2023-06-08 17:13:15 ET
Summary
- Warrior Met Coal serves the steelmaking industry and is developing a new low-cost mine.
- Its profits and cash flow should rise once the project is completed, assuming coal prices hold up.
- The stock offers 30% upside to fair value.
Introduction
ESG investing may be the trend du jour, but fossil fuel companies have done well over the last year. Most of them are holding back on capacity expansions, having been burned when the cycle turned in the past.
Warrior Met Coal ( HCC ) is an exception. It is a metallurgical coal company that is building a new mine that promises to lower its cost structure, expand its capacity by half, and provide it with a 50-year revenue runway. If you’re wondering why it has the ticker symbol HCC, it’s because it stands for hard coking coal !
The basics of coal
There are two types of coal – thermal and metallurgical. Thermal coal is burned to produce power, and is rapidly being replaced by natural gas and renewables. It typically sells at a big discount to metallurgical coal, which has more carbon, less ash and lower moisture. Met coal is used to make steel in a blast furnace from iron ore. The other way of making steel is using recycled scrap in an electric arc furnace, which does not use coal. This method is slowly gaining ground, and now accounts for about 30% of steel production. I will provide a link for those who’d like to learn more about the steelmaking process.
Warrior Met Coal, as its name implies, produces only metallurgical coal. I would add that occasionally met coal is used as thermal coal, even though it is more expensive.
To believe in the future of metallurgical coal, one has to believe in a future of increased steel production. We live in a materialistic world with increasing standards of living, and more cars, more infrastructure, and more appliances will all use more steel, even with substitutes like aluminum. The dirty secret is that subsidized alternative energy products like electric vehicles, windmills and solar panels all use substantial amounts of steel made from coal. Subsidies merely shift carbon production from one part of the supply chain to another.
Company background
Warrior Met Coal is headquartered in Alabama, where it operates two underground mines. It is developing a third mine, called Blue Creek, which is expected to be operational in 2026 and will increase the company’s production capacity by more than 50%. The company has no legacy pension liabilities as its predecessor company went through bankruptcy.
In Q1 2023, 52% of Warrior’s revenue came from exports to Europe, 23% to South America, and 21% to Asia. The company has a cost advantage for deliveries to Europe based on a two-week transport time vs five weeks from Australia, which is the world’s largest coal exporter. The company’s mines are near the Port of Mobile in Alabama.
Warrior financial overview and outlook
For the quarter ending March 31, 2023, the company reported $510 million in revenue and $210 million in operating income. EPS came in at $3.51. The company ended the quarter with $871 million of cash and $295 million of debt. Thus, it had net cash of $11 for each of the 52 million diluted shares.
The company plans to spend $430 million on capex this year, with about 75% being discretionary, primarily on the Blue Creek project. This project is expected to cost up to $700 million over five years. Once developed, it is expected to be in production for 50 years, with minimal maintenance capital expenditures. According to the company, the project has an NPV of $1 billion at a coal price of $150/ton, in line with the historical average. Coal prices are currently elevated, though they have come down from the highs of last year. Futures prices are remarkably flat, in the $210 to $230 per ton range. Blue Creek’s expected cash cost is $70 per ton, lower than the company’s $80 average.
For 2023, the company is expected to earn $9 per share, going down to $5 per share next year as prices normalize. If coal prices hold up as futures indicate, I would expect the company to earn $8 per share in 2027 as the new production comes online.
HCC valuation: Fair value of $47
I will apply a conservative below market 8x multiple on 2027 EPS of $8 to value the stock at $64 in four years. I will discount this back at 8% a year to arrive at fair value of $47. Thus the stock offers 30% upside from the current $36 price, with a 0.8% dividend yield while you wait. The company’s net cash position, cash generation and reasonable valuation put it in a good position to buy back stock and pay out special dividends if it chooses to. Much will depend on the spending profile for Blue Creek as well as how well coal prices hold up.
In a bear case, coal prices will plummet and the company’s earnings could come in much lower. A 50% drop in expected earnings would imply a share price of $24, for 30% downside.
For those with the stomach for risk, I recommend buying the shares. The return and yield can be enhanced by selling covered calls at the $40 or $45 strike prices.
At a $1.5 billion enterprise value, the company could be a target for a larger player in the space, especially given its growth prospects.
External ratings
Seeking Alpha’s quant rating gives the stock a buy, with an overall rating of 4.4 out of 5. It garners an A for valuation and A+ for growth and profitability. Wall Street analysts are a little less enthusiastic, with a rating of 3.7, still good enough to be a buy. The average price target is $43.
Risks are high
The biggest risk here is that the company’s earnings will come in lower than expected due to a drop in the price of the company’s commodity product.
As a miner, the company is exposed to the risk of a catastrophic accident at one of its mines. It is also subject to various regulations, and there is a chance these may become more restrictive.
With operations in the US and exports to the rest of the world, the company is exposed to geopolitical risks, including the imposition of tariffs, effects from the war in Ukraine and the disruption of shipping.
The company depends on its employees doing a dangerous job, and needs to maintain good relations with them.
Shareholders depend on a company’s management being good stewards of their capital. There is a risk that the company is miscalculating the investment returns from the Blue Creek project. If the history of large capital projects is any guide, it will cost more and be less profitable than expected.
Conclusion
An investment in HCC offers an opportunity for reasonable upside, even with the high risks. The company’s net cash position and investment in growth opportunities offer downside protection.
For further details see:
Warrior Met Coal: A Potential Growth Stock