Description

Investment Summary

Westmoreland Coal (“Westmoreland”) is an underfollowed stock and underappreciated cash flow story. Pro forma for the completion of the Sherritt acquisition in late April, the combined entity is the 6^th largest North American coal producer. Unlike other North American coal players who are tied to the volatile natural gas and spot coal market, Westmoreland operates more like a regulated utility with cost protected agreements and a weighted average contract life through 2025. The company’s mines (largely mine-mouth) benefit from long term relationships due to location and transportation advantages.

At current prices, the shares trade at a 15% FCF yield. As the market further appreciates its stability, pro forma cash generation and its ability to add and integrate additional assets, I believe the shares will trade less like a mining company and more like a Yieldco or MLP. In the interim, the company’s NOLs will shield taxes for at least the next 5-7 years, with a likely conversion to an MLP upon exhaustion of these benefits.

For those who want the quick and dirty thesis skip to the EBITDA, FCF and valuation sections

Company Description

Legacy Westmoreland consists of six surface coal mines in Montana, Wyoming, North Dakota and Texas. Sub-bituminous coal comprises two-thirds (heat content of 8,500-10,000 BTU/lb), whereas lignite (heat content of 6,500-7,000 BTU/lb) is the remaining one-third of tonnage. Annual production (Westmoreland standalone) is 25-28 million tons equating to a 19 year reserve life based on proved and probable reserves of 514 million tons. Production is substantially contracted (95% for legacy Westmoreland - see “Major Contract” section). The asset base also includes two modern (non-core) coal-fired power plants in North Carolina (Roanoke Valley plants, or “ROVA”).  

Compared to other North American coal companies, Westmoreland focuses on niche assets that are strategically-located near customers and/or rail transportation. The majority of production (75% at legacy Westmoreland) is mine-mouth coal transported via conveyor belt and sold under long term contracts to neighboring power plants.

Coal power plants supplied by Westmoreland (legacy and combined with Sherritt) are cost competitive with natgas at $2/mmbtu. Additionally, the boilers of adjacent power plants are often specifically designed for the chemical specification of Westmoreland’s coal as these plants were purposefully built near the mine to limit transportation costs. Customer concentration is significant as the top five buyers* represent 67% of revenues but as an offset these relationships span multiple decades (e.g. principal customers supplied for over 25 years).

*Colstrip Units 3&4 + 1&2 (30%), Naughton Power Station (17%), Limestone Generating (13%) and Coyote (7%)

  Sheritt’s largest customers include SaskPower (13%) and Capital Power (12%)

In December 2013, Westmoreland announced a transformational acquisition when it purchased Sherritt’s coal business for $435 million (4.5x EBITDA adjusted for legacies), comprised of $293 million of cash consideration and the assumption of $142 million of capital leases. The assets are complimentary and include seven thermal coal mines in Alberta and Saskatchewan producing 26 million tons, a 50% interest in an activated carbon plant and a char production facility.

Coal is a major source of power generation in Saskatchewan and Alberta, and the purchase provides access to the export market through port facilities in western Canada. The life of mines is 28 years based on reserves of 736 million tons.

Westmoreland funded the purchase through the issuance of $425 million of 10.75% secured notes at 106.875%. The additional proceeds were used for increased reclamation bonding requirements ($58 million), to fund the repayment of the WML bonds and for general corporate purposes.

Upon completion, proved and probable reserves aggregate 1.25 billion tons for a reserve life of 25 years (before potential extensions from 2.1 billion tons of additional resources). Approximately 77% of the mines will be mine-mouth. Furthermore, since the Canadian contracts are longer term, contract duration will increase (67% of tonnage remains through 2030).  

Major Contracts

Rosebud:

-Cost protected contract with Colstrip Units 1&2 for 3 million tons annually through at least 2019

-Cost plus contract (+ specific ROIs) with Colstrip Units 3&4 for 7 million tons annually through the end of 2019

Absaloka:

-Sells on open market + under several 3-5 year contracts. Tonnage is 5.5 million

-Minnesota power plants consume ~42% pursuant to several contracts based on mine costs and inflation indexes

-These mines benefit from a 300-mile rail advantage vs competitors in Southern PRB; aided by rail price escalation

-New Western Wye rail spur allows for production to TransAlta’s Centralia unit. Potential ~1.5 million tons increase

