On January 29, Cloud Peak Energy (“CPE”) announced that it had hired a team of professionals to help it review its capital structure and formulate restructuring alternatives. That followed its announcement last November that it was pursuing strategic alternatives, including possibly a sale of the company. These steps have been precipitated by the company’s weak financial performance and deteriorating liquidity, which prompted the disclosure in its 2018 annual financial statements of substantial doubt about its ability to continue as a going concern. On March 26, CPE’s shares were delisted from the NYSE because its share price had remained below the minimum $1 threshold for more than 30 consecutive days. (CPE shares now trade in the pink sheets under the symbol “CLDP.”)
2018 was Another Tough Year. The decision to pursue strategic alternatives was a logical response to Clouding Peak’s deteriorating performance in 2018 and its outlook for continuing profit pressure in 2019. Market conditions in the Powder River Basin, where CLD operates, have been depressed for most of this decade, due to the steady decline in the demand for thermal coal. In 2018, the company also faced several operating and market-related problems that hurt its financial performance.
Antelope Spoil Failures. The biggest challenge last year came from ‘spoil failures” (i.e. wet coal deemed to be unusable) caused by heavy rains at its Antelope Mine in Wyoming in the second quarter that reduced output and raised operating costs for the rest of the year. Sales at Antelope declined 18.4% to 23.2 million tons in 2018. The company said that the ongoing necessity of re-handling the wet coal will continue to divert equipment away from pre-stripping activities (which expose more coal for future production). This will delay shipments further and add to operating costs in 2019.
Low Demand for Low BTU Coal. Besides the problems at Antelope, demand for Cloud Peak’s 8,400 BTU coal, which is produced from its Cordero Rojo mine, declined sharply in 2018, due primarily to the loss of a major customer. A measure of the heat generated per pound, the BTU content of coal mined from Cordero Rojo is on the low end of the range for coal mined in the PRB and also below the averages of CPE’s two other mines. In 2018, the BTU content of mined coal averaged 8,851 per pound at the Antelope mine and 9,252 per pound at the Spring Creek mine.
The low BTU coal produced at Cordero is still sought mostly by utilities with power plants located nearer to the Powder River Basin (PRB) as the lower freight cost helps offset the lower heat content.
Demand for 8,400 BTU coal has been declining for years, but last year’s decline of 23.1% in tons sold at Cordero Rojo was especially steep. The drop in 2018 sales of about 3.8 million tons was reportedly due to the loss of its customer, the JT Deely power station in San Antonio.
While power plant closures can have a devastating effect on the sales of individual coal producers, the demand for 8,400 BTU coal from power plants that continue to operate is driven by the interplay between freight costs and the price and demand (both domestic and international) for higher BTU coal. Any further decline in coal demand could make difficult to produce coal at Cordero Rojo at a profit. (In fact, CPE declared its previous forecast for the mine’s production to be uneconomic at the end of 2018 and revised downward its production forecast for 2019.) On the other hand, a rebound in the overall demand for thermal coal (either for domestic use or for export) should also help lift demand for 8,400 BTU coal.
The declines at Antelope and Cordero Rojo were partially offset by a 10.3% increase in tons sold at CPE’s Spring Creek mine. In total, Cloud Peak’s 2018 sales volume declined 13.4% to 49.7 million tons and its operating cost per ton increased also by 13.4% to $11.19 per ton (driven by the extra handling costs at Antelope and reduced overhead efficiency caused by the volume declines at Antelope and Cordero Rojo).
Problems in the Logistics Business. Besides the problems at Antelope and Cordero Rojo, Cloud Peak reported that its logistics business suffered a loss of $4.7 million in the 2018 fourth quarter, its worst quarterly performance since the 2017 first quarter, as a result of a sharp drop in pricing for exported thermal coal. That price decline was reflected in the 13.6% drop in the Kalimantan 5000 GAR index price from $53.25 at Sept. 30 to $46 per tonne at year-end. The Kalimantan index is a measure of the average price of thermal coal shipped out of Indonesia. The drop in the Kalimantan was caused by the removal of export restrictions on coal by the Indonesian government in response to a sharp drop in the rupiah vs. the U.S. dollar. (Higher exports bring more dollars into the country alleviating some of the downward pressure on the rupiah.)
At the year end Kalimantan price, Cloud Peak said that its logistics business would not generate positive economic returns. However, the Kalimantan price had rebounded to $56.55 per tonne, as of March 1. (I have so far been unable to find a more current price quote.) If the Kalimantan price holds at or near that level, I expect that Cloud Peak’s logistics business will once again be viable.
