Description

2017.09.25 Long CLD 12% 2nd Lien Notes ($105) Writeup

In a world in which “high-yield” is largely a misnomer, I believe the Cloud Peak Energy (“CLD”) 12% 2nd lien Senior Notes due 11/1/2021 fit the bill.  I expect these bonds to be called on 11/1/2018 at 106, representing a YTC of 12.2%.  While the vast majority of my coal exposure today resides in the common equities of other coal names, and while I haven’t before bought bonds a premium to par, I believe these bonds nonetheless represent an attractive risk-reward.

CLD is a pure-play Powder River Basin (“PRB”) thermal coal miner.  The CLD 2nd lien Notes came into existence late last year, a product of distressed exchange offers.  Per page 62 of the 10-K filing: “The primary purposes of the Exchange Offers were to extend the maturity of the 2019 Notes to November 2021, to reduce leverage by capturing the trading discounts on the Old Notes and to further our ongoing efforts to provide sufficient liquidity to manage through depressed industry conditions and better position the capital structure to help facilitate a future extension of the Credit Agreement or new bank facility or other line of credit before the Credit Agreement terminates in February 2019.”

At present, the 2nd lien Notes are essentially atop the capital stack and the company has $80.5mm of unrestricted cash on the balance sheet.  The only funded debt ahead of the 2nd liens are $6.2mm of capital leases.  At the current price, the Notes create the company at 2.4x EBITDA and 3.0x EBITDA-Capex.  Meanwhile, CLD should generate levered FCF for fy17 of $15-40mm.  

The $400mm undrawn 1st lien revolver matures 2/21/2019, meaning it will “go current” as of the Q1’18 report.  As such, I strongly suspect the revolver will be extended or replaced before then during either Q4’17 or Q1’18.  I expect that any replacement financing would mature after the 2nd liens, but to likely include a springing maturity to early 2021 in advance of the 2nd liens if the 2nd liens haven’t been taken out 6-9 months in advance of their 11/1/2021 maturity.  

I anticipate any such extension or replacement will contemplate the refinancing and extension of the 2nd lien Notes.  So I suspect the roadmap for taking out the 2nd lien Notes will be made clear based on the specifics of the revolver replacement. If not, I anticipate such a roadmap to become clear shortly thereafter as the extension of the revolver and specifics of the credit agreement reduce the degrees of freedom around what could potentially be done.  Barring an unexpected calamity, I believe the 2nd lien Notes get called on 11/1/2018 at 106, at their first call date.  I believe the next most likely scenario would be the 2nd lien Notes getting called in part, but not in full, on 11/1/2018, with the remainder being called relatively shortly thereafter simultaneous with the next capital markets transaction (debt or equity offering).

Management has demonstrated a recent history of credit positive actions, and a methodical focus on extending the nearest term maturities one by one.  Specifically, the bulk of the 2019 unsecured bonds were effectively pushed out to November 2021 via the distressed exchange offers.  The remainder of the 2019s were then retired in February 2017 with proceeds from a common equity offering.  In total, $153mm of debt reduction has occurred in roughly the last 12 months.  Massive potential liabilities from take or pay contracts extending out to 2024 were also reduced by nearly $500mm, and now only extend until the end of 2018.  Reclamation bonding requirements have also been reduced by nearly $200mm in the last two years.  

Clearly, management seems focused on extending the equity option (or perhaps enhancing the stability of their jobs) by pushing out maturities, even if that means potentially lower the value of that option via dilution.  The near term maximization of shareholder value via levered recap or other “going for broke” types of actions have not been seen at all – quite the opposite.  CLD issued 13.5mm of new shares in February to fund the redemption of the remaining 2019 unsecured bonds.  Even in the distressed exchange offers last year, the priority was on addressing the nearest term maturity, not on creating incremental equity value by capturing the greatest discount to par in the longer dated unsecured notes.  I wouldn’t be surprised to see another common equity offering in the future in the event of the stock running up.

While FCF is positive today and could swing negative in future years if both PRB and Newcastle coal prices fall meaningfully, it is very hard to envision a major use of cash before the 2nd Liens are retired.  The only significant cash usage I could foresee would be capex to further develop the Spring Creek Complex (i.e. moving forward on the Youngs Creek project or potentially the Big Metal Project).  However, I see those as more likely to be catalysts for calling the 2nd lien Notes than risks to the 2nd lien Notes.  Given how meticulous management at CLD has been to preserve and maximize liquidity and to push out debt maturities, I’d be shocked to see CLD moving forward on spending material growth capex dollars unless the longer term outlook had significantly strengthened, suck a project were materially de-risked via strong offtake agreements, and the capital structure were first addressed.  Given how strong Newcastle pricing has been of late, I actually view a potential desire to move forward on Youngs Creek or Big Metal as likely de-risking the 2nd liens by first pulling forward their retirement.

