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2022.09.17 CEIX 11% 2nd Lien Bonds due 11/15/25 ($102.18 last)

I believe the CONSOL Energy (ticker: CEIX) 11% 2nd Lien Bonds due 11/15/2025 are an attractive long.  

The thesis is pretty simple.  CEIX has the best thermal coal mine complex in the US, along with an export port facility that gives it the ability to export more of its volumes than any of its peers.  You’re also “creating” the company through the bonds at close to $0 today, and what should soon be a negative “create” valuation given accelerating FCF.

Market conditions at present are the best they have been in many years.  Export coal prices have levitated to prices never seen before in the wake of a global energy shortage that firmly declared itself in Europe and Asia last Fall, and has been further stoked by disrupted and sanctioned Russian energy flows over the past 6 months.  Domestic US coal pricing has also moved dramatically higher – not only in sympathy with seaborne coal pricing, but also buoyed by domestic natural gas pricing at levels most would have thought impossible just a few years ago.

While “peak conditions” may turn out to be either a risk or an opportunity for the equity (depending on the duration and magnitude of such conditions), I believe the strong current market is unequivocally a major credit positive for CEIX bonds.

Ever since these bonds were issued nearly 5 years ago (in connection with CEIX being spun off from its natural gas parent company), CEIX has been singularly focused on aggressively paying down debt.  The deleveraging process has dramatically accelerated not only as market coal pricing has moved higher of late, but especially as realized coal pricing has only just begun to move higher (as legacy contracted tons at trough prices get replaced at much higher prices).  In fact, CEIX declared its first dividend to shareholders only last month to inaugurate its capital return policy.  Even then, CEIX suggested only 35% of quarterly FCF would initially be earmarked for capital return, implying the majority of FCF will remain targeted for accelerated debt reduction.

CEIX ended Q2 with under 0.5x net leverage using LTM EBITDA and ~0.3x using fy22 EBITDA.  The net debt balance should approach 0 at the end of Q3 and move to net cash before year end.

Its revolver is undrawn and was just pushed out several years to 2026.  More interestingly, the revolver commitment was reduced from $400mm to $260mm due to both a lack of anticipated need in the face of massive upcoming FCF and the continued attempt by the largest banks to flee their thermal coal borrowers as quickly as possible.  

CEIX’s gross debt target has been reduced multiple times, with the goal now down to ~$300mm.

This bond is CEIX’s highest cost debt, further incentivizing its repayment.

So the biggest drawback I see with the investment is a high likelihood the bond gets called away in just under 2 months at ~13.9% yield / IRR when the call price drops to 102.75.

If it instead gets called away 11/15/23 when the call price drops to par, the YTW is 8.9% over almost 14 months.  In that case, we’d earn a +500 bps spread to UST with only 1 year of duration.

The yield to maturity (YTM) at 11/25/25 is 10.2%, offering a spread of +635 bps and only ~2.5 years of duration.

While I think it likely our bonds get called, it is possible to imagine they might (or at least the majority of the bonds) actually remain outstanding to maturity.  First, the issue size is too small to refinance them into a similar institutional bond offering.  Second, the bonds could certainly be refinanced with a new / upsized term loan, but CEIX just voluntarily prepaid $110 million of its term loan balance in late in Q2 and an additional $50mm on the TLB in July 2022 after Q2 ended.  Most banks are still running away from lending to thermal coal companies – especially CEIX’s historical lending group.  Here is a table showing that behavior quantitatively by comparing revolver commitments before and after the latest amendment.

You can observe the largest Wall Street money center banks who might syndicate a new TLB just took the opportunity to run away in connection with the revolver extension / downsizing / lender replacements.  Specifically, of CEIX’s top 7 bank lenders which together comprised over 76% of its revolver due to mature in March 2023, 6 out of 7 top lenders declined to extend even $1 to the new 2026 revolver maturity.  Instead, they happily saw their entire TLA balances prepaid early, and then proactively cut their revolver commitments in half on the original revolver maturity (which was already less than a year from original maturity).

The new lenders in the revolver who replaced the banks that wanted out are mostly small local banks (i.e. Summit Community Bank, First Foundation Bank, City National Bank of West Virginia, etc.).  While they may not face the same institutional imperatives and reputational risk committees forcing them to flee thermal coal, their small size and capital bases may limit the amount of exposure they can have to CEIX.

It may be coincidental, but it is interesting that CEIX’s $178mm of muni bonds form the core of its ~$300mm gross debt target.  The 11% 2nd Lien bonds balance of $124mm could thus fit in neatly to a $302mm gross debt balance if CEIX pays off the remaining term loan and lets its short term equipment financing / leases roll off.  

While the equipment financing is lower coupon arguing against letting it roll off, that source of financing was the only available capital at all to CEIX in the most recent trough conditions.  So especially in light of the reduced revolver commitment, it might not be crazy to let the equipment leases roll off and then look to future equipment financing as a potential source of further liquidity in a future downturn.

The CEIX 2nd Liens may well turn out to be an all-too-brief cash alternative that gets called away on November 15 at mid-teens IRR.  That would be disappointing, but okay.  

Alternatively, I see this as nearly bulletproof short dated paper offering ~9-12% and 500-600+ bps of spread at a time of great broader market uncertainty.  Maybe we get lucky and the combination of credit market stress and the stronger broader movement to starve thermal coal of financing means these bonds don’t get called prematurely.  And the duration is short enough that we need not worry about rising rates.  

In short, I believe this paper is fundamentally undervalued and the credit ratings (Caa1 / B-) don’t seem compatible with the credit risk.  I like the risk-reward.

Catalysts

Continued sharp increases in realized pricing, margins, EBITDA, FCF.

Bond coupon payments and maturity date.

Call price steps down to 102.75 on 11/15/22 and 100.00 on 11/15/23.

Risks

CEIX’s Pennsylvania Mining Complex has a single massive prep plant.  A major outage or issue here could be catastrophic.

CEIX is dependent on the Eastern Rails, NSC and CSX.  CEIX has limited stockpile capacity at the mines / prep plant.  An extended strike at the rails would thus shut down production.

Catalyst

Continued sharp increases in realized pricing, margins, EBITDA, FCF.

Bond coupon payments and maturity date.

Call price steps down to 102.75 on 11/15/22 and 100.00 on 11/15/23.