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Monday, May 21, 2012

Bet the Debt

After my column on stocks that are leading the market lower, I got the usual round of "but what about?" queries from readers and associates. The biggest one was: "What about coal stocks?" Cola stocks have been what can only be called a disaster so far this year and indeed, they have been a month the biggest losers in the past month. Depending on your current position the declines have either been impressive or depressing. Alpha Natural Resources (ANR) shares have slipped by 28% so in the past month. Arch Coal(ACI) has declined by 24%. Cliffs Natural Resources (CLF) has dropped 28%. Patriot Coal (PCX) has seen a gut-wrenching drop of 40% while James River Coal (JRCC) is down a mere 30% in the last month of trading. It has been brutal, and trying to pick a bottom has been a disaster for some contrarian investors.
Coal's problems are pretty well known. New regulations have cast a dark shadow over the industry's future prospects. The Environmental Protection Agency (EPA) hasn't exactly outlawed coal, but they have done the next best thing. You simply cannot build new power generation plants that burn coal and be EPA compliant. To make matters worse, natural gas prices have declined to the point that gas-fired generation plants are as cheap to run as coal-fired plants. Fellow Real Money contributor Glenn Williams has discussed this in greater detail and I will be talking to him about coal's future usage in the U.S. sometime in the next few days. Coal stocks have been declining and, given the earnings shortfalls and possible asset write-downs, they will probably continue to go lower this year.
My "aha" moment came when I was looking at James River Coal at the request of a reader. Coal companies are being traded as if they are going to go out of existence. Some just might, but the industry will survive. Even with the stricter regulations they face, coal is still used to provide more than 40% of our electricity in the U.S. Although emerging markets may pay lip service to the environment their chief concern is cheap sources of power, and outside the U.S., that still means coal. Coal will survive and that makes the industry a distressed debt story right now.
I use a very simple rule for distressed debt investing that I got from Marty Whitman of Third Avenue. I use his criteria of looking for performing credits that are priced in such a way that if the company files bankruptcy, I can still make money by holding the debt. Asset-rich situations, such as coal companies, are fantastic candidates for high recovery rates and most of them are still making their debt payments in a timely manner.
I have mentioned the James River debt before. James River owns 25 underground coal mines, 12 surface mines and 14 preparation facilities. They have reserves of about 370 million tons of coal. The company is struggling and it has a substantial debt load of $582 million, but it also has a lot of assets. In fact, it has enough assets that Standard and Poor's gives the senior unsecured notes a recovery rating of 2, indicating a 70%-90% recovery rate in the event of a bankruptcy workout. The senior unsecured 7.875% notes due in 2018 are trading at 66 with a yield to maturity of 16.27%. At the low end of anticipated recovery, I should still make money even if the company files bankruptcy because the company is still paying the interest.
Debt issued by Patriot Coal is not quite as attractive, but it's getting there in the current market. The company owns 14 mining complexes and has reserves of 1.9 billion tons of coal. The debt-laden company has a recovery rating of 3, indicating a 50%-70% recovery in the event of a bankruptcy. Right now, the 8.25% notes of 2012 senior unsecured bonds are trading at 63 with a yield to maturity a little above that level. At the current price, you need to collect interest on the notes for a year and a half to be break-even at the lower end of the predicted recovery range. That would seem to be a reasonable speculation, given that recovery could be closer to the high end of the range if coal markets improve.
Coal equities will eventually be a decent opportunity. Right now, I find the debt much more attractive.
Originally published on Real Money 

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