Like most of its peers, Westmoreland Coal Company (WLB) has seen its stock price fall precipitously over the past several years. Its stock is down more than 80% since it peaked in July 2014.
Unlike its peers, Westmoreland has avoided bankruptcy (so far, at least). Its stock still trades at a level – around $8-$10 – that suggests that it may have a better chance of working through this rough patch without having to restructure.
Since 2012, Westmoreland has used its balance sheet to expand through acquisitions. During this period, the company has tripled in size. From its original base of five mines and 307 million tons of reserves, it now owns and operates 21 mines with 1.08 billion tons of reserves.
In 2012, it bought the Kemmerer mine from Chevron Mining for $165 million. In April 2014, it acquired seven Canadian coal mines from Sherritt International Corporation for $763 million, including assumed liabilities. At year-end 2014, it purchased the general partner of Oxford Resource Partners for $35 million and contributed coal reserves worth $36.9 million for a 73% stake in Oxford’s limited partnership units, thus gaining control over eight mines located mostly in Ohio. (Upon completion of that transaction, Oxford became Westmoreland Resource Partners and now trades under the symbol “WMLP.”)
In January 2015, Westmoreland acquired for $32.5 million the Buckingham Coal Company of Ohio, which operates a mine near WMLP’s facilities. Most recently, in January 2016, Westmoreland gained control of the San Juan Coal Company, which serves the adjacent San Juan Generating Station owned by Public Service of New Mexico (PSNM). The purchase price was $126.9 million, $125 million of which was borrowed from an affiliate of PSNM. Westmoreland San Juan’s operations and finances are ring-fenced, so the debt is non-recourse to WLB and neither WLB nor its creditors can lay claim to San Juan’s assets or cash flow (until the debt is refinanced or paid off).
While Westmoreland has tripled its revenues and reserves with these acquisitions, it has also tripled its debt. WLB’s total debt now stands at $1.13 billion and the company is near the practical limit of its borrowing capacity. Consequently, it will focus going forward on improving cash flow and profitability and reducing debt, rather than making acquisitions.
Despite the additional revenues and profits provided by these acquisitions, the performance of Westmoreland’s underlying business has suffered from reduced demand for coal and lower coal prices. The company’s cash operating income (which I define as revenues minus cost of sales, selling and administrative expenses and heritage health benefit expenses plus other operating income) is up by 50% over the past two years (2013 to 2015), but that’s well below the growth in revenues and debt. Interest expense has therefore risen at a faster pace than operating profit, so adjusted EBITDA coverage of interest expense (as I define adjusted EBITDA) has slipped from 2.4 times to 1.5 times. It remains to be seen how well the larger enterprise will perform without the benefit of acquisitions.
Although cash operating income (as defined) has improved, Westmoreland has reported large GAAP net losses over the past two years. A significant portion of the losses is due to the sharp increase in depreciation, depletion and amortization expense associated with the acquisitions. But in 2014, the company booked a large loss on derivatives and significant restructuring costs. In 2015, it recorded a $136 million impairment charge.
Both the derivatives and impairment charges are associated with Westmoreland’s Roanoke Valley Power Facility (ROVA). ROVA has two coal-fired power plants that serve Dominion North Carolina Power (Virginia Power). Output from the power plants is sold under a contract that expires in March 2019. At current prices, it is cheaper at times for ROVA to purchase power for delivery to its customer than to run the power plants. Westmoreland uses derivatives to hedge its power purchases. The sharp decline in power prices in recent years triggered mark-to-market losses on its derivatives book in 2014 and led to the large impairment charge against ROVA’s carrying value in 2015.
Besides seeking improved performance across the entire enterprise, Westmoreland will seek to utilize WMLP to create additional value (albeit for WMLP unitholders). The company intends to drop its existing mines into WMLP over time in order to benefit from the tax-exempt status of the partnership.
Its first drop, the Kemmerer mine, was completed in August 2015. Upon completion of the drop, Westmoreland received $115 million in cash and $115 million of Series A Convertible LP units, which raised its total stake in WMLP to 93%. In conjunction with the drop, all of the employees of Kemmerer and their associated liabilities, include pensions and health care costs, were transferred to Westmoreland.
The MLP strategy is a little surprising, because Westmoreland already has significant net operating loss and tax credit carryforwards. At December 31, 2015, these credits and carryforwards totaled $260 million, which should shelter a considerable amount of future profits. Still, Westfield believes that the MLP structure will attract income-oriented investors, providing another avenue to raise capital. The company also sees the partnership units (of which it currently own 93.9% of the total outstanding), as a source of liquidity.
Although Westmoreland booked a large profit in the 2016 first quarter, its underlying performance, excluding one-offs, was mixed. Revenues declined 4.5% to $354.7 million, despite $26.6 million of additional revenues from the San Juan acquisition. The company attributed the overall decline to the warm winter weather, lower export volumes and a fall in the Canadian dollar.
Despite the drop in revenues, cash operating income (see definition above) improved by about $8.2 million to $48.2 million. Besides the benefits of operational improvements, the San Juan acquisition made a positive contribution to profitability in the quarter (by $11.2 million, according to my estimates).
With the sharp rise in interest expense due mostly to acquisitions, the company’s interest coverage ratio (i.e. adjusted EBITDA divided by interest expense) declined from 1.9 times in 2015 to 1.5 times in 2016.
