Westshore Terminals (WTE, listed in Toronto), is by all appearances an amazing business. Located just south of Vancouver, WTE operates one of the largest coal export terminals in the world, loading around 30 million tons (mt) per year while operating almost continuously, 24 hours a day, 365 days a year, either from trains arriving directly at the terminal or from storage facilities that WTE maintains onsite. Until recently, it has been the only coal terminal of scale capable of serving Alberta’s export-oriented metallurgical (met) coal mines, giving it significant pricing power over key producers in the region; it also handles coal for export railed to the coast from the Powder River Basin (Wyoming/Montana in the US). WTE operates the port on a throughput basis – getting paid a fixed, and often escalating, fee per ton loaded – and never takes ownership of the coal – thereby taking no coal price risk and making the business ‘capital-light’. Meanwhile, underlying capex requirements are low, since invested equipment has a long usable life and WTE leases the right to use the port from the local government. These features have allowed the business to historically generate >50% EBITDA margins, convert >65% of EBITDA to free cash flow, and generate sustainable returns on invested capital (ROIC) of >20% across the cycle. Moreover, the company distributes most all its free cash to shareholders in the form of dividends and buybacks, because it has no debt.

Sounds great, right? Well, despite all of the above, I think WTE is an incredible short opportunity today. Oftentimes the best shorts occur not when a middling or poor business inflects lower (although I like those too ;)), but when a heretofore excellent business undergoes a fundamental change. Just such a change is coming to WTE, and will be inexorably reflected in the company’s earnings power in the next couple of years. I believe the sleepy, dividend-oriented Canadian ownership currently in the stock simply hasn’t cottoned on yet – they have been clipping their 3-4% yield consistently now for a decade – and that creates the opportunity we have today.

In a word, the problem is customer concentration (well, two words, I guess). WTE relies on one customer, Teck Resources (TECK, listed both in Toronto and New York), for >60% of its volumes; and another, Cloud Peak Energy (CPE), for ~15% of its volumes. This would be concerning for most businesses – as customer concentration increases the volatility of any company’s earnings stream – but in this particular case it is downright alarming. That’s because CPE is about to go bankrupt; and shortly thereafter, TECK’s loading contract – responsible for so much of the business’ stability over the last decade – expires in March 2021. Both issues are likely to prove huge negatives for WTE’s future prospects. Let’s look at the CPE impact first.

Impact of Cloud Peak’s impending Bankrutpcy

Cloud Peak is a distressed Powder River Basin (PRB) thermal coal producer. Thermal coal – used to produce electricity, as opposed to met coal, which is used to make steel – has been progressively losing share to nat gas and renewables as a generation fuel, both because of the environmental imperatives of many developed countries but also because of the increase cost competitiveness of gas-fired plants. Without going too much into the weeds of how CPE came to be in the situation it is in (see here for more background), suffice to say, the recent 10-K made it very clear CPE that is on its last legs as a public company and will need to be restructured shortly.

The real question however is not the ultimate filing, but the form the company takes during/after restructuring. Last year CPE produced 50mt of coal, from three different mines (Antelope, Cordero, and Spring Creek) – but they only shipped 4.6mt through WTE (all from Spring Creek). This shipment number is meant to escalate to as much as 10.5mt by 2022 – meaning as soon as in a couple of years, this mine alone was meant to account for ~30% of WTE’s then-notional capacity! (35mt per company guidance), As far as WTE is concerned, it is really only what happens to Spring Creek (the one Montana mine with coal of quality/type suitable for Asian utility customers) post B/K that matters, but I believe it may be quite difficult to ‘extract’ the Spring Creek operations from the husk of the rest of CPE, as we shall discuss.

In many bankruptcies, companies will use the process to shed themselves of uneconomic assets and restructure around a smaller, more profitable, core. Here, you could argue that CPE could perhaps shut down/curtail the Antelope and Cordero mines – which the 10-K makes clear are the main sources of the company’s current liquidity crisis and are the most structurally-unappealing assets in CPE’s stable – and simply operate Spring Creek, gradually ramping export production as that appears to be the only profitable market left for its coal.

