Peabody Puts Its Bankruptcy Plan to a Vote (Part 1)

On January 27, 2017, the bankruptcy court approved Peabody’s bankruptcy plan and disclosure statement.  By now, these documents have been distributed to creditors who are eligible to vote on the plan.  The voting deadline is March 3.  Objections to the plan must be received by the court by March 9.  The confirmation hearing is scheduled for March 16.  If the plan is confirmed, Peabody will likely emerge from bankruptcy in early April.

The bankruptcy plan contemplates that the debtors will raise $3 billion in financing.  $1.5 billion will come from a replacement for the first-lien credit facility.  $750 million will be raised from the issuance of 8.75% mandatorily convertible preferred stock (dividend payable in-kind, preferred convertible mandatorily when common trades at a 30% premium to original plan equity value).  The remaining $750 million will come from a rights offering of new common stock available to holders of the debtors’ second-lien notes and unsecured claims, including the unsecured senior notes.

It is highly unusual for a bankruptcy plan to depend upon an immediate capital raise of roughly 75% of the reorganized company’s estimated enterprise value (including both debt and equity).  Accordingly, the plan anticipates that these financings will not come cheap:  The new first-lien credit facility is assumed to carry an interest rate of LIBOR plus 9.0%; the preferred will be convertible at a 35% discount to the estimated equity value of the reorganized company; and the rights offering will be issued at 45% discount to the estimated plan equity value.  In addition, penny warrants exercisable into 5% of the new equity will be offered to the noteholder co-proponents and other creditors who take part in the equity rights offering.  Peabody’s financial advisor believes that these discounts are necessary to attract new investors given the weak financial performance that led to Peabody’s bankruptcy filing one year ago.

The bankruptcy plan and disclosure statement (and indeed the motion to approve these financings as filed with the bankruptcy court) do not provide a detailed breakdown of the use of proceeds from these financings.  However, from those and other available documents, I have developed an estimate of them:

The total outstanding amount of the first-lien revolver of $1.82 billion includes $612.8 million for letters of credit reimbursement obligations.  Most of these, according to the company’s disclosure in the 2016 third quarter 10-Q, are associated with its reclamation liabilities in Australia.  As a result of the bankruptcy filing, the beneficiaries (primarily certain state governments in Australia and the U.S.) decided to draw upon these letters of credit.  Final resolutions for the debtors’ reclamation liabilities are required in order for the bankruptcy plan to be declared effective.  Although Peabody’s bankruptcy plan provides for repaying the banks for all amounts outstanding, including these letter-of-credit drawdowns, it seems reasonable to expect that a substantial portion of this $612.8 million will be recovered eventually by the company.  Yet, Peabody’s projections assume a recovery on posted collateral of only $38 million.

Distributing the New Equity.  The proposed equity financings figure prominently in creditor recoveries.  By my estimates, as a result of the large discounts offered on these new issues, the proposed convertible preferred, equity rights offering and associated penny warrants will end up with 86.1% of the reorganized equity value of the company.  That leaves a residual of 13.9% for existing creditors, including the holders of the Second-Lien Secured Senior Notes and the Unsecured Senior Notes.  However, these noteholders can gain a greater stake in the reorganized equity by participating in these new offerings, especially through the rights offering for new common shares.  (For purposes of this analysis, I do not incorporate the 10% equity stake reserved for Peabody’s management under its proposed Long-Term Incentive Program (LTIP).)

The discounts offered to the new convertible preferred and rights offering common shares are used to determine their relative ownership positions in the reorganized company’s equity, based upon an assumed total equity value of $3.105 billion.  Thus, according to my calculations, investors in the convertible preferred will pay $750 million for a security convertible into a 37.2% stake in Peabody’s new equity.  Likewise, investors in the rights offering common shares will receive a 43.9% equity stake for their $750 million.  Penny warrants purchasers will get 5% of the new shares for $85 million (according to my estimates).  The remaining 13.9% will be split between the 2nd lien noteholders and holders of general unsecured claims (the majority of which are unsecured senior noteholders).

Yet, the holders of both the 2nd lien notes and general unsecured claims will receive all of the equity subscription rights and (if they exercise those rights) half of the penny warrants.  Applying the 85.2%/14.8% split to all of the proposed components of the equity distribution, I estimate that the general unsecured creditors will receive (and have the opportunity to acquire) a 51.4% stake in reorganized Peabody; while the 2nd lien noteholders can obtain an 8.9% stake.  (See the Estimated Equity Distribution table above.)