Jewett:

-Cost protected agreement with NRG Limestone plant for ~5 million tons, although NRG has termination right

-NRG responsible for mine’s capital and reclamation expenditures

-Increased usage of PRB coal (lower in sulphur) due to environmental regs could impact volumes

Beulah:

-Contracts based on mine costs with Coyote Electric and Heskett Power for 2.5 million tons until 2016

-Upon expiration, the Coyote station contract is not expected to be renewed (2.1 million tons)

Kemmerer:

-Supplies 2.9 million tons annually to adjacent Naughton Power Station under agreement expiring in 2021

-Additional 1.7 million tons to industrial customers shipped via short haul rail or truck in Wyoming

-Prices based on certain mine costs with adjustments based on inflation indexes

-Naughton (Unit 3) conversion to natgas (2018) to impact volumes; contract terms will partially offset through 2021

 -Should be able to replace this contract as coal is high quality and can be exported

ROVA:

-Supplies power to Dominion under revised contract through March 2019; clean coal

-Pro forma EBITDA of $15 million per management

Sherritt

These operations are cold weather driven with 75% of production and EBITDA in 1Q and 4Q, respectively.

Paintearth:

-Supplies 3 million tons annually to ATCO; mine-mouth

Sheerness:

-Supplies 3.3 million tons annually to ATCO; mine-mouth

Boundary Dam:

-Supplies 5.7 million tons annually to SaskPower; mine-mouth

-SaskPower invested $1.5 billion in carbon sequestration for Boundary Dam

Poplar River:

-Supplies 3.5 million tons annually to SaskPower; mine-mouth

Bienfait:

-Supplies 0.6 million tons annually to SaskPower, domestic consumers and the char and activated carbon plants

Genesee:

-Supplies 5.0 million tons annually to Capital Power. Direct operating costs reimbursed

Coal Valley:

-Produces 4.0 million tons annually for the export market

Liabilities – Debt / “Heritage” and Asset Retirement Costs

Pro forma gross debt is $841 million or $776 million net of estimated cash of $65 million. Net leverage is 3.7x EBITDA but the company expects to deleverage rapidly much like after the Kemmerer acquisition (leverage of 3.7x in early 2012 reduced to 2.3x in 2013).

-Defined benefit pension plants are underfunded by $21 million

-Postretirement medical obligations are estimated at $285 million (discount rates of 4.50%-5.05%)

-Black lung and workers’ compensation are $14 million and $8 million, respectively

-Gross reclamation liabilities are $281 million, but net is $110 million after deposits and customer recoveries

 -Pro forma for Sherritt, reclamation/mine closing liabilities increase by $123 million** ($58 million collateralized)

*On its 4Q conference call, management noted that historical spending on heritage costs have been below actuarial projections

**Figures are gross, so this liability is likely smaller

EBITDA

Pro forma EBITDA (management figure) is $231 million ($116 million guidance midpoint for legacy Westmoreland + $115 million for Sherritt). This excludes any benefits from Indian coal tax credits (potentially $7 million)* or synergies. To this number, I add non-recurring charges (rail disruptions of ~$2 million) and subtract two non-cash addbacks - stock compensation and AROs of $5 million and AROs of $20 million** for a net of $208 million.

The cost plus agreements and fixed contracts give me a high degree of confidence around this figure. Additionally, since the coal operations were a non-core business for Sherritt, there are plenty of opportunities for synergies***.

*Management expects these credits to be renewed especially considering it represents a huge portion of Crow Nation income

**Assume the current run-rate of $12-$14 million increases to $20 million pro forma for Sherritt - probably conservative as the cash number is lower (in the early years)

***Improved dragline procedures and utilization, better capital and operational planning, more effective coal segregation, cleaning and blending and implementation of augers to increase resource recovery and lower costs.

Pro forma FCF

I assume three scenarios:

1. EBITDA of $208 million, net out cash interest of $81 million and capital expenditures of $75 million*. This implies FCF of $52 million or $3.25/share**.

2. Unchanged EBITDA, but cash interest is misleading because bonds are trading well above par. The refinancing of the 10.75% senior secured notes (callable February 1, 2015 at 103.583%) should save 400 bps*** or more depending on the construct (bank vs. bond) of the new capital structure. Near-term debt reduction should also lead to savings. I calculate savings of ~$30 million which increases FCF to $5.15/share.

