Hot Topics in Distressed: Coal Names

On May 22nd, Patriot Coal (PCX) announced that it had engaged The Blackstone Group "to achieve an optimal financing package." Here is the chart of the opco Senior Notes:

I have covered Patriot Coal, in one form or another, since their spin-off from Peabody in 2007. My more mean spirited friends and colleagues like to remind me how I got long the stock in late 2008 in the mid-teens only to see it fall to a price ~$3.  I held on, added to the position, and eventually sold out in early 2010 (luckily). Since then, I have not established a position across the capital structure.

When Patriot Coal first announced a new bank deal to refinance their convertible notes due 2013, I began to look under the hood at the situation given the attractive terms that the new deal was being marketed. I had a few inbound suggestions that the best play here was to short the converts on the deal falling apart. The trade made a lot of sense: very little downside of 1-1.5 points, with big upside if the deal did indeed fall apart. Unfortunately I was a tad late to the game and there was no borrow.

And then the deal fell apart and the converts proceeded to drop 40+ points, now trading in the low 60s from a price of 98/99.

Coal has a rich history in distressed "war stories." Many people point to the success Wilbur Ross had building ICO which was eventually sold to Arch Coal at the absolute top of the met coal market since the crisis. And now analysts are sharpening their pencils again with sentiment caused by the PCX news sending ripples throughout the prices of capital structures across the space, with specific names such as James River and Xinergy, as well as the majors (moreso in the equities).

Patriot Coal's near term situation is difficult to handicap. They have an impending maturity a year away of hold-co, non guaranteed debt. They have a few options:

1. File
2. Exchange / Refinance converts for more senior opco debt
3. Exchange converts for equity 
4. Extend converts for like converts of a longer maturity
5. Sell assets and refinance converts

...or some sort of the combination of the above 5.

It is my contention that sometime in the next few years Patriot Coal has to file for bankruptcy to deal with the massive post-retirement health benefits they carry on their balance sheet which will be a significant drain on cash flow for the foreseeable future: $1.386B of accrued postretirement benefit costs as of the most recent 10Q with approximately 80-100M of cash payments each year. Further, as of the most recent 10K, a 50 bps drop in the discount rate for postretirement health benefits is a $92M swing. The 10K discount rate of 5.1% which will most surely go lower and push the legacy liability higher.

The problem of course for the converts: The legacy liabilities are at the guarantor subsidiaries and the converts are issued at the holding company with no opco guarantees. A good assumption in a Chapter 11 filing is that there will be a large rejection claim for the post retirement health benefits which will, at a high level of confidence, donut the converts.

In the interim then, Patriot can push off the filing (kick can down the road?) with some sort of exchange / refinancing. With the TOUSA decision so recent in everyone's mind, would bank lenders or other new providers of credit (second lien) chance the risk of lending to a potentially insolvent company and be at the bottom of the heap in a few years. Therefore I think option 2 is a possibility but there are technical hurdles to get there - I also have to think that the consortium invoked the MAC given the news that one of PCX's largest met customers is facing a default.

There is no doubt that PCX's asset value comes from their met assets. Some of their mines are better than others in terms of coal quality (vol). A lot of their met assets are leased reserves which hampers value realization potential. They could sell one or more mines, use the cash on the balance sheet (over $100M at holdco), and possibly issue equity to refinance the converts.

Options 3 and 4 seem the most plausible, technically feasible options outside of bankruptcy. In a conversion to equity, the convertible note holders would end up owning the lion share of the equity. I would also lop in a possible case, where Peabody, and possibly selling Australian thermal assets to a China, injects equity into Patriot, gets some ownership (non consolidated stake) and removes the risk of damages of the $150M in black lung damages disclosed in BTU's 10K (if PCX doesn't pay them) and any other damages that may flow to BTU in a PCX bankruptcy.  

Here are my expected values and recovery values on the converts:

• Near Term Bankruptcy: 35%: 0
• Exchange / Refinance into Second Lien Debt: 15%: 90 - assume if they refinance = par, if convert they trade to 80, splitting difference
• Debt for Equity Exchange: 15%: 75 - probably the hardest to figure out...i.e. what kind of market cap does this thing have, what's dilution of current equity, etc.
• Conversion into New Holdo, higher coupon, but longer maturity Convert:: 25%: 75
• Sell Assets, Refinance Converts: 10%: 100

for an expected value of right around 53 versus a market price in the low 60s. I think the largest delta between my valuation and the markets is I am more pessimistic on a refinancing into a senior / opco security based on fraudulent transfer issues. I am not a buyer of bonds at these levels though realize they could be par when I wake up tomorrow. The risk of permanent capital loss is just too high.

From a management incentives perspective, new CEO, Irl Engelhardt, veteran in the coal industry (CEO of Peabody from 1990-2005), now owns ~650k shares after being granted 200k in his new CEO appointment.  At a price of $2/share, that is $1.3M of economic interest.  While not small, that is nearly 50% less than he made at Peabody in his last year. A filing here would enable him to delever the company, deal with legacy liabilities, and give him a healthy portion of the equity. Not filing in a non-dilutive exchange would not be terrible as he could extend the runway, clip a very health salary, and give himself "non-diluted" option value.

Senior note holders do not want a filing and at the same time do not want  to be primed. To them the best option is either a debt for equity swap (or a BTU injection) or a like for like swap. In a bankruptcy the senior note holders would be pari with rejected legacy claims and even at a healthy multiple would be still recovering far far less than par.

Converts want to be paid off, or exchanged into a better security.

The banks do not want to fund the new facility they signed on for but also want to protect themselves from damages claims brought against them by PCX.

Equity holders are praying for an non dilutive exchange.

The unions want to not want to see a filing (reword wages - though uphill battle b/c of coal union protection).

And we haven't even talked about CAPP coal which is facing increasing costs, declining volumes on excess supply, and environmental regulation that is going to make it very hard to operate. With PCX's coal being high in sulfur content it makes the situation all the worse. A filing at PCX would allow them to lower costs to at least be competitive in a very tough market.

If you made me put on a trade here it would be long the senior notes hedged with long puts though this trade would be difficult to put on given the liquidity of the puts. In a refinancing, even one that primes, the bonds should trade up to cover loss on puts. If they file down the line, at a purchase price of 50, after a few years of coupon, your effective cost drops by 1/3 and you're puts will probably expire in the money. If they file tomorrow, the wildcard becomes the unsecured legacy claims, bonds would trade down, but you'd make it up in the puts. In a debt for equity exchange, bonds go higher, puts go higher, you win across the board. 

Coal is a space we will be covering extensively as the situation plays out not just at Patriot, but across the industry. In the last few days, I've received many inbound emails on the situation. The above are summary thoughts - if you want to discuss more, email me at hunter [at] distressed-debt-investing [dot] com.