HCC - Warrior Met Coal: Coking Coal Stoking Value

Summary

• Warrior Met Coal is in the midst of a long-running labor strike that will eventually be resolved or become irrelevant to operations.
• Management has been able to successfully leverage boom-time prices to bring on the world-class Blue Creek mine with no debt.
• Near-term softness in demand should give way to a long-term supply/demand imbalance that favors the company. We assign a Strong Buy on HCC stock.

Thesis

Warrior Met Coal ( HCC ) is on pace to have a record-setting year. Despite numerous secular tailwinds, we believe the stock appears cheap on just about any metric you use. In what follows we'll demonstrate why we think the stock could double from now.

The Basics

One of the great ironies of the clean energy transition is that the process itself is quite dirty. While thermal coal, which is used for energy generation, has long been in the doghouse with investors, another type of coal will be vitally important to the world for decades to come. The company we'll be exploring today deals exclusively in the latter type which, we hope to show, is unfairly undervalued by a market that has a tough time distinguishing between dirty and necessary coal.

Based in Alabama, Warrior Met Coal is a pure-play metallurgical/coking coal miner that emerged from the Chapter 11 bankruptcy of Walter Energy in 2015. Their primary end customers are steel manufacturers, but the company also sells natural gas which is a mining byproduct. Warrior operates “longwall” mines, the mining process by which coal is sheared off a long, exposed wall (think of a gigantic cheese grater). After the coal is removed from the wall, conveyor belts bring the coal to the surface. It's important to note that longwall mining happens to be the most efficient form of coal mining.

Once brought to the surface, the coal is loaded onto trains or a river barge and brought port in Mobile, AL, where it is shipped to other countries. HCC’s largest market is Europe, followed by South America and Asia, in that order.

Coking coal is the highest BTU coal available on the market. It is also the cleanest and hottest burning. It differs from thermal coal in that it is not used for energy generation, but primarily for manufacturing. The global market for coking coal is about 1/3 the size of the market for thermal coal. While coal in general has a dirty reputation and is unpopular among ESG investors, we believe that this reputation is somewhat misplaced with a pure-play coking company such as HCC. Coking coal is vital for manufacturing and will have a place within the global economy long after thermal coal’s use diminishes or disappears.

Management is also heavily incentivized to deliver. 83% of CEO Walter Scheller’s annual compensation is dependent on company performance, with 53% (approximately $2.2 million) of that variable comp being in the form of performance-based RSUs. The COO and CFO are similarly comped at 76% and 39% respectively on the same metrics. The four performance based metrics and their weightings are as follows:

The combination of operational incentives (longwall and miner feet of advance), efficiency incentives (keeping the cash cost of per-ton production low), and financial incentives measured directly in shareholder return themselves provide a compelling case in our view.

Short-Term Headwinds & Risks

Coal is heavy. Really heavy. Because of this inescapable fact, the cost of transport is an enormous expense for any coal producer. HCC has a geographical advantage of being only 300 miles from its port (most Appalachian producers are at least 400 miles from their nearest ports), but it does struggle with rail issues. Q1, Q2, and Q3 of 2022 saw logistical disruptions from CSX—HCC’s rail provider—which caused shipping delays and resulted in high carried inventories (approx. worth $140 million) leading into Q4 2022. A further short-term headwind for the company is the fact that transportation costs are adjusted each quarter based on the previous quarter’s pricing of coal, so investors should understand that a windfall quarter driven by higher coal prices will see tighter margins the following quarter as transportation costs adjust. Given that we’ve seen met coal prices fall from their Q2 high, transportation costs will squeeze margins, but this pressure should relent as the coal market begins to normalize.

Other headwinds present near-term challenges for the coking coal market, but as with so much in today’s world it is difficult to untangle what forces will dominate. Global steel demand is softening, but China’s massive economic stimulus package could prove to be a boon for steel production and, hence, coking coal suppliers. Management is “cautious” on China for the back half of 2022, however, due to the threat of continuing COVID lockdowns as well as its boiling-over real-estate crisis. A lack of clarity exists on the supply side as well. Russia has been shut out of the global met coal market, but Australian producers are expected to ramp up production this year (note that China continues to ban Australian coal).

