLT worth a look. The metallurgical coal industry is not going anywhere despite attempts to curb usage in its sister industry thermal coal and debt maturities within Walter’s balance sheet remain far enough off to give the company time to maneuver. Looking more closely and seeing if it has a place in their portfolio might just be one of the most Foolish things long term investors could be doing today.
Sean O'Reilly has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!