On July 6, the bankruptcy court approved Arch Coal’s Third Amended Bankruptcy Plan and Disclosure Statement. That set in motion the voting process which is scheduled to end on August 31. If there are no hitches and creditors vote in favor of the Plan, the court will hold a confirmation hearing on Sept. 13. That would set the stage for Arch to exit bankruptcy as early as September 30, less than nine months after it filed for bankruptcy. By most bankruptcy benchmarks, that would be a remarkable achievement.
There were notable changes from the Second to the Third Amended Plan. The tussle between the company and unsecured bondholders has been resolved. Under the Third Plan, unsecured noteholders will get a combination of cash, new warrants and new common stock. GSO Partners, a creditor which had filed a suit related to Arch’s failed exchange offer last fall, has settled for $5 million.
The Plan estimates the allowed claims for unsecured funded debt at between $3.35 billion to $4.46 billion. That’s a pretty wide range. ACI’s 2015 10-K puts unsecured funded debt at $3.2 billion, including the 8% senior secured notes due 2019, which are deemed to be unsecured under the Plan because the First Lien Lenders are impaired. The difference between $4.46 billion and $3.35 billion, I believe, represents the amount of the First Lien Lenders claim that is deemed to be impaired. According to the bankruptcy plan, the First Lien Lenders will forego their share of consideration from the unsecured debt claims’ pool, as long as the unsecured debt holders vote in favor of the plan and do not opt out of certain release provisions.
The Plan specifies that unsecured debtholders will get their prorata share of (i) $22.646 million, plus (ii) either $25 million or 7-year warrants for 12% of the new common (at a strike price of $1.425 billion), plus (iii) 6% of the new common. Assuming that the warrants are equal in value to the $25 million in cash (so that there is no difference between choosing cash or warrants in item (ii)) and using the disclosure statement’s estimate of the value of the new equity of $324-$666 million, I calculate that the package of securities represents a recovery of 2.0%-2.6% of par for unsecured debtholders (at the lower bound of estimated allowed claims, which assumes that First Lien Lenders will not press their deficiency claims). The Plan indicates that claims holders must (should?) not opt out of certain release provisions, as specified in section 11.8 of the Plan and in item 4 of the ballot, in order to avoid the First Lien deficiency claim.
As calculated, my estimate of the entire recovery for unsecured funded debt holders ranges from 1.5%-2.6%. This is within the Disclosure Statement’s estimate of 1.2%-2.9%. The difference between the two, I believe, is that ACI has probably estimated a range for the value of the warrants (whereas I have assumed that the warrants are equal in value to the $25 million in cash).
Since my previous post on Arch Coal, the unsecured debt has traded up from around 0.50% of par to about 2.00%, which is in line with the revised valuation.
As noted, the Disclosure Statement assumes that the new equity is worth between $324 million and-$666 million. To put this into perspective, I have backed into the implied enterprise value-to EBITDA multiple, using the company’s financial projections. This calculation is given in the table below:
A couple of points are worth noting here: First, the company’s projections are essentially the same as those provided in an 8-K filing in mid-April. Tons sold, average prices, sales and EBITDA are all the same. There are some differences in cash flows, primarily due to adjustments to expected payouts during the bankruptcy process, in part as a result of changes made to the Plan over the past couple of months.
In the table above, I provide two estimates of enterprise-value-to-EBITDA multiples: One compares the assumed equity values (i.e. $324-$666 million) to projected EBITDA and total debt outstanding at the end of 2016. The other compares those equity values to the same metrics projected for 2018, but discounts that value back to the present at an annual rate of 15%.
The 2016 assumptions imply an enterprise-to-EBITDA multiple of between 6.1 and 9.3. That is reasonable based upon current comparable valuations. (By comparison, Westmoreland Coal (WLB) currently has an enterprise-to-EBITDA multiple of 6.3. Cloud Peak Energy’s (CLD) is 4.8.)
The 2018 assumptions, on the other hand, translate into an EBITDA multiple range of 3.7-5.8. That lower range is driven predominantly by an expected near doubling in ACI’s EBITDA from $108 million in 2016 to $208 million in 2018.
Yet, the implied 2018 EV-to EBITDA multiple of 3.7 to 5.8 is low relative to broader market averages. That suggests either that (1) the discount rate is too low (A discount rate higher than 15% would result in a higher EV-to-EBITDA multiple) or (2) Arch’s projected 2018 EBITDA is unsustainably high. Yet, a lower EV-to-EBITDA multiple does not square with the company’s long-term historical performance. A higher multiple may therefore be warranted.
