Season Investments

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Micro Update: Walter Energy

Posted on January 20, 2012

WALTER ENERGY, INC

Walter Energy (ticker: WLT) is a pure play metallurgical coal producer with operations in the United States. Unlike thermal coal, metallurgical coal (aka met coal or coking coal) is low in sulfur and is primarily used in the production of iron ore and steel. The market for met coal has been very tight over the past several years due to constrained supply and increasing demand from emerging markets like China, India and Brazil. Walter has thrived during this period, increasing revenues by an average of 20% a year for the past 5 years and recently doubling its size through the acquisition of Western Coal. Unfortunately, the integration of Western Coal has not gone as smoothly as anticipated leading to higher costs and lower profitability over the last two quarters. There has also been a good amount of turnover in some key executive positions which has prompted concern about the strategic direction of the company. In addition to these company specific headwinds, the macro factors surrounding global growth expectations have weighed on the stock. Today, we believe a good amount of pessimism is priced into the stock as it sits around $60 a share versus the $130 it peaked at last summer. 

Walter’s recent performance and uncertain leadership have led some analysts in the coal industry to speculate that the company could be ripe for the picking by a larger coal company or even a steel/iron ore producer in the ever expanding emerging markets. Looking at industry comps, most analysts have put the buyout price on WLT at around $100 - $150 per share. Even the most bearish of these estimates would provide a handsome profit to shareholders purchasing the stock at today’s level. This being said, management is still confident that they will be able to get their production costs back under control in the next year or two. Michael Tokarz, the Chairman of the Board, signaled a vote of confidence in the company when he purchased $1.5 million worth of WLT stock shortly after the price decline this summer.

We like WLT for the following reasons:

  1. We are long-term bulls on natural resources, such as met coal, which are consumed by emerging markets as they build out their infrastructure. A return to $300/ton met coal prices seen last summer (see chart below) is not out of the question since met coals’ tight market leaves it vulnerable to supply shocks or marginal increases in demand. Walter is a major player in a key commodity market with built in long-term demand.
  2. Investors have a potential win-win as the company will likely either restore profitability or be taken out by a larger competitor/customer, either of which would assign a value north of the current market price to WLT’s assets and operations.
  3. With WLT trading close to its 52-week low, there is a good margin of safety built into the price. We estimate that the intrinsic value of the stock is close to $100 per share using our discounted cash flow model.

Coal_prices_small.jpg

There are several risk factors when it comes to owning WLT stock. If the company isn’t sold and doesn't rein in costs as expected, EPS will drop and the stock price will follow suit. Coal stocks are extremely sensitive to the global economy, so if Europe goes into a deep recession and drags the rest of the world (particularly emerging markets) down with it, met coal prices will soften along with WLT’s profitability and stock price. Lastly, Walter has had a high amount of turnover at the executive level over the past year which could indicate a "where there is smoke there is fire" type of situation in regards to the company’s operations and its ability to rein in costs post-merger. We believe at current price levels these risks are properly reflected, and the risk/reward profile of the investment is favorable. 


We want Transparency to be one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. Regular Micro Updates will address our reasoning behind making specific investments. Also watch for Macro Updates to stay in tune with our perspectives on broader economic and capital market topics.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.