2023-03-29 00:30:08 ET
Summary
- Growing net-cash balance sheet.
- Stock trades at less than 2x FCF.
- Dividends reduce the risk of capital impairment.
Warrior Met Coal ( HCC ) faced numerous headwinds over the past several years. From an overleveraged balance sheet forcing them into bankruptcy to a two-year-long strike causing them to hire temporary workers and lower production. With a net cash balance sheet and an end to the strike, HCC is set to benefit from elevated met coal prices. We recommend buying the stock at its current attractive valuation
Background
Warrior Met Coal is a pure-play Metallurgical Coal producer used in steel production. In 2015, due to an overleveraged balance sheet and a collapse in met coal prices, Warrior Met (then known as Walter Energy) filed for bankruptcy, as did several other players. After reorganizing, they came public in 2017 with a healthier balance sheet and ~$2B in NOL carryforwards. On April 1, 2021, the CBA contract with the UMWA (United Mine Workers of America) ended, and ~1,100 mine workers went on strike. The union sought higher wages, better scheduling, and additional time off for their members. Many of these workers took pay cuts when the company went through bankruptcy and were seeking to recoup lost wages. On February 16, 2023, UMWA offered to return to work under the original contract, and Warrior Met accepted a day later.
Thesis
Previously mentioned headwinds are gone, positioning HCC to benefit from elevated coal prices. A healthy balance sheet with net cash of ~$500m allows HCC to fund the next leg of its growth story without raising debt. The company is currently developing the Blue Creek Mine. The economics of this mine are incredible, even using prices of met coal well below spot and forward prices. Below are management projections Blue Creek presentation here . Blue Creek is a low-cost production mine with an all-in cash cost per ton of $65-75. Management used $150/mt as their base case scenario, yet today, Australian Coking Coal (industry benchmark) currently trades at $354/mt, and January 2024 futures trade around $292/mt. The payback period for the new mine at these prices would be less than one year. Below are the Australian Coking Coal futures prices, found here .
Forward Prices of Coking Coal (Bar Chart)
Warrior missed millions in revenues due to the labor shortage stemming from the previously mentioned strike. Warrior Met has underproduced relative to its full capacity. In 2018 and 2019, they sold 7,641 and 7,981 mt, while in 2021 and 2022, they only sold 6,282 and 5,621 mt due to lower production volumes. With this headwind dissipating and production returning to normal, the company could generate north of $1B in earnings. Management guided for 2023 Capex of $420 - $450m, with $325-$345m attributable to the Blue Creek expansion. FCF for the year could come in around $700m based on the current forward curve. Based on today's $1.3B EV, the stock trades below 2x FCF and closer to 1.3x, excluding growth Capex.
In Millions of $ | 2023E |
Average Selling Price | $330.0 |
Tons Sold | 7,200.0 |
Cash Cost Per Ton | $120.0 |
Revenue | $2,376.0 |
(-) COGS | 864.0 |
(-) SG&A | 50.0 |
(-) D&A | 130.0 |
(-) Interest Expense | 24.0 |
(-) Tax Expense | 261.6 |
Net Income | 1,046.4 |
(+) Depreciation | 130.0 |
(-) Capex | 435.0 |
FCFE | 741.4 |
Warrior has federal NOL carryforwards of approximately $122.1m and state NOL carryforwards of ~$951.7 million. The federal NOLs will be used in Q1, and HCC will become a taxpayer again in Q2-Q3. The company's high profitability outweighs the negative of returning to a cash taxpayer. One negative from Covid and the strike was the inability of the company to retire its high-interest rate debt. In December 2021, they refinanced their 8% notes with 7.875% notes due in 2028. Management purchased ~$40m of the 2028 bonds at a discount in the open market in 2022.
Management has telegraphed a preference to distribute excess cash as dividends rather than buybacks due to the cyclical nature of the business and previously unsuccessful buybacks. In 2022 they paid out $1.30 in special dividends and recently paid out an $0.88 special dividend while maintaining a $0.06 quarterly dividend. I expect quarterly and special dividends to increase with the net cash balance sheet and substantial cash generation. As noted earlier, I estimate they will generate around $700m in FCF. They should return most of this capital to shareholders through dividends, equating to ~$13.50 with 51.7m S/O. HCC would have over $500m in net cash, as I do not expect the company to make any acquisitions.