Impairment Charges. The decline in Cloud Peak’s 2018 profitability and especially the drop in sales for Cordero Rojo’s 8,400 BTU coal, prompted CPE to test the carrying value of its assets for impairment. Although Cordero Rojo generated significant cash flow in 2018, management determined that the reduced demand combined with higher expected operating costs will probably reduce the profitability of the mine going forward. Consequently, in the 2018 fourth quarter, Cloud Peak wrote down the carrying value of Cordero Rojo’s assets by $372.4 million. (To my knowledge, the company has not disclosed the pre-impairment carrying value of the mine.)
Despite the write-down, CPE estimated Cordero’s total proven and probable reserves at year-end 2018 to be 285.3 million tons, down 13.7 million tons from 2017 which is 1.1 million tons more than the 12.6 million tons that were sold from the mine in 2018. Since the company is required to take into account the future expected average sales price and production costs of the mine in its estimates of the reserves, it appears that CPE still does consider future production at Cordero Rojo to be economic and thus the mine to be viable.
Besides the Cordero Rojo impairment charge, CPE also determined that that its increasing inability to fund the significant development expenditures required for two follow-on mining projects, Youngs Creek and Big Metal, necessitated an additional $309.2 million impairment charge at year-end 2018.
Continuing Pressure in 2019. The squeeze on 2018 profits and expectations of continued losses in 2019 have caused Cloud Peak to lose its access to credit. With reduced borrowing availability as a result of its deteriorating financial condition and the concern that it might not be able to avoid a default (that would trigger cross-defaults on other debt), the company terminated its bank credit agreement in November 2018.
The Path to a Bankruptcy Filing. CPE declined to make its scheduled March 15 $1.8 million interest payment on its 6.875% Senior Notes due 2024. According to the terms of those Notes, the company now has a 30 day grace period to make the interest payment. Failure to make that payment by April 15 would be an event of default, which would allow the holders of the Notes to accelerate their claims (i.e. declare all of their interest and principal due and payable). It would also trigger cross default provisions in other CPE debt issues and agreements, including its accounts receivable securitization facility and its 12% Second Lien Senior Notes due 2021. The prospect of cascading defaults raise the likelihood that CPE will file for bankruptcy.
On March 14, Cloud Peak entered into a forbearance agreement with lenders participating in its accounts receivable securitization program to avoid a default that would have been triggered by its going concern qualification in its 2018 financial statements. The agreement extends until the earlier of 1) April 14 (the day before the expiration of the grace period for the interest payment due on the 6.875% Senior Notes) or 2) the date on which any additional events of default occur.
Subsequent to the end of 2018, CPE received letters from some of its third party surety providers (who issue letters of credit backing the company’s legal obligations to prepare for land reclamation throughout the life cycles of its coal mines) demanding additional collateral to secure the company’s obligations. Since CPE has terminated its credit facility, it has met those collateral demands by issuing letters of credit against its accounts receivable securitization facility, effectively using up all of its available borrowing capacity.
At year-end, CPE had $91.2 million in cash, which represented all of its available liquidity. (Cloud Peak could conceivably sell assets to obtain additional funds, but probably only at fire sale prices and probably not on a timely basis.) Given its projected continuing need for cash in 2019, the company will most likely need to obtain another financing source. Although the CPE cancelled its bank credit agreement, it can still grant a first priority lien to a new lender, either a bank or an investment firm, on a new credit facility
In current circumstances, however, because of the risk that a new loan could still lose its priority ranking, it is likely that CPE will find more potential lenders (or investors) willing to extend credit after a bankruptcy filing, when they would be granted first priority status by the bankruptcy court. Similarly, holders of the Second Lien Senior Notes may be willing to roll their Notes into an expanded new First Lien credit facility as part of a prepackaged bankruptcy plan, rather than risk that such a roll up before a filing might later be deemed a preference action by a bankruptcy judge. For these reasons, I think that it is more likely that CPE will file for bankruptcy on or before April 15.
Upside Potential in CPE’s Assets. A new creditor (or investor) should find a lot to work with here. Despite the 2018 fourth quarter impairment charge, the company still showed an equity book value of $293.7 million or $3.84 per share at the end of 2018, well above its current equity market value (on April 5) of $6.9 million or $0.09 per share. Indeed CPE’s total market capitalization (included its debt at market value) is only $75.1 million or a little over 10% of the current book capitalization of $690 million. Likewise, at its $75.1 million total market capitalization, its 977 million tons of proven and probable reserves are valued at only $0.08 per ton.
