Description

Four weeks ago, Contura Energy, Inc. completed its merger with the remainder of Alpha Natural Resources. On a pro-forma basis, CTRA sold approximately 11.9 million tons of metallurgical coal in 2017, making it the largest met coal supplier in the U.S. The combined company also sold 13.1 millions tons of thermal coal, and owns 65% of the Dominion Terminal Associates (DTA) coal export facility located in Newport News, Virginia.

Contura was also the subject of a previous write-up in March, 2017 by alcideholder under the symbol CNTE, as well as extensive analysis on Seeking Alpha.  While Contura’s stock price has been stuck in the mud, the other predominant player in metallurgical coal, Warrior Met Coal (ticker: HCC) had a tremendous rally from mid-2017 through mid-2018. HCC’s pureplay on met coal when compared to the complexity of sorting out the FCF and forward balance sheet and capital structure of Contura has undoubtedly been a contributing factor in the underperformance of Contura’s stock, even when including the $9 special dvd CNTE paid in mid-2017.

While met coal prices remain firm, CTRA should produce significant adjusted EBITDA and FCF. In addition, their net unrestricted cash position should also get a boost over the coming year via the release of restricted cash and tax receivables. This should position the company to advantageously repurchase stock from those shareholders who have been awaiting a liquidity event since the 2016 launch/emergence of Contura and Alpha from its reorganization.

As a comparison, Arch Coal (ticker: ARCH) has repurchased roughly 25% of its shares since the launch of their buy-back program six quarters ago while maintaining its own modest 2%ish dividend.

While there is no doubt that the current low valuation multiples for met coal producers reflect an understanding that met coal prices should inevitably revert lower, there would still be ample profit margins at much lower prices. Meanwhile, improved domestic steel production has led domestic steelmakers to lock in $20 to $25/t increases in their 2019 calendar contracts and some producers have signed contracts indexed to moves in the met coal benchmarks.

Although the merger is now complete, CTRA didn’t make it any easier by releasing their third quarter results in mid-November without providing a meaningful update to the pro-forma combined financials nor forward guidance for 2019. In addition, CTRA had a rough quarter due to a $40M cost surprise caused by clay issues at its North Appalachia Assets. Hence, there has been absolutely no momentum story to accompany the completion of the business combination.

Adding to the complexity for investors is that the company doesn’t report its revenues, costs, margins and other relevant financial info in a way that makes it straightforward to break out met coal explicitly from thermal coal. Instead, they report by the Central and North regions (CAPP and NAPP), Trading & Logistics, and All Other.

By contrast, when they made the original investment case for the merger, the company laid out an easier to understand pro-forma roadmap for investors that summarized the operations via a presentation which broke it down by met coal, thermal coal, and the rest. One way or another, investors need to cut through the clutter and understand the tremendous variability introduced by the met coal results. Pretty vital considering that the combined business is estimated to have 1 billion tons of metallurgical coal reserves.

Here is the current financial snapshot at Tuesday’s close of $64.68/share and 19.6M shares:

Market capitalization: $1,241M
Cash & equivalents: $   238M
Total debt: $   367M

Enterprise value: $1,370M

Pro-forma combined 2017 revenues: $2,320M
Net income from continuing operations: $   245M
Wtd avg shares (basic and diluted): 19.96M (20.51M diluted)
Net EPS from continuing operations: $12.28/sh  ($11.95/sh diluted)

Pro-forma H1 of 2018 net income (cont ops): $    213M
Pro-forma H1 of 2018 EPS from cont. ops: $9.76/sh  ($9.42/sh diluted)

Note that in addition to cash & equivalents on the balance sheet, there is substantial restricted cash. In the April merger presentation, Contura estimated that $100M restricted cash would be release over the next several quarters. On top of that, they announced an estimated $125M-$150M of estimated tax benefits.

Given anticipated remaining 2018 FCF and the combined effects of these various releases, cash & equivalents might be better thought of as closer to $600M coming into year-end.