A cyclical company's fair value or price target is challenging to determine. I think the bulk of one's cost basis will be paid out in dividends over the next 2-3 years. If met coal prices revert to a normalized price of $120-$150 / mt, the economics of Blue Creek will still be favorable, and the company will still generate substantial FCF.
Balance Sheet
As noted several times, Warrior Met has a pristine balance sheet with $829m in cash and just $302.5m in Long-term debt. With the FCF generated from the first quarter, I estimate the company could have enough cash on the balance sheet to fully fund the Blue Creek mine, estimated to cost $650-700m, and have enough cash to pay off its debt today. Due to certain covenants and restrictions on the debt, they cannot begin to pay off the debt until the end of 2024. Given the substantial interest costs, I suspect the company will call the debt then. The current interest expense is ~$24m per year.
Management
The current CEO Walter Scheller was the previous CEO of Walter Energy from 2011-2016 and has over 35 years of experience in the mining industry. It's important to note that during 2015-2016 when coal prices plummeted, by 2018, six of the ten largest coal producers (Met and Thermal) in the U.S. went through bankruptcy. When Walt Scheller was the CEO of Walter Energy, the company ended Q3 2014 with ~$3B of debt and, for the first nine months of 2014, lost ~$417m. In the first three quarters of 2015, the company lost ~$600m. Q3 2015 was the last 10-Q filed before the company reorganized and sold the assets to Warrior Met Coal. The combination of high debt and low pricing drove this company out of business. You can find the last Walter Energy filing here . I believe the company and industry have learned from past mistakes. Once they pay off their debt, I believe they will and will operate with a net cash and balance sheet. Dividends should be the primary capital return to shareholders.
Risks
The market doesn't let traditional stocks trade at sub 2x FCF without risks. One of the primary risks is the cyclical nature of the industry. Since 2019, the price of met coal has gone as low as $50/mt (during covid) and as high as $431/mt (September 2022). This swing makes forecasting the business challenging. Warrior Met generated positive gross profit when met coal was $50/mt, though it generated losses after factoring in SG&A and Depreciation (Depreciation is an actual expense given the ongoing maintenance Capex required by the company).
Another risk is the capital allocation strategy of the company. Most commodity companies are returning FCF to shareholders either through buybacks or dividends. Warrior Met is taking a different approach, reinvesting into the business to expand production coupled with periodic special dividends. The inherent risk is that Blue Creek's economics are worse than management's estimates; thus, the reinvestment is at an ROI below the cost of capital.
Lastly, as steel producers using Blast Oxygen Furnaces [BOF] slowly transition towards Electric Arc Furnaces [EAF], the demand for met coal will decline. This risk is overblown as the demand for Hard Coking Coal is projected to grow over the next several decades despite the cleaner EAF adoption. See slide 16 in HCC's Blue Creek Presentation for details. There are different ways to play this theme. One is to invest in stocks that are in liquidation mode, paying out earnings as dividends/buybacks, reinvesting solely in sustaining Capex. The other is to invest in Warrior Met, where the long-term growth potential could result in a multi-bagger over 3-5 years as production capacity grows from 8.5 Mst (Metric Short Tons) to 12.8 Mst. When Blue creek comes online and all three mines are in production, the 12.8 Mst could generate almost $2B in earnings. The clear risk in this is what the price of met coal does between now and then and do any other competitors increase production or bring on new mines.
Summary
While met coal production is not the clean ESG business most are searching for, the product is vital to the steel industry, supporting economic growth. The market values Warrior Met Coal as an over-earning, cyclical, high-risk company. While parts of this may be true, the market is overly pessimistic at sub-2x FCF. Given the company's ultra-conservative balance sheet, dividend payout history, and high cash generation at current met coal prices, HCC stock is far too cheap. Dividends will consistently lower the cost basis of owning the stock, reducing the risk of permanent capital impairment.
For further details see:
Warrior Met Coal: Too Cheap To Ignore At Less Than 2x FCF