But there are a few intractable problems in this case:

1. Remedial obligations: coal companies are required by law to ‘fix’ the land after mining is complete (basically this means trying to restore the land to closely resemble what it was before mining began). This may indeed be futile from an environmental perspective, but it is mandatory, and more importantly for our considerations, it is expensive. As of the 10-K, the dollar value on the balance sheet of these liabilities was $93mm – but note that this is a discounted number: simply the present value of a number estimated to be paid in the far future, using a ‘credit-adjusted, risk-free rate.’ We do not know what the actual, absolute number is (it is undisclosed), but it should be much higher than $100mm. We know this because the company has $408mm of reclamation and lease bonds – a number that only required $25mm of collateral until recently (due to the perceived creditworthiness of the company) but now, as the company’s distress has become more urgent, is being requested to be topped up:

Translating this into normal English: in order to keep mining, someone needs to provide more funds to third-party insurers of CPE’s remedial obligations because they are worried they will have to cover these costs if the company is not around to pay the tab (which could be much sooner than the nominal long mine lives left, if the company folds and no-one else wants to mine coal in the PRB anymore). This is all a long way of saying that it is not simply a matter of shutting down the ‘bad’ assets: someone still needs to pay for the remedial work, and this number is in the hundreds of millions. Moreover, since the company’s mining permits depend on reclamation liabilities being funded, there is a reasonable chance that Spring Creek’s continual operation rests on the willingness of someone to fund the clean-up costs at the other two mines. Inevitably this affects both the price paid and the economics of any ‘good’ assets that remain in operation (since they would have to presumably fund the cleanupfor anyone willing to buy them). That alone has dire consequences for WTE…

2. Spring Creek economics: another big problem is the underlying earnings power of CPE’s export business as it stands today. CPE reported the following in their 10-K:

(‘logistics business’ refers mostly to tons for export). During 4Q, the Kalimantan (Indonesian) benchmark index for this type of coal declined aggressively because EM currencies got killed and also because Indonesia stopped a ban on coal exports (which had been supporting prices). Elsewhere in the 10-K, CPE discloses that its cost of production on a per ton basis was $54/t last year – hence the uneconomic nature of these exports even close to $50/t. While prices have since recovered to the high-50s, it’s quite clear that even CPE’s ‘good’ export business remains priced out of the global market with its current cost structure when Kalimantan prices are below the mid-$50s/t. This conclusion is also problematic for WTE, as transportation/loading costs constituted 70% of delivered cost to customers in 2018 ($183mm out of total export coal opex of $266mm). Because logistics costs are such a massive contributor to all-in costs, the solution to anyone in bankruptcy is simple: use the process to recut all the logistics contracts (indeed, this is primarily what B/K is designed for, to allow distressed businesses to exit onerous contracts).

3. CPE is burning huge amounts of cash: this point may seem somewhat facetious but I think it’s important to emphasize that CPE is not entering B/K with stable operations. They disclosed $93mm of cash on hand at Dec’18, but have no sources of liquidity beyond that (since they canceled their Credit Agreement as they were going to bust covenants). At the same time they disclosed they only have $65mm of cash on hand as of early March:

They thus appear to be burning >$15mm PER MONTH and so if/when they enter bankruptcy will require significant and immediate a cash injection to maintain operations. They may well negotiate some kind of DIP financing – despite the issues mentioned – but I think it is worth highlighting that the cash needs alone could dictate much lower near-term (or mid-term) production as they simply don’t have the liquidity needed to support operations.

What does it mean for WTE?

To summarize all of the above: CPE has unavoidable, large, remedial obligations and continues to rapidly burn cash. Even in the scenario where the export-oriented mines continue producing (and this is not a given), the economics of that operation need to be significantly improved to maintain that mine’s ability to produce throughout the cycle. Since WTE’s terminal loading fee is one of the most significant cost items contributing to CPE’s export coal delivered cost, it appears inevitable that the estate will use the bankruptcy process to renegotiate WTE’s loading fees significantly lower. To me, this represents the best possible outcome, as there remains a very real chance CPE assets exit the market either partially or completely.

