Get Back In Coal
Welcome all new subscribers to Alpha Letter. Every week I write about interesting opportunities in the public market. I focus on stocks off the beaten path. Broken businesses. Assets trading under liquidation value. I don’t like investing in large, popular companies and find a fascination with assets no one else is looking at. Today’s piece will be about coal and how it might be the right time to double back in. But before we get in today’s piece, first a word from our sponsor…
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Alpha Letter Pro subscribers made a ton of money on coal equities last year. It was almost one year ago today when I was pounding my fist on the table telling everyone I knew to buy coal stocks. Valuations were cheap. Coal prices were starting to move upwards. And contracts for the 2022 season were about to get locked in at all time highs. Despite the bullish tailwinds, coal equities at the time were trading for 1-2x forward free cash flow because of the anti-ESG nature of the industry, preventing large institutions with real money from investing.
I was underwriting coal equities assuming a $105-120 per ton average sales price. $50 per ton margin for most coal equities meant there was strong upside from current valuations. Then prices started to fly. Prices across the board went ballistic and every producer started to print cash flow. Literal money printers selling dirty black coal. Oh that sweet dirty black coal.
Before the epic rise in coal prices, producers were trading for nickels on the dollar. Many of the large players had so much debt that any downturn in coal prices could lead to a potentially dangerous Chapter 11. The coal industry is littered with bankruptcy and restructuring. Nothing new to industry veterans. But if coal prices held the levels we saw in the Fall of 2021 for at least a couple quarters, balance sheets would see a large infusion of cash and a rapid paydown of high interest debt.
As you can see from the prior chart, coal prices did hold those pricing levels, and even increased as the spring of 2021 approached. By the time Q2 2022 rolled around, almost all highly levered coal companies had net cash on their balance sheets for the first time since I can remember. Even the highly tarnished Peabody Energy Corporation (BTU) was sporting net cash, something I never thought I would ever see in my lifetime.
The dynamics in the coal industry has changed rapidly over the past year. One year ago I was underwriting coal equities with the view that the high levered names could potentially go bust. Today, I’m trying to figure out where Mr. Market will price unlevered coal equities should prices fall another $100/ton. Understanding where Mr. Market will price risk free bankruptcy coal equities in a lower price environment is quite challenging.
It’s challenging to figure out future valuations at lower price levels because there has not been a period where coal equities have had more cash on their balance sheet than debt. How do you value an unlevered coal company producing 15 million tons of met coal per year? Can you place a future value on the reserves in the ground? Will these equities always trade at an implied 1-2x forward free cash flow?
The problem with coal equities is most institutional investors will not touch them given ESG mandates. The market could be practically giving them away for free and ESG mandates will prevent most large money managers from buying. So what you are stuck with is a base of retail investors who are not as sophisticated as your typical money manager. This gives professional investors without mandates a leg-up as your competition should not be as intelligent. Which makes me think when coal prices continue to fall, we could get some real bloodshed in the equities.
Here’s my thought on the potential bloodshed. There is a large base of retail investors in coal names who have chased companies like Alpha Metallurgical Resources (AMR) from $10 to $150 per share and are more momentum FOMO investors over fundamental value guys. When prices start moving down, equity prices could collapse and give fundamental investors like myself another bite of the coal apple.
But there is also an interesting dynamic going on in the coal market that hasn’t gotten a lot of media coverage. This dynamic is the pricing of thermal coal versus met coal. Today, thermal coal is priced higher than met coal, an interesting situation that I have not seen before. For reference, met coal is priced around $250 per ton and thermal coal into Europe is over $300 per ton.
Coal management team teams including Alpha Metallurgical Resources, Ramaco Resources and Arch Resources have recently stated on their earning calls that they will begin selling met coal into the thermal market in order to capitalize on this development. Each of these management teams have stated that this will be a great opportunity to monetize met coal in a way that hasn’t been done before, and the end user is excited.
What makes this important is the 2023 bidding season that has just started. Steel companies and met coal companies are currently in the process of negotiating fixed price contracts for the 2023 season. Companies like Ramaco and Alpha historically try to lock in 50-75% of their production for the year in order to secure cash flows. In 2022, Ramaco locked in 1.67 million tons at $197 per ton. Alpha locked in at $196 per ton. Today, met pricing is higher than it was in 2021 and we have more supply being mopped up by thermal coal users in Europe who are trying to commit enough tons to heat the European Union.
So while we have companies like Ramaco, who have recently sold off due to rail issues, mining issues and a potentially slowing down economy, we have a very interesting dynamic in the market that could result in a strong 2023 pricing season. If companies like Ramaco can lock in 50% of their production at say $215 per ton, Ramaco could lock in $275 million of Adjusted EBITDA on just half of their production. With an enterprise value of only $511 million, the company would be trading at under 2.0x EV/EBITDA, on just half of their production!
I haven’t taken any position in coal names since I sold them after their giant run-up over the past year. But I am getting interested in buying in again. I am a student of the coal market and love the space. Over the next few weeks I will be updating my research notes on all of the coal names we made a bunch of money on last year. If you want access to this actionable research along with an archive of all my old notes consider becoming an Alpha Letter Pro subscriber today. As a Pro subscriber you get 1-2x high quality off the beaten path ideas per month. If you don’t like it, unsubscribe anytime, no questions asked.
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