3. EBITDA increased for synergies (corporate and operational) related to Sherritt and for the renewal of Indian Coal Tax**** by a total of $15 million. This improves FCF to slightly >$6.00/share. Potential further upside from lower capital expenditures ($70 million run-rate) and if coal prices rally as Coal Valley (export business - Sheritt) generates limited earnings in the current environment.

NOLs shield taxes - US NOLs of $265 million / C$70+ million of Canadian NOLs. Management projects sheltered income taxes for at least 5-7 years (should grow with refinancing of HY notes and potential sale of ROVA assets). Upon exhaustion of the NOLs, I expect an MLP conversion.

*Capital spending is estimated at $1.00-1.50/ton of production. For reference, the company spent $28, $21 and $29 million in 2011-2013. For 2014, combined capital expenditures are projected at $75 to $85 million as extra spending is to be used for mining operations and equipment maintenance. Management expects to be on the lower end of this range per 1Q call

** There are 15,847,092 shares outstanding assuming the remaining preferred stock is converted to shares

*** Based on HY comps and the company’s leverage profile I believe these notes will be called and refinanced at <7%

       Murray Energy 2^nd liens trade at 6.6% YTW

****Since 2009, the company received $6 million of cash annually from these credits. The credits expired at the end of 2013, but management is confident that Congress will reinstate these credits, possibly even retroactively  

Free cash flow will be used to reduce debt, acquire more mines and to pay out dividends/repurchase shares. Strategic port access provides an entry to Asian markets and an opportunity to participate in the recovery of the export market, specifically for Coal Valley and possibly Absaloka and Kemmerer in the future.  More importantly, the ability to acquire assets from motivated sellers and improve operations is a real source of incremental value here considering management’s proven track record of integration*.

The most recent acquisitions – Sherritt and Kemmerer were purchased from motivated sellers. Kemmerer was noncore to Chevron who sold it for 3.5x EBITDA based on current numbers, whereas Sherritt needed cash to support its other businesses and sold its coal assets for ~4.5x EBITDA. Management indicates there are 20-30 additional mine-mouth opportunities in North America.

*Improved productivity by 18% and mining costs/ton declined 5% at Kemmerer

  Purchase price of $165 million implies multiple of 3.5x current EBITDA vs 9x EBITDA at purchase

Valuation

US REITs trade at nearly 16x FFO

Regulated utilities trade at 16x EPS

MLPs are priced at 13x DCF

Yieldcos trade at 12x DCF

Unlike other coal and E&P MLPs, there is little spot market exposure. However, due to limited organic growth prospects, I apply a 10x multiple to $5.15/share (scenario 2) of pro forma cash flow. At this valuation, the shares are worth over $50, or 40%+ above current levels. Assuming the return of the Indian Coal Tax, synergies and inorganic growth, a $60+ stock a few years out is a distinct possibility.  

Environmental Regs

A word on the recent news surrounding carbon legislation. The headline number of a 30% reduction from 2005 is misleading since carbon reduction has already occurred due to coal-to-gas substitution and other factors. For example, the 30% reduction shrinks to ~15% compared 2013 levels. Previously announced coal plant shutdowns plus other “building blocks” (heat rate improvements, energy efficiency, etc.) will further reduce this burden.

In the markets served by Westmoreland (and formerly Sherritt), coal is the primary fuel used for power generation* and the power plants the company supplies are key to the grids where they operate. Capacity factors exceed average US generation and should only increase as other smaller coal units are retired.

The majority of Westmoreland’s customers’ plants are scrubbed with environmental controls. Furthermore, management believes plants (except Naughton 3) not currently compliant will put in place all necessary controls to satisfy environmental requirements. In Canada, power plants can run for 50 years before the requirements for CO2 become mandatory. Extensions for another 50 years are also possible. Existing plants served by Sherritt have a remaining life well over 20 years

*Power generation in Mountain and West North Central is 54% / 67% coal. Alberta and Saskatchewan is 52% / 47% coal 

  State emission goals vs. 2012 emission rates are low in states where Westmoreland operates relative to the average

Catalyst

-Additional research coverage

-Refinancing of high yield debt and deleveraging

-Indian Coal Tax Credit reinstatement

-Demonstration of earnings power and cash generation

-Conversion to MLP (longer term given NOLs)