The Super Commodity Changes Everything
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 commodities and how the super commodity cycle has completely changed capital structures. But before we get in today’s piece, first a word from our sponsor…
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The Super Commodity Cycle has Changed Everything
I’ve spent a considerable amount of time studying commodity based companies. Commodity companies fascinate me. When prices are high significant operating leverage kicks in and you make a ton of money. When prices are low the business model breaks and there are bankruptcies galore. If you are a deep value investor knowing and understanding the commodity cycle is key to achieving outsized returns. The boom and bust nature of the industry presents many phoenix like opportunities where fallen and beaten companies rise from the ashes to outperform in years ahead.
There is just one thing that I have never understood about commodity companies, their terrible capital structures! No matter what commodity industry you look at, they always have terrible balance sheets. Management teams tend to lever up during the peak price cycle and go bust when the cycle ends. When prices are sky high management teams get excited and use debt to acquire their peers for what seemingly seems like a 2.0-3.0x deal. It never fails, after the acquisition is complete the market falls off and they go bust given the newly issued debt with strict covenants. That 2.0-3.0x deal quickly becomes a 7.5x deal. My number one rule in investing and business is to never lose money. You lose money when your destiny is tied to the credit markets in a cyclical industry.
For years commodity companies would make a ton of money during the upcycle and go bankrupt during the downcycle. Think of any industry that deals in commodities and you will see once high flying stocks turned to bankrupt stink-pits: steel producers, coal miners, oil and gas, fertilizer manufacturers, gold miners, etc. In all of these industries debt is the common denominator that blows the equity out of the water. Equity owners get wiped out. Debt owners become equity owners. The cycle continues and a new set of investors make millions and lose millions in years to come.
We are currently in the midst of a super commodity cycle, dictated by global inflation, a supply chain crises and out of control government spending. Commodities across the board are up triple digits. We are seeing or have saw all time highs across multiple commodity based industries. In all my collective years of investing, I have not seen anything like this. Sure, prices have come down from the top, but we are still seeing sky high commodity prices that are generating significant free cash flows to operators and investors.
What is interesting about this commodity cycle is the nature of capital allocation seen by the major players. For over a decade investing in commodities, mostly energy, has been a losing man’s game. Returns for energy only investors have been some of the worst in the hedge fund game. Investors have been aching for a return on capital and now that we are in a super cycle, that is what investors are getting, a lot of cash returned to them.
Even more interesting, many companies are using the cash they are generating to completely change their capital structure. Companies like Peabody Energy Corporation (BTU) have reported for the first time in history that they have net cash on their balance sheet. This is the same Peabody Energy that has emerged from bankruptcy multiple times during the bust cycle of the thermal coal market. The same Peabody Energy that appeared to be on the verge of yet another restructuring just one year ago. The same Peabody Energy that had over $1.5 billion of real debt and another billion in pension and black lung liabilities. Read that one more time, Peabody Energy has net cash for the first time in the company’s history.
On capital allocation, as we said, everything we do is with a keen eye to increase shareholder value. And we've said for a while now that the repayment of the senior secured debt is the pathway to do, and that's the first step. Since the start of 2021, we've repaid more than $625 million of debt. We expect to continue that course and so we've eliminated the secured debt. We have about $600 million of that remaining. And once that's repaid, we'll then look to address the unfunded $320 million LC facility that matures in 2024. That facility is used right now for noncash collateral for the reclamation liabilities. That needs to be replaced as we continue to fund long-term reclamation liabilities.
The super commodity cycle has not only changed the capital structure of a dog like Peabody, but the entire coal industry has completely revamped their balance sheets. The most levered player in the met coal space, Alpha Metallurgical (AMR) has more cash than debt for the first time ever. Ramaco Resources (METC) has built up an impressive balance sheet and is using excess free cash flow to invest in interesting opportunities. Even Arch Resources (ARCH) is killing it and used excess free cash flows to pay a large $6.00 per share special dividend in the recent quarter.
The coal space isn’t the only industry that is changing capital structures. Oil and gas operators are using free cash flow to paydown debt and return excess cash flow to investors. Very few oil and gas companies are using cash flows for exploration, which for a long period of time was the function for executive bonuses.
Levered companies like Cleveland-Cliffs (CLF) have paid billions down in debt. United States Steel (X) almost has more cash than debt on their balance sheet. This is the same United States Steel that had over $2.5 billion in net debt just a few years ago. Look across any commodity based industry that has seen the price of the input they sell soar. Capital structures have changed and the operators are behaving in a conservative fashion where shareholder returns outweigh growth.
In the short-run it appears as if investors in commodity based industries will continue to receive a large return of capital. Operators have not been vocal on a rapid debt fueled expansion or rollup type strategy. It is all about generating free cash flow, paying down debt and rapidly returning as much capital to hungry investors.
In the long-term, the greedy nature of the capitalist will likely reemerge from the dust. Entrepreneurs will be licking their chops seeing bloated balance sheets and uninvested assets to capitalize on. Private Equity will probably try to take over public companies in true LBO fashion. The ambitious new CEO will make buyout offers for their peers and roll the industry up using high interest debt. The cycle will repeat and bottom fishing vultures like myself will get interested yet again.
The capitalist hunger for economic profit is real and alive. Traditional school of thought is to use debt if your returns will be higher than your cost of capital. As an entrepreneur, using other people’s money to build an empire is one of the best ways to build generational wealth and limit your own liabilities through the protection of an LLC or corporation. You can only cash flow an asset until you can’t. Eventually the growth mindset of Wall Street will continue.
But right now, if you are invested in any commodity industries, enjoy the cash flows and return of capital while you can. The super commodity cycle has changed industries and set new destinies that are not dictated by credit markets. Keep an eye on the management team and their firm focus on strategy 3-5 years from now. Allocation policies will likely change. And it will be good to know your own plan when those allocation policies do change.
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