ARO Liabilities as of 12/31/2017 for the combined business was down to $128M (from $483M at launch/emergence in 7/2016). Legacy liabilities, including workers’ comp, black lung, life insurance, ARO, and Pension and OPEB liabilities were $647M at the time of the merger announcement, but did not include netting out $364M in restricted cash held at Contura and Alpha which backed those liabilities.

While the combination of current LT debt, legacy liabilities, restricted cash, cash & equivalents, and spikes in working capital make for a bit of a moving target, the argument can be made that it all nets out some time in the next few quarters and that subsequent FCF all drops to the bottom line and can begin to subsequently and dramatically move the needle via stock buybacks.

Before diving into the modeling of adjusted EBITDA and FCF, it helps to review the 5-Year Historical Pricing for Met Coal:

Here is a simple pricing calculator that we use to get a sense of how the benchmarks get reflected back into price per short ton:

Here is the more complex calculator that we utilize to derive EBITDA and FCF. In the following case, we are using prices and costs from CTRA’s third quarter 8-K, and the volumes from page 19 of the Contura and Alpha merger presentation:

Valuation: If one feels comfortable netting out the various pools of cash and assorted liabilities, then at some point, that Adj FCF represents a FCF yield run rate of 37.5%.

Similar calculations can be made for further out years, keeping in mind to use steadily lower met coal inputs, which would result in steadily declining FCF’s. However, given the eagerness for liquidity reflected in the S-4 summary (see below), a decent case can be made that stock buybacks will keep the per share FCF yield attractively high.

Aiming to be aligned with management’s expectations for Adj EBITDA and FCF, we also examined our assumptions in light of the recent (10/5/18) S-4, where Contura and Alpha laid out their internal estimates that were updated in August as part of their negotiations.

From the S-4, here are the Projections from the Relative Contribution Analysis:

Note that 2019E through 2022E adjusted EBITDA totals $1.794B vs. the current EV of $1.4B.

Free Cash Flow conversion from the ANR projections side was updated in August, 2018 and resulted in 2019 FCF of $485M vs Adj EBITDA of $886M or nearly 55%. However, the 2020e to 2022e had FCF conversion of 48%.

FCF conversion fluctuates dramatically depending on whether met coal is at current windfall pricing or at the more reasonable forward estimates built into the S-4 assumptions.

Applying the S-4’s FCF conversion from Alpha’s assumptions across the pro-forma combined companies suggest the adjusted EBITDA for 2019E through 2022E would result in approximately $900M in FCF.

[Please note that for these purposes, the definition of Adjusted EBITDA includes market adjustments and accretion reduced by asset retirement obligations cash settlements, and that FCF represents cash flows from operating activities (including cash interest), less the amount of capital expenditures and contingent royalty payments and mitigation settlement payments, plus the amount of surety bond restricted cash released.]

Windfall pricing or not, and met coal pricing has remained quite robust lately, CTRA still reflects a discount to its peers. Once again from the S-4:

The valuation analysis constructed by Moelis included this peers’ analysis:

We often construct trades around these peer-to-peer valuation spreads and are happy to discuss further in the thread.

Further notes:

Two last items from the S-4, the first is a summary of the low-hanging fruit for further met coal production. The second is some color from the proxy on the process that led to the merger.

Additional Met Coal Growth Opportunities (page 183 of the proxy):

Contura and Alpha have also identified organic met coal growth opportunities that can be developed in supportive pricing environments.

Opportunities identified by Contura include:

• Deep Mine #42 in CAPP, which could provide an incremental 1.0-1.5 million tons per year of High-Vol. A and Mid-Vol. met coal; and

• Freeport mine in NAPP, which could provide an incremental 2.5-3.5 million tons per year of primarily High-Vol. B met coal, with some steam coal as byproduct.

Opportunities identified by Alpha include:

• Black Eagle in CAPP, which could provide an incremental 0.3-0.5 million tons per year of High-Vol. A met coal;

• Panther Eagle in CAPP, which could provide an incremental 0.3-0.5 million tons per year of High-Vol. A met coal; and

• Road Fork 52 in CAPP, which could provide an incremental 0.6-0.8 million tons per year of Low-Vol. met coal.