The above graph illustrates the global flow of metallurgical coal. Europe draws the majority of its met coal from the US, which will create some near-term headaches, but which we believe will be alleviated (as we’ll show below) in due time.

Another near-term risk to the stock is an ongoing labor dispute with the United Mine Workers Association. We will discuss this in detail below, but we believe that management has delivered exceptional results in the face of the strike and that the current low valuation is in part due to the ongoing risk presented by the strike being baked in at current levels.

We believe that downside risks are somewhat muted here simply because of the generous amount of cash and book value per share of the company. The company also has the added benefit of holding onto some of North America's highest quality coal reserves and enough cash to mine them with almost no debt (more on that later).

And for the naysayers of coal producers in general, while we believe that thermal coal--despite its newfound day in the sun with the advent of the European energy crisis--is in long-term decline, we will show that the long-term demand for metallurgical coal is strong and will continue to grow.

Catalysts & Hidden Value

HCC experienced an incredible Q2 and a solid Q3 due to the explosion in price for coking coal per short ton (it peaked around $430 MST in the first half of the year). The result of this was a huge windfall of profits, which saw the company declare a special dividend of $.50 to supplement the declared $.06 dividend. While we should not expect that these prices will remain (as of this writing coking coal prices have already declined to around $250 pst), the dividends of this windfall will last for years. HCC had long planned to open the Blue Creek mine with an expected cost of $650-700 million. After the Q2 success, management states that the near entirety of the cost to open Blue Creek has been prefunded. This catalyst is not yet priced into the stock in our opinion, most likely due to the fact that the mine is slated currently to become operational in 2026. While that may not qualify the mine in and of itself as a near-term catalyst the fact that the company will incur no or little debt—the proverbial anchor around the neck of any mining & resource company—has a degree of value itself that is not priced in at this point. While we do not advocate holding HCC for several years with a simple hope that the market will recognize this latent value, it is important to also remember that the stock will not simply jump the day the mine opens—its value is more likely to be priced in quarter-over-quarter as management provides updates on construction.

Using a 10% discount rate and assuming an average met coal price of $150 per short ton, the NPV of the coal in the Blue Creek mine is $19.20 per share. The shares currently trade at $29.16 per share. The company currently operates two mines, No. 4 and No. 7. Mine No. 7 has proven and probable reserves totaling 39.4 million metric tons, while Mine No. 7 has 50.7 million metric tons. The company values the existing mine’s reserves between $153-187 per metric ton, but we’ll use the $150 price utilized for the Blue Creek analysis. (The company's presentation on Blue Creek and the main source for our analysis of it throughout this article can be found here .)

On an operational note, Blue Creek holds one of the largest reserves of high-quality coking coal in the US. Opening this mine with no debt attached will translate immediately to bottom-line performance. As it stands, the estimated per-ton breakeven price for Blue Creek is $71 per short ton, which will place the mine among the top 10% globally for cost per ton.

This is vital for the investor’s margin of safety since—as noted in the graph above—coking coal prices often present feast-or-famine scenarios for miners with higher break-evens.

A second, more near-term, catalyst is the pending resolution of Warrior’s ongoing labor strike. WCC’s collective bargaining agreement ((CBA)) with the United Mine Workers of America expired in April 2021. This agreement covered 66% of Warrior employees. Management and labor failed to reach an agreement, and the strike continues to this day. Warrior incurred a $34 million idle mine expense for 2021. For the first half of 2022 idle mine expenses were $4.7 million. In 2022 the business has also accumulated business interruption expenses of $13 million to cover the cost of additional mine safety and security provisions and labor negotiations. The fact that Warrior management has been able to mitigate the business impacts of an 18-month strike to $18 million while taking in just over $1 billion in revenues—while also maintaining a strong safety record—is astonishing. This speaks to the determination of management to keep the mines operating and also to the strength of their shareholder-aligned incentives.