Nearer term, strong Newcastle pricing could potentially drive upward revisions to EBITDA and FCF estimates.  Here is a YTD chart of the front-month Newcastle contract:

Note that pricing has risen into the upper $90s.  And for a longer term perspective, here is the 5 year chart of the front-month Newcastle contract:

More importantly, here is a YTD chart of the Newcastle contract 12 months into the future:

With pricing now at $85 looking out 12 months, it would seem that CLD could be both de-risking 2018 EBITDA and creating potential upside by locking up tons.  Perhaps this will be discussed on the Q3 earnings call.  Again for better context, here is a 5 year chart of the Newcastle contract 12 months into the future.

As can be seen, 12 month forward Newcastle pricing is now the highest we’ve seen since 2013.

Again, given how much Newcastle has ripped, especially at the longer end of the curve, it would seem all the more timely to be pursuing the longer term clarity around and potential development of Youngs Creek or Big Metal now.  This pursuit seems far less crucial for the debt, but would appear to be among the biggest priorities for trying to maximize long term shareholder value.

On a related note, the long term take or pay contracts with the rail and export terminal were significantly reduced and shortened as CLD sought to aggressively reduce potential liabilities (even at the expense of potential future optionality).  The strong current Newcastle pricing environment would logically present another timely reason to now consider extension of those agreements to enable better intermediate and longer term planning around the existing export business.  But again, it seems clear from management’s actions to date that they’d look to first push out of the revolver and 2nd lien Notes before increasing or extending major take or pay agreements.

Another possibility is that consolidation takes place in the PRB.  That should be an unequivocal positive for CLD, as it would presumably result in better pricing regardless of which companies or mines combined with each other.  Moreover, should CLD be the target, the acquisition of CLD should be beneficial for the 2nd lien Notes.  The change of control put at 101 should provide some more certain downside support.  More likely, if the Notes were assumed by the acquirer, they would likely trade up to reflect the tighter current spreads of the potential acquirers’ bonds.  Most likely, a potential acquirer would simply call the 2nd lien Notes at the earliest possible date given the 12% coupon and the acquirer’s lower cost of debt  (and strong current cash flows).  

Rumors and suggestions of PRB consolidation have been around for years.  But in many ways, with industry balance sheets having been repaired, with clear and strong competition from natural gas and renewables, and especially with the Trump Administration now in office, it seems like the next few years would be “now or never” time for the long awaited PRB consolidation.  Consolidation could also be seen from either an offensive or a defensive posture.  Offensively, it ought to drive better pricing, lower costs, and higher margins.  Defensively, acquiring CLD would represent a cheaper way to extend reserve life than more traditional methods.  

CLD didn't have the "benefit" of going through bankruptcy that most of its competitors had.  Yet it is non-union and doesn't have major employee legacy liabilities.  CLD’s debt burden from not discharging legacy debt in a bankruptcy is more of an issue for the CLD equity.  For now, the 2nd lien Notes are atop the capital stack.  Meanwhile, there are $56.4mm of face of unsecured bonds due 2024 beneath the 2nd liens, along with an equity market cap of ~$270mm.  So there is roughly $326mm of capitalization beneath the 2nd liens Notes’ basis at market (net of cash) of ~$221mm.

I think it is obviously worth mentioning that US thermal coal has already taken major body blows in terms of both volume and price, as is widely understood.  In the case of CLD, volumes are already down 35% vs 2012 levels.  Not surprisingly, pricing has also fallen by $1.01 from $13.19 per ton in fy12 to $12.18 per ton for fy17 for CLD.  Adjusted EBITDA for CLD has already fallen from $338.8mm in fy12 to $98.6mm in fy16 and $95mm at the midpoint of fy17 guidance.  Projections from here suggest volume stability for the foreseeable future.  Note that H1'17 PRB coal production was actually up 22% yoy for the industry off of a low base.  Domestic coal burn is also up yoy so far in 2017.  As of July 21, ~56% of fy18 tons had been priced at an average of $12.49 / t vs ~97% of fy17 tons having been priced at an average of $12.18 / t.  Simple math would suggest that the unpriced 2018 tons could be priced at $11.79 / t to drive a weighted average of $12.18 / t comparable to 2017 pricing.

In summary, as the table below shows, I believe the CLD 2nd lien Notes are an attractive long most recently quoted at 104 / 105.  (I assumed a price of 105 for purposes of the write up).

I believe we most likely get called in 13 months, representing a spread of over 10.9% to comparable maturity UST yields.  Alternatively, I think we still get taken out at a low double digit IRR in the next few years.  I believe a worst case downside scenario is one in which the 2nd lien Notes never get called or refinanced, and thus CLD files for bankruptcy shortly in advance of their maturity.  Such a scenario seems incredibly remote for all the reasons previously noted, especially management’s focus and history to date on protecting the credit; meanwhile, we collect a 12% cash coupon in the interim, and we remain atop the capital stack for now.

Catalysts

Amendment / extension / replacement of undrawn $400mm 1st lien revolver in Q4’17 or Q1’18

Call of 2nd lien Notes at 106 effective 11/1/2018, with notification before 10/16/18

Maturity of 2nd Lien Notes 11/1/2021

Catalyst

Amendment / extension / replacement of undrawn $400mm 1st lien revolver in Q4’17 or Q1’18

Call of 2nd lien Notes at 106 effective 11/1/2018, with notification before 10/16/18

Maturity of 2nd Lien Notes 11/1/2021