Production at these adjacent mines provides embedded growth potential while leveraging existing infrastructure. In addition, Contura’s operational footprint in multiple U.S. coal basins provides significant opportunities for potential synergies from domestic acquisitions.

Interesting tidbits from the background to the merger via the proxy filing (very much simplified and various timeline items consolidated for brevity’s sake):

Following the emergence of Alpha from Chapter 11 proceedings in July 2016, the Alpha related boards regularly sought to evaluate potential strategic opportunities to enhance stockholder value and provide liquidity to their stockholders, many of whom were former creditors of Alpha Natural Resources.

In July, 2017, ANR sold idle assets located in KY, IL, TN and WV while simultaneously eliminating approximately $250M in self-bonding obligations, reducing ANR’s reclamation liabilities, and eliminated restrictions that included a prohibition on making dividends or distributions to shareholders. Following announcement of this asset sale, interest in this more legacy free version of ANR began to pick up.

One interested party (Party D)  wanted Alpha to reduce their exposure to Central Appalachian thermal coal, which excluded that possibility. Another interested party, Blackhawk, was proposing a transaction that would dramatically increase the uncertainty of closing and subsequent value due to the amount of debt and financial leverage involved.

At the end of March, 2018, Contura offered 43% of the combined entity to Alpha. Alpha countered at 50%, they settled at 46.5%. In mid-April, Blackhawk came back with their proposal which contemplated a $720M refinancing and take it private with Alpha owning 35% of the combination. In May and again in June, these terms were modified, but suffice to say it was still a complex capital structure but would include an NYSE listing.

On June 29, 2018, Contura notified Alpha that unforeseen geologic conditions at its Cumberland mine (the $40M-cost clay problem noted in the third quarter earnings), and this initiated a “force majeure” that was subsequently cured in early August as the mine resumed full coal production.

In late August, the Blackhawk-Alpha talks began to disintegrate based on Alpha not supporting preferred stock senior to its common stock nor pro-forma financial leverage of greater than 1.0x to 1.2x debt/EBITDA (Alpha estimated it to be closer to 2.2x to 2.5x). Blackhawk responded by disputing those leverage figures and also that a pfd stock was critical to raising financing and Blackhawk’s first lien lenders were unwilling to equitize any portion of Blackhawk’s first lien debt.

In mid-September, one of the players from the Blackhawk group joined with another operator to form Party H and made a non-binding proposal for an all-cash acquisition for $650M, reduceable to the extent that the Alpha Parties’ net indebtedness and unfunded liabilities were greater than $50M.

Then, Blackhawk came back the same day with another very complex offer, involving a merger, a common equity financing, a rights offering, 10-year warrants for 50% dilution struck at a 40% premium, a share repurchase dependent on size of rights offering subscription, an MRP, increase in first lien debt, elimination of certain EBITDA ratio commitments, and no proposed board composition.

…

The Alpha boards concluded that the Blackhawk proposal had numerous deficiencies surrounding that complexity. The boards also concluded that the Party H proposal had a valuation significantly lower than $650M given the amount of indebtedness and unfunded liabilities.

The Contura exchange ratio would enable Alpha stockholders to own approximately 48.5% of the combined company, and the combination would ultimately be expected to generate cost savings on a run-rate basis of approximately $34M annually.

And one additional key quote:

that there has been only limited trading in Alpha’s common stock, and that some of Alpha’s largest stockholders had expressed a strong desire to achieve liquidity for their investment;

DISCLAIMER:

The author of this posting and related persons or entities (“Author”) may currently holds a position in this security and may hold long or offsetting short positions in related or mentioned securities.  Author may transact in additional shares at any time.  Author has no obligation to inform anyone of any changes to Author’s views.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in mentioned securities.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

Catalyst

Further guidance on pro-forma balance sheet and income projections

Stock buybacks

Continued strong pricing for met coal