Valuing the Reorganized Company.  Estimates of the enterprise value of Peabody are based upon the company’s projected financial performance, which is given in Exhibit C of the disclosure statement.  Those projections assume that Peabody’s 2017 financial performance will benefit from the recent run-up in coal prices; but that benefit will prove to be short-lived.  Based upon the company’s projections and my estimates for the 2016 fourth quarter, Peabody’s average price sales price per ton is expected to rise to 20% from $23.82 in 2016 to $28.60 in 2017.  However, total tons sold from its mining segments are projected to drop 3.2% from an estimated 188 million tons in 2016 to 182 million tons in 2017.

The expected drop in tons sold seems at odds with the latest industry trends.  By all accounts, 2016 will be a trough for industry production as a result of a confluence of events, including the low price of natural gas, unusually warm winter weather and (until the second half of the year) lower demand from the Chinese for coal imports.  Since the fourth quarter of 2016, U.S. coal production has picked up and is tracking much closer to 2014 and 2015 production levels.

More importantly, while Peabody projects that coal sales volume will increase modestly in 2018, it assumes that sales volume will remain flat thereafter (at a level 10% below 2015 sales and 16% below 2014 sales).  Similarly, the company’s projections assume that its average sales price per ton will decline 16.9% in 2018 and another 5.5% in 2019 and hold that level through the 2021 projection period.

In its filings with the bankruptcy court, Peabody says that its projections are consistent with the views of analysts, most of whom believe that the recent run-up in coal prices will likely be short-lived.  I too believed that the second half surge in coal prices was unsustainable.  However, I also believe that it is unlikely that prices will fall back near the 2016 lows and remain there for the next four or five years.

A more optimistic view of the outlook for coal sales and average prices is supported by several factors.  First, natural gas prices are well off their 2016 lows, which is beginning to tip the economics back in favor of coal-fired power plants.  Oil & gas production cutbacks and the expected growth in LNG exports will also serve to limit the future downside in the price of natural gas.  Second, the Trump administration is more supportive of the coal industry.  As a result, environmental regulations, such as the Clean Power Plan, will likely be modified.  Consequently, electric power producers may eventually halt and perhaps even roll back plans to close their coal-fired power plants.  Third, although the weather is always variable, it is unlikely that the U.S. will experience another winter as warm as the 2015-2016 season in the very near future.  All of these factors are supportive of increased demand for coal, which should help to improve coal prices.

Peabody’s historical financial performance also supports a more optimistic financial forecast.  Since most of the decline in coal prices and production is attributable to the plunge in natural gas prices, the company’s financial performance could rebound sharply if natural gas prices return to the $4-$5 per million BTU level for an extended period.  In 2011, Peabody generated $2.0 billion in EBITDA.  Its average annual EBITDA over the past six years (2011-2016) was over $1 billion.

Peabody’s bankruptcy plan assumes average annual EBITDA of about $700 million over the 2017-2021 forecast period and less than $600 million in average EBITDA from 2019-2021.  While those projections are more than double the average $340 million in EBITDA that Peabody generated in 2015 and 2016, it is certainly within the realm of possibility that the company could generate $1 billion in annual EBITDA level during the forecast period, perhaps even on a sustained basis.  If so, Peabody’s valuation and debt capacity would certainly be higher.

Nevertheless, it Is hard to argue against management’s projections.  Along with their financial advisors, bankruptcy judges typically view the debtors as experts.  Despite my belief in a more optimistic base case projection, Peabody’s projections are not outside the realm of possibility (and probably not more than two standard deviations away from a more likely base case scenario).

Peabody’s CFO has testified that the company determined its proposed post-bankruptcy capital structure with a goal of ensuring that it will be able to meet its obligations at any point in the business cycle.  Any bankruptcy judge would be hard pressed to challenge that assertion and order the company to raise its projections without a strong counterargument from creditors and interests.  Valuation was an issue in the plan negotiations.  However, the projections included in the disclosure statement represent part of the negotiated compromise between Peabody and the creditor co-proponents.

Had they started earlier on in the process, before the plan took shape, and received the court’s support, the junior creditors and interests might have succeeded in nudging those projections higher.  Similarly, they could have agreed to disagree with the company on the projections, but still succeeded in getting the court to acknowledge the upside potential in the forecasts.  That might have earned them the right to a potential recovery through deep out-of-the-money equity warrants (or terms on the proposed securities that might have limited the upside potential for senior creditors to the legally-entitled limit of principal and (for secured creditors) accrued interest).

Links to related posts:
Peabody Puts Its Plan to a Vote (Part 2)
Peabody Puts Its Plan to a Vote (Part 3)

February 15, 2017

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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