While it is unclear when the strike will be resolved, we believe the odds are tilted toward management for a favorable outcome. We believe that the stellar operational performance of the company without an in-force CBA drives the point home that management is dealing from a position of strength and will likely feel no need to dole out pricey concessions to labor.

The case for a positive outcome for labor is compelling but grows weaker as time drags on. It is remarkable that more than 80% of striking workers have not crossed the line as the strike has extended past its 500 ^th day (in deep-red, anti-union Alabama no less). Strikers were receiving $400 per week from the UMWA, and the amount was recently bumped to $500. Whether the bump is due to inflationary pressures, cracks in the coalition, or both, is unsure. The strike made headlines when BlackRock—HCC’s largest shareholder—publicly rebuked management for allowing the strike to continue for so long at the expense of operating profits. BlackRock also voted against a motion for executive pay to be raised. Management maintains that it has performed in the face of the strike and thus executives should be compensated for successfully navigating it. There are signs, however, that the company may be struggling to find enough temporary labor. Aside from an explicit acknowledgement of the difficulty in the Q2 earnings call, recent postings on Indeed offer competitive wages of $25.85 an hour plus over time (and relocation assistance) for entry-level mine laborers.

Whatever BlackRock’s frustrations with the company, their 14% ownership wasn’t enough to persuade a majority of shareholders. All of the Blackrock-proposed ballot initiatives failed to pass. At the end of the day the strike will not persist forever, and we believe that the scales (red-state presence, management sitting on an enormous windfall of cash, and the general advantage of time) are tipped towards management in the end.

While the terms of a renewed CBA might involve a bit of crystal-ball gazing, the operational results of an ended strike are a bit easier to understand. The company estimated that with the strike ongoing through 2022 that it could produce between 5-6 million short tons (MST) of coal. The company seems to be on track to deliver on that promise with 1.5 MST produced in the first quarter and 1.7 MST in the second. At full (non-strike) capacity the combined output of the mines is around 7 MST per annum, a 40% increase over their current output. In this light it is easy to understand Wall Street’s frustration with management as a 40% increase in coal production during a record-shattering Q2 would have generated enough FCF to pay for Blue Creek twice over. When the strike concludes, it will take about one quarter for the company to resume full capacity production, which should result in a nice bump for the stock even if the outcome is favorable to labor.

Secular Tailwinds—The Long-Term Case

When Warren Buffet was asked by an oil executive if he would invest in his company, Buffett is reported to have replied, “Yes, if you can tell me what the price of oil will be in one year.” The uncertainty of the market for coal is the single biggest risk to the investment thesis, but a risk which we believe has a pleasant margin of safety.

The above chart details the cost of a ton of coking coal over the past two years. The lowest price in that time was $130, which is comfortably above Warrior’s cash cost per ton of roughly $83. In fact, since 2010 the only time the global spot price for coking coal has dipped below $100 per ton was from early 2015 to early 2016, after which prices promptly spiked to $300 in the latter half of 2016. Barring the previously described headwinds over the next year or so, we believe there is a good long-term case to be made that coking coal will experience sustained elevated prices over the next decade.

A benefit of the met coal business is the ability for investors to make reasonably accurate customer capacity forecasts since steel production is such a capital-intensive exercise that takes years to plan and execute. While much has been written about China’s potentially peaking steel production and transition to EAF steel production (Electric Arc Furnace, a less coke-intensive form of steel production), we believe there are two main drivers of long-term met coal demand: emerging markets and the energy transition.

Coking coal is used most extensively in BF-BOF (blast furnace – basic oxygen furnace) steel production, and for every ton of steel produced approximately 0.848 tons of coal are required. BF-BOF production is the primary method of production in emerging markets due to the lower cost compared to EAF production.