As I noted in that earlier post, Arch’s average EBITDA over the seven-year period ended December 31, 2015 was nearly $500 million and its peak EBITDA in 2011 was nearly $900 million. Although there have been some structural industry changes, such as the shutdown of coal-fired plants due to the EPA’s MATS rule, that will impede the recovery in coal, most of the decline has been due to the low price of natural gas and, for this year, unseasonably warm winter weather. There are still threats to the long-term viability of coal-fired electricity production, mostly as a result of EPA efforts to regulate greenhouse gases under the Clean Power Plan (CPP). However, the CPP still faces challenges from many states and may be revised by the incoming Administration. Utilities generally believe that the diversity in generation mix supported by coal-fired power production is necessary to ensure reliability.
Most of the factors that have contributed to the downturn in the coal sector are reversible. The price of natural gas has rebounded in recent months. While the spot price of natural gas hit a new low of $1.71 per Mcf in February, it has since rebounded to $2.79. Futures markets now anticipate that prices will remain at $3 or above for most of 2017. Higher natural gas prices would encourage utilities and merchant power plant operators to shift some production back to coal-fired power plants. Along with a likely return to seasonable winter weather this year, a sustained rise in natural gas should therefore support steady improvement in coal demand and prices over the next year or so.
Although U.S. coal production has improved in recent months, it is still lagging behind prior year levels. Prices, meanwhile, remain at multiyear lows. (Prices in Australia, however, have begun to rebound, which may be good news for coal exports.)
I have been hoping for a stronger rebound in coal production due to the increased electricity demand from the hot summer weather. That should help power producers work off their coal stockpiles.
Nevertheless, it appears that natural gas has been the primary beneficiary of hot summer weather. According to the EIA, the percentage of electricity generated by natural gas-fired power plants will reach a new record in 2016. Yet, the increased natural gas burn has also contributed to the rebound in natural gas prices and higher futures price levels. This too should help to drive greater demand for coal over time.
If the coal industry is indeed working through a cyclical downturn and not a secular decline, then a higher equity valuation is warranted. It is also possible that the recovery in coal demand and prices could be stronger than current valuations and projections currently indicate. If so, given the proposed restructuring of the Arch’s capitalization, First Lien Lenders could reap a windfall that would be unfair to those longer-term holders of Arch’s unsecured funded debt who have suffered significant losses.
The proposed strike price of $1.425 billion on the new warrants is intended to allow First Lien Lenders to recover 100% of their claims before the warrants have any intrinsic value. The Lenders are certainly entitled to a quicker recovery of their claims; but if and when Arch’s new equity is worth $1.425 billion, they will still own 82% of the company. Thus, they will earn a return in excess of 100% of their claims (and maybe significantly above 100% of their claims), if Arch’s new equity rises above $1.425 billion in value.
On the one hand, a case can be made that the Lenders may be entitled to more than 100% to be compensated for the time value of money, since it will probably be at least a couple of years before the equity reaches that level. They also bear the risk that Arch’s performance could fall short.
Even so, I believe that long-term unsecured funded debt holders are entitled to a greater portion of the appreciation above $1.425 billion than they are getting under the Plan. There are a number of ways that this might have been achieved.
Despite what I see as a flaw in Arch’s Bankruptcy Plan, the unsecured creditors’ committee has voted in favor of the Plan and has also submitted a letter with all of the documents distributed to claims holders ahead of the vote. I do not offer any comments on that letter because I have not seen it. (I have not been able to find it through the court docket, so the letter may not have been filed with the court.) I suspect that the letter indicates that the committee feels that the proposed recovery is the best that unsecured creditors can hope for under the circumstances and that they could fare worse, if they reject the Plan.
As noted above, current noteholders and other claims holders must submit their vote by the deadline of August 31. Although I believe that those who own the unsecured notes at or near current levels still have the potential to reap significant gains, I believe that those who purchased their bonds at higher levels should have reservations about voting in favor of the Plan as it is currently structured.
Unfortunately, the structure of the ballots makes it difficult for claims holders to reject the Plan outright. The ballots require that claims holders indicate their choice of extra cash or warrants, whether they accept or reject the plan. This does accommodate those claims holders who wish to make a choice between cash and warrants, if the Plan is ultimately accepted by the requisite supermajority over their objections. Yet, despite the lack of flexibility in the ballot, the Plan does anticipate that some claims holders may not specify a choice between cash and warrants (in which case, they would get the extra cash).
August 24, 2016
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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