Higher interest expense combined with a negative swing in foreign exchange (from a gain to a loss) produced a wider pre-tax loss of $17.8 million vs. $11.8 million in 2018. Yet, the company recorded a $47.9 million tax benefit, attributable to a decline in the company’s valuation allowance against deferred tax assets as a result of the San Juan acquisition. Thus, Westmoreland’s GAAP net income was $30.6 million or $1.67 per share in the quarter, compared with last year’s loss of $11.7 million or $0.67 per share. On balance, despite the reported profit, this was a challenging quarter for Westmoreland (as it was throughout the industry).
Consensus estimates anticipate a net loss of $0.38 per share for all of 2016. Excluding the $2.63 per share tax benefit from the San Juan acquisition, the expected non-GAAP loss per share is $3.01. For 2017, analysts currently project a loss of $2.36. Consequently, base operating performance is expected to improve only modestly in 2017.
At the recent shareholder meeting, Westmoreland added two directors – Robert Flexon, Dynegy’s President and CEO and Robert Tintsman, Chairman of the Board of Idacorp, while Chairman Robert Klingaman has retired from the Board. Mr. Flexon and Mr. Tintsman should help Westmoreland manage its existing and possible new relationships with power producers. Conceivably, their companies could also acquire some of the mine mouth power plants currently served by Westmoreland. Dynegy might possibly be a buyer of ROVA.
Valuing Westmoreland today is not easy, given its recent history of operating losses and projections that those losses will continue. The company’s equity book value per share is negative. I calculate its enterprise value-to-adjusted EBITDA multiple at 6.4 times (assuming that debt is valued at 70% of par), This is generally considered cheap and is much less than the current broad market average; but it may be high relative to industry peers (who currently generate little or no EBITDA).
The bull case for investing in Westmoreland is based upon the contrarian view that the coal industry’s fortunes will improve before too long and Westmoreland has the staying power to avoid a restructuring while it waits for the upturn.
The company has only modest available liquidity, $54 million as of 16Q1, not including another $15 million available to WMLP. It can probably dance for a few more quarters or longer by pursuing another mine drop down or perhaps even by selling other assets. (A sale of ROVA, though unlikely, would almost certainly be well received by investors.)
Ultimately, however, the company (as well as the entire U.S. coal industry) needs higher natural gas prices, which would cause power producers to utilize more of their coal-fired capacity. This, in turn, would lead to higher demand for coal and higher coal prices.
The company and the industry would also benefit from a repeal (or substantial modification) of the EPA’s Clean Power Plan either by a Supreme Court decision or Congressional action. Neither are likely before the U.S. Presidential election. A Republican administration would be more inclined to support the coal industry.
The industry’s performance should bottom out in the second quarter. Revenues and profits should begin to show at least some modest improvement in the second half of the year, against much easier year-over-year comparisons.
WMLP is an interesting, but highly speculative investment. The partnership current pays an $0.80 annual dividend. A substantial proportion of the total dividend cost, that portion payable to the Series A Convertible Units held by Westmoreland, is payable-in-kind (i.e. in WMLP shares rather than cash). Against the current price of $5.80, the $0.80 dividend works out to a 13.8% yield.
WMLP too has been posting significant GAAP losses, but it was able in 2015 to generate sufficient cash flow to cover its interest expense, capital expenditures and partnership distributions. The money that it borrowed in 2015 was used entirely to finance the Kemmerer drop and repay a small amount of other debt. Several of WMLP’s mines will run out of reserves in the next few years, but the Partnership has a couple of idle mines that it can tap. (though I do not know the cost of bringing those mines into service.) WMLP can also expand its operating base with future mine drops from its parent. Buckingham would be an obvious candidate. With 93.9% of its estimated 21.4 million outstanding beneficial limited partner interests held by Westmoreland, however, WMLP’s current float is only about $7.5 million.
2016 Second Quarter Results. Today, Westmoreland reported a second quarter loss of $1.37 per share, compared with last year’s loss of $2.04 per share. Revenues increased 2% to $356.2 million, but without San Juan, they would have declined. Operating income improved from a loss of $6.9 million last year to a profit of $3.0 million, but excluding the contribution from derivatives and asset sales, both of which swung from losses to gains, the company’s operating loss increased.
Westmoreland generated positive cash flow from operations and investing activities in the quarter, part of which was used to reduce debt. However, interest coverage (using my definition of adjusted EBITDA), declined from 1.2 times last year to only 1.0 times.
The second quarter is the slowest of the year for Westmoreland and this year’s second quarter was exceptionally slow, given the industrywide supply glut and low coal prices. Despite the weak performance, management reaffirmed its full year targets for coal tons sold (53-60 million tons), adjusted EBITDA ($235-$275 million) and free cash flow ($60-$80 million).
At midday, WLB shares were down 13.1% to $8.07, bringing its valuation down to 6.2 times enterprise value to trailing 12 month adjusted EBITDA (assuming debt valued at 70% of par and using my definition of adjusted EBITDA).
Clearly, WLB is highly speculative. Without any improvement in industry conditions, it may be hard for Westmoreland to avoid an eventual restructuring. Yet, if the coal industry can regain its footing and price pressures subside, it is very likely that Westmoreland’s shares would trade at three or four times the current price.
August 2, 2016
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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