The largest manufacturer of steel in the world is currently China, and it is expected that over the next ten years the country will reduce its overall steel production by the mid-single digits. This makes sense as China has spent the better part of 30 years (when it was the 4 ^th largest producer of steel) aggressively investing in heavy industries and modernizing its infrastructure.

Three other countries, however, are making aggressive investments in steel and have a growing need for seaborne metallurgic coal—India, Vietnam, and, to a lesser extent, Brazil. India surpassed Japan as the world’s 2 ^nd largest producer of steel in 2019. The country has modernization aims similar to China, and with the world’s second-largest population it has plenty of runway ahead of it. According to the IBEF, from 2016 to 2020 the per-capita consumption of steel (measured in infrastructure improvements) increase from 64kg to 74kg. Annual production is forecast to grow from 133 million tons today to 230 million tons per year by 2030.

Companies that don’t want to deal with the country risk headache that China has become known for are increasingly turning to Vietnam, and Vietnam’s economy has been a winner as a result. It’s estimated that the CAGR of Vietnam’s steel production from 2013 to 2021 was 32.7% . This is partially the result of increased manufacturing capacity, and partially due to the economic boon of foreign investment. From production to investment in critical infrastructure, Vietnam’s BF-BOF steel production is forecast to grow by over 40% in the next 8 years. Critically, both India and Vietnam are net importers of coking coal, and their growing appetites will strain the global market for seaborne metallurgical coal.

Lastly, the energy transition presents an enormous opportunity for Warrior. First, some numbers:

While the output of green energy is clean, the inputs are generally not. As long as nuclear energy remains out of favor, solar and wind will be the most politically acceptable forms of renewable energy for most countries.

As mentioned above, Europe is Warrior’s largest customer. The EU had already put together an ambitious plan to go green, but given the continent’s current energy crisis and sudden realization that its energy dependence on Russia is unsustainable, the EU will mobilize to accelerate its energy transition even faster than before. (In April the EU proposed an increased target of 45% total renewable energy up from 40% by 2030). This will spike demand for steel and, by extension, met coal.

Wind power in the EU was the largest component of renewable energy, and in order to meet its goals the EU will need to install more than 35 GW per year of capacity across the continent. Offshore wind is also a critical component of the European energy plan, which is considerably more steel-intensive than onshore wind projects. 35 GW per year of constant, straight-line demand adds 4.9 MT of steel demand on Europe, which admittedly feels like a drop in the bucket compared to the 152 MT produced in Europe in 2021. However, it should be noted that demand for these products will not be straight-line but exponential, and each project will be competing for a finite amount of steel production capacity and a finite supply of metallurgical coal.

Valuation

Warrior currently trades at a forward P/E of 4.4x and a near historic low EV/EBITDA of 1.5x. Warrior has geographic advantages and lower cash costs per ton of coal than competitors like Ramaco Resources ( METC ). Due to the ongoing strike and, we believe, the lumping in of all coal into the same 'dirty' bucket whether it be thermal or metallurgical by the wider market, Warrior is an extremely interesting value play.

Take, for example, the relative premium that the market is assigning to SunCoke Energy ( SXC ) with a forward P/E of 8.7x and an EV/EBITDA of 4.5x. SunCoke. We believe SunCoke is an appropriate comparison company given that the two companies posted nearly identical sales and both traffic exclusively in metallurgical coal.

The Bottom Line

The reason for the value disparity, we believe, is largely--if not completely--wrapped up in the ongoing strike. We also believe that due to the faraway timeline of Blue Creek, virtually none of those assets have been baked into the current price. Given the top-tier quality of the Blue Creek assets, and the fact that the strike will either a) be resolved, or b) not be resolved so much as rendered irrelevant as Warrior continues to train and develop its replacement workforce, we believe that Warrior deserves at least the same multiple as a company like SunCoke. Ascribing it the same P/E as SunCoke gives us a target price of $66, nearly double its current price. All of this leads us to conclude HCC is a Strong Buy.

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