Peabody Energy (BTU) is a coal company. As most anyone who hasn’t had their head in the sand the past couple years will tell you, it is a terrible time to be a coal miner (see here or here for some background – this post is less about the problems facing coal and more an exploration of one company’s cap structure). The travails in the industry were naturally reflected in the capital markets, and 2015 was something of an annus horribilis for the sector, with three large-scale bankruptcies – Arch Coal, Walter Energy, and Patriot Coal. BTU has managed to scrape by – for now – but as the subsequent discussion will show, it is merely a matter of time before Peabody too joins its compatriots in the restructuring bin.
The impetus for this post was a quick look at BTU’s capital structure. In evaluating potential investments I always try to think about how the various pieces of a company’s cap structure – 1st lien debt, 2nd lien debt, unsecureds, equity, etc – fit together. People often say valuing a stock is more art than science, and that may be true for the equity piece, but looking at the whole enterprise is much more akin to solving a jigsaw puzzle. We can argue about the ‘right’ valuation for the whole entity, but the values ascribed to each piece of the piece must at least be consistent with each other. If the value of the equity portion is meaningfully out of whack vis-a-vis the bonds (or vice versa), we can try to profit by buying/selling the different pieces until they are back inline (this is ‘capital structure arbitrage’).
With this in mind, take a look at BTU’s capital structure – perhaps one of the most egregiously mispriced I have seen in quite a while. The below cap table summarizes BTU as of mid-Feb (I have used some estimates where data is not available). Note I am using 2016E consensus EBITDA ($350m) to calculate leverage through the cap structure:
There are a few things going on here but the most important takeaways are as follows:
- BTU is massively levered: 6x levered through the 1st liens alone is well in excess of 1st lien revolver covenants (<4.5x levered on a LTM basis), suggesting covenants will be breached imminently (next few quarters or earlier);
- ALL of BTU debt trades at HUGE discounts to par: the 1st lien paper trades at 37c on the dollar, while even the 2nd liens trade at just 8c on the dollar. These are insanely low levels for a going concern, and clearly imply a very high likelihood of full impairment on everything junior to the 1st lien paper. Indeed, the 2nd liens have a 5pt coupon payment due in merely a couple of days, yet trade at 8pts – implying to me a very high likelihood of that coupon being skipped (and thus BTU falling into default)
- Implied equity/credit valuation disparity is massive: given the market-price discounts of the debt, the bond market is effectively telling you the company is worth ~$900-$1bn (treating the 1st/2nd lien paper as senior to non-debt obligations like asset retirement and pensions). Alternatively, treating 1st/2nd liens as pari-passu with non-debt obligations would imply an EV of ~$2.5bn at current debt prices. Meanwhile the equity is telling you the EV of Peabody is ~$8.7bn today. It is also worth noting that the value implied by the equity at current suggests an EV/EBITDA multiple of 25x – which, even on a trough EBITDA number, is ~15-18 TURNS higher than normalized multiples for a coal company
Of course, it is not unusual for so-called ‘stub’ equities of highly-levered companies like BTU to trade with ‘option value’ even though bankruptcy, restructuring, or otherwise equity-destroying events loom large down the road. But the BTU situation is different – not just because the equity valuation is particularly egregrious, relative to the debt, but because there are a number of imminent catalysts that suggest not just equity but most of the unsecured debt portion of the cap structure could be wiped out, pronto. To wit:
- Cash burn: As horrible as the above picture is, it is merely a static shot as of Feb’16 and does not consider the ongoing cash burn BTU is suffering. Consensus EBITDA for 2016 is ~$350m. Against this BTU is guiding for $130m capex, is on the hook for $450m in interest payments; owes another $250m to the US government for land rights; and owes another $75m in cash related to legacy Patriot Coal obligations. This suggests cash burn of ~$550m in 2016, with all liquidity already drawn down and precious little in asset sales (more below) likely to offset. This also doesn’t include any lost liquidity if BTU’s self-bonding obligations are deemed less credible and the government demands cash collateral posted against asset retirement obligations (this discussion is ongoing).
- Structure of the leverage: more worrying for equity holders is the structure of the outstanding debt. Of BTU’s outstanding debt, ~71% (~$5.5bn out of $7.7bn) is below the first lien level; of the ~$450m in interest payments going out the door in 2016, only ~$71mm relates to 1st lien debt, or just 16% of 2016’s interest bill. This means, of course, that the vast majority of cash out the door goes simply to maintain 2nd lien and lower creditors – though the 1st lien covenants are the ones that need re-negotiation for BTU to survive the near term. Simply put, there is no incentive for BTU 1st lien lenders to waive/renegotiate covenants only to see BTU’s dwindling cash cushion be wiped out in a matter of quarters – and then see the company need super-senior debtor-in-possession (DIP) financing when bankruptcy finally arrives down the road. This makes it infinitely more likely that 1st lien lenders will exercise their rights to tip the company sooner rather than later (which Franklin Resources, one of the principal lenders, is apparently already pushing for)
- Failed asset sales: while BTU is fully tapped out on their credit lines (another bad sign – disclosed at 4Q earnings), they are trying to sell some assets in NM and CO to Bowie Resource Partners for $358m. While this would not be enough to even make a dent in overall leverage, it would nevertheless buy the company time. Unfortunately for BTU, credit markets seized up at the wrong time, and Bowie has thus far been unable to raise the necessary funding to consummate the transaction. Indeed, BTU disclosed in a NT-10K filing in late Feb that if they were unable to close the Bowie transaction, they would be forced to include a ‘going concern’ notice in their 10-K (due by mid-March, so, imminently) which would be classified as an event of default in their credit agreement. This would provide the 1st lien lenders the breach required to accelerate and tip the company (and even if it didn’t, a breach of the 1st lien leverage covenant in a quarter or two would serve the same purpose). At this point, it seems highly unlikely BTU will be able to close this transaction in the next week or so as they need.
- Upcoming interest payments: BTU has two large upcoming interest payments on Mar 15th (the 2nd lien 10% ’22s, and the 6.5% ’20s unsecureds) which cumulatively amount to $71m – a large amount of liquidity for BTU given their prospective 2016 needs and dwindling cash sources. Again – I find it highly unlikely that the company would choose to pay these large coupons on subordinated debt (indeed, the market prices of the debt suggest they get skipped) while they are negotiating with senior lenders for relief. As per point 3 – skipping the payment (assuming the grace period was also violated) would constitute an event of default and – under cross-default provisions – allow the 1st lien lenders to accelerate on the company.
All in all, then, I am very much at a loss as to why the equity has continued to trade at such generous (relative) levels – particularly in the last couple of weeks, when it has more than doubled. Clearly the rally in all manner of ‘junky’, levered, commodity equities (CHK, FCX, etc) has helped, though the situation at BTU seems pretty clear-cut. Indeed, were it not for the day to day volatility of the stock, you could quite easily structure a short equity/long bond trade (probably vs the cheapest unsecured instrument) that leaves you well covered in most all scenarios, even where the equity survives in some highly diluted form.
However, it is my contention that the current dynamics – which have seen the stock squeeze aggressively and bonds barely move – are symptomatic of cap arb players who already the trade on getting carried out of the trade just as the finish line has come into sight. This – along with my distinct bearish bias in this case (ie, I think this ends in bankruptcy pretty soon with zero equity recovery) means this is one cap structure play I am expressing purely through owning short-dated downside puts. I expect a resolution in the very near term (next month or so, allowing for 30 day grace period on potential skipped Mar’15 coupon payments).
Disclosure: short BTU stock (via Apr/May low strike puts), no position in bonds