Warrior Met Coal: An Asymmetrical Bet - Warrior Met Coal, Inc. (NYSE:HCC)

Warrior Met Coal (HCC) is one of the only companies exporting premium hard coking coal in the United States. What differentiates Warrior Met Coal from most coal companies is that its coal contains extremely low sulfur content. It's the only American producer which can match the premium quality coal produced in Australia that steelmakers favour. Hard coking coal supplies Basic Oxygen Furnaces (BOF), which account for 70 percent of steel production worldwide. Thus, it is no surprise that a company like Warrior Met Coal's attractiveness is closely tied to the situation in the steel industry.

However, there's reason to believe that the stock price doesn't accurately reflect the underlying fundamentals of the company.

The imposition of export and import tariffs greatly benefited US steel producers as those tariffs protected their margins. In fact, based on anecdotal evidence from contacts in the steel industry, American producers have started operating plants that had previously been shut down pre-2017. That's great for domestic steel production, but now that the tariff lever has been pulled, how well steel producers will do depends almost entirely on economic growth, not further government intervention like tax cuts or tariffs.

My three favourite metrics to use when predicting steel production are the Manufacturers' New Orders: Nondefense Capital Goods Excluding Aircraft leading indicator from the Federal Reserve, the Architectural Billings Monthly Index by the American Institute of Architects, and the China's Purchasing Managers Index by the National Bureau of Statistics of China.

This leading indicator is an excellent proxy for domestic manufacturing as a whole as it outlines purchases of capital goods like manufacturing equipment. Historically, there has been a very high correlation between this indicator and demand in the following six months for steel production. Growth has slowed for the first time since May 2016, and while the past couple of months have been more positive, the indicators seem set in a holding pattern like the 2012-2013 period.

This indicator measures the total amount of work being done by architecture firms and serves as the canary in the coal mine for the construction market as a whole. Growth has been modest this year but has shown signs of waning growth.

As a producer of almost half of all steel worldwide as well as being its largest consumer, it would be foolish to talk about the prospects for steel without mentioning China. This indicator gives us insight into China's manufacturing trends and despite the potential for manipulation, it still offers us the best chance of predicting economic growth in the country. With respect to Warrior Met Coal, which exports metallurgical coal to a wide array of European and Asian countries, China's PMI serves as the best single proxy to measure industrial demand in those countries.

As I'm writing this, Warrior Met Coal is trading at a P/E ratio of 1.91, a deep discount typically reflecting distressed circumstances for a stock. In this case, I think that the reason for this discount is the expectation of a cyclical high for coal companies and the imminent prospect of a crash in coal prices. This fear is justified. A previous gradual downturn in coal prices from 2012 to 2015 saw a slew of bankruptcies in the coal industry, with both Peabody (BTU) and Arch Coal (ARCH) filing for Chapter 11 proceedings in 2016. So, it would be logical to assume that with the trade war jitters and the prospect of lower global growth, a coal producer like Warrior merits a low valuation.

However, the reasons that coal producers like Arch were forced to file for bankruptcy don't appear to hold for Warrior. The two primary reasons why Arch Coal, for example, was forced into bankruptcy was because it was significantly over-indebted and overexposed to high cost coal production assets. That overexposure ensured that when coal prices fell, it was unable to turn a profit, never mind service the interest payments. That's why when over $5 billion in secured notes came due in 2016, the company had to file for Chapter 11 bankruptcy.

Neither of those two reasons applies to Warrior. For one, Warrior produces a significantly different type of coal from what Arch produces, with its premium coking coal fetching significantly higher prices than thermal coal. How significant can that price difference be?

In 2018, while thermal coal prices hovered around $12 a tonne (with margins of less than $2 per tonne), Warrior's premium coal sold for an average of $194 per tonne with a cash margin of almost $90 per tonne. Even if metallurgical coal prices fall to cyclical lows of about $85 per tonne, Warrior will likely still be able to make a significant profit, albeit one smaller than before (in 2016, their production cost per tonne was a measly $82). This is in stark contrast to Arch Coal circa 2016 when Arch was stuck losing $7 on every tonne of Appalachian coal they sold. This is if prices for coking coal fall to cyclical lows, which is far from a sure thing. In fact, industry experts expect coking coal prices to rise to $195 per tonne for the next 12 months due to near-term supply disruptions in Australia. Over the next four years, even the most pessimistic industry forecasts only see prices at cyclical lows of $90, which is more than enough to guarantee a profit for Warrior.

On the revenue side of things, there are only two ways for Warrior to increase sales: increase production or have prices rise. We've already covered the latter, so let's talk about production. Warrior is expanding production with its Blue Creek project. With the potential for 3 million tonnes of annual production at its outset, the project could expand Warrior's production by 50% over the next few years. Its existing mines are also seeing record production levels with the company as a whole seeing a 10% increase in production year-on-year. In short, Warrior is having no problems with production.

The only issue left to examine is if Warrior has a strong enough balance sheet to survive a downturn, assuming one is coming. Again, let's turn to the Arch Coal case study. In 2016, before Arch filed for bankruptcy, they had over $5 billion in debt due while its revenues were less than half that at $2.5 billion. That's more than two times revenue in debt, while Warrior has merely $345 million in long-term debt ($123 million was recently retired by the company) on over $1.3 billion in revenue. In other words, if you adjust for revenue, Arch was over 7.5 times more indebted than Warrior. That doesn't even account for the fact that Warrior has over $150 million in cash (almost 50% of the debt). Thus, it's clear that Warrior's balance sheet is really quite resilient.

The point I'm trying to make is that Warrior is an asymmetrical bet: either the price of coking coal goes back to cyclical lows of around $90 (which is not what's being forecast by industry experts), in which case you pay a fair price for the stock or it continues within this range, in which case, you are paying a truly bargain price for this low-cost metallurgical coal producer. Given the fact that Warrior's balance sheet is strong, the only risk here is that coking coal prices take a massive plunge, which is unlikely.

Warrior Met Coal is the only pure play metallurgical coal producer in the United States. It's massively undervalued, with a price that implies severe distress. However, it is financially solvent and likely to stay that way with a solid balance sheet. I believe that the market is overpricing risk in the stock due to the lack of understanding regarding the massive difference between metallurgical coal and thermal coal. Leading indicators show no signs of a massive drop and comparisons with a prior case study show that Warrior's valuation should be substantially higher than it currently is, which is supported by management's actions (they just authorized a new $70 million stock repurchase plan).

You don't often see bargains like this without major problems, but Warrior Met Coal might just be one such asymmetrical bet.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Seekingalpha.com

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