(It should be noted that 96% of CPE’s reserves are leased and require the payment of royalties (roughly 12.5% to the Federal government and not including royalties and fees payable to the states of Wyoming and Montana). Even so, the company’s current market valuation suggests that the reserves have almost no value, which I believe is highly unlikely.)
CPE’s low valuation reflects in large part a bleak outlook for the U.S. thermal coal market (and also for U.S. exports of thermal coal). The sector defied my expectations (supported in large part by forecasts from the U.S. Energy Information Administration (EIA) that it would bottom in 2018 and stabilize before beginning to recover modestly in late 2019. The EIA’s forecasts made early in 2018 implied that purchases of coal by the electric power sector would rise 1.2% in 2019 after falling 4.5% in 2018. Instead, EIA data now suggests that electric sector coal purchases fell 5.9% in 2018 and its current forecast implies another 6.4% decline in 2019 and 4.9% decline in 2020. By that forecast, the EIA sees a continuing free fall in coal demand.
Rebound in Natural Gas Price is Key to Recovery in Coal. The primary drivers of the weaker outlook continue to be low natural gas prices and steady growth in renewables. A year ago, EIA anticipated that coal’s share of the U.S. electric generation market would begin to stabilize in the mid- to high-20% range. It now sees coal’s market share falling to 23.4% in 2020.
As noted, a key driver of this forecast is the assumption of continuing low natural gas prices. Despite an average annual increase in the Henry Hub spot price of 11.8% over the past two years, the EIA projects that the Henry Hub spot will decline 6.4% in 2019 and 1.4% in 2020. Similarly, the EIA anticipates total consumption growth of 1.8% in 2019 and 0.1% in 2020, compared with the average annual increase of 4.5% from 2016 to 2018. Although its price forecast is not out of line with the futures markets, it is noteworthy that the EIA expected that natural gas in storage at the end of March would be 28% below the five-year average. In making its price forecast for 2019, the EIA anticipates that injections (and thus production) will pick up sharply over the next six months, bringing inventories back to the five year average. This despite a 70% increase in projected LNG exports (though admittedly from a small base).
The persistently low price of natural gas has encouraged consumption growth (both domestic and now through exports). This raises the risk of an eventual sharp rise in natural gas prices, if natural gas production slows. That in turn would lift the demand for coal and coal prices. Predicting the timing of the inflection point, however, is difficult. It could conceivably be more than a year or two away; but anyone seeking to invest in CPE today must believe that such a turnaround is coming.
Investment Considerations. CPE’s extremely low market capitalization reflects a concern that the company will be unable to finance its operations going forward and so it will be forced into a messy Chapter 7 liquidation or sold at a fire sale price. If it is possible to reconcile the company’s financial statements with its current market valuation, investors should conclude that CPE is asset rich, but income poor. It has assets that should be worth significantly more in the future, but existing creditors and shareholders may suffer a nearly total loss because the company lacks the financial flexibility to continue its operations.
From my perspective, CPE seems to be a potential investment best suited for an active (or activist) investor: a firm that is able and willing to take a long-term view and commit its capital to see the company through its current problems. Since most shareholders and bondholders are not able to meet that need, an investment in the company’s currently outstanding publicly-traded securities is highly speculative. On the one hand, it sure looks like the market has significantly overreacted to the company’s current problems; but those current low market values may prove to be right, if the company is forced into a Chapter 7 liquidation.
If I were to recommend a speculative investment in Cloud Peak today, I believe that the most prudent investment would be in the 12% Second Priority Senior Notes (due 2021) which at last check were trading at 19 ($190 for every $1,000 face amount). Those notes still have a junior security interest in substantially all of the company’s assets. They also are protected by covenants – change of control, restricted payments, asset sales. leverage -which provide additional support for their security interest, but in the current situation also make it more likely that the company will file for bankruptcy to void these restrictions. (Under the indenture for these Notes, the company can issue up to $450 million of First Priority debt.) Even so, these protections give the Notes a better chance of receiving a meaningful recovery, even if a turnaround is some time off.
The 6.875% Senior Notes (which at last check were trading at 2 (or $20 per $1,000 face amount) and CPE’s equity have very little leverage in this situation. While they could conceivable realize a substantially greater recovery in percentage terms, if CPE is able to achieve a quick turnaround in its financial performance, the likelihood of that happening before a restructuring of CPE’s capitalization is complete is in my opinion low. Consequently, investors should view these securities as extremely speculative.
April 9, 2019
Stephen P. Percoco
16 W. Elizabeth Avenue, Suite 4
Linden, New Jersey 07036
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