But how much does WTE actually make off CPE coal right now? That number is not disclosed, but in 2018 WTE generated CAD $11.7/t of coal handling revenue on average across all its customers. The CPE agreement has been renegotiated a few times, but I think CPE pays somewhat less than the average fee (mostly because TECK, WTE’s main customer, is locked into an above-market contract, more on that later). I estimate CPE is paying ~$11/t, or $51mm CAD (perhaps a little more with commitment fees, etc), which – using 77c USD/CAD avg in 2018 – implies ~$40mm USD, or around 22% of total transportation costs (the rest being the cost to rail the coal from minehead to port) and 15% of total opex for the export business. Note that total transportation costs for the exported coal last year were $40/t on a per ton basis (including both rail cost and WTE’s loading fees).

So, how much would cash costs have to come down to satisfy new owners, and how much of that burden would WTE have to share? While this is a difficult question to answer precisely (made more difficult without knowing what form the new cap structure would take and indeed if CPE could even garner new capital), consider the following points:

• even well-capitalized, low-cost, through-the-cycle coal producers (Warrior Met Coal, Peabody, Coronado Resources, etc) trade with extremely low multiples (3-4x EV/EBITDA or lower) and implied high costs of capital (low to mid-teens %). Anyone potentially bankrolling a restructuring high-cost 100% thermal producer would of course demand an even higher cost of capital as well as a huge improvement in pro-forma operational returns;
• there are limited direct comparables, but Consol Energy owns and operates a smaller coal handling terminal in Baltimore that charges $5 (USD)/t all-in loading fee – significantly less than CPE is paying today for similar services in a similar market;
• discussions with Australian coal-handling infrastructure providers suggests they charge at least 30% cheaper than the rates WTE is earning today (this is, in essence, one of the reasons TECK is so unhappy).

None of this provides a straight answer, but pulling it all together, if we applied, say, a blanket 30% cut to all logistics costs (meaning the railway company shares the pain), then on a per ton basis this would fall from $40/t to ~$27/t; all-in costs (assuming no other efficiencies on the non-logistics costs) would fall from $57/t to ~$45/t; and since depreciation is ~10% of costs, this would imply a low-$40s cash cost number (versus mid-$50s cash cost number today). In other words even if Kalimantan coal went back to the high 40s (where it was in December), the mine should still be generating 15-20% EBITDA margins – not too far below what a somewhat-comparable PRB producer like Peabody (BTU) is earning today. Something like this may be an acceptable business to consider recapitalizing with new money (relative to simply investing in an existing asset like Peabody or Coronado).

In this scenario, WTE’s take would be haircut, clearly, by 30% – thus falling from say CAD $11/t to $7.7/t – which sounds fairly drastic but is still a near 20% premium to what the East coast terminal owned by Consol is charging (in USD terms); and indeed a similar rate to what WTE used to charge back in 2011 (before many years of price escalation):

Such a move would immediately remove ~$15mm CAD from WTE’s EBITDA, if volumes remained flat at 4.6mt rates – this is only 7% of FY18 EBITDA, so not too bad, right? Maybe not…but since we know CPE is trying to get to 10.5mt over the next few years, the implications are actually disastrous if applied across the pro-forma larger loading volume – almost 1/3 of WTE’s loading tonnage in 2021-22 – because effectively they will be displacing TECK volumes rolling off at much higher rates, and fixed costs are very high, as we shall see.

We will come back to the all-in economics, but let’s turn to the second issue, TECK, now.

Teck Resources is going it alone

In 2011, Teck Resources (TECK), a Canadian mining conglomerate and the second-largest met coal player in the seaborne market, signed a binding, take-or-pay, 10yr contract with WTE the load at least 19mt/yr of met coal. This agreement expires in March 2021. TECK’s annual met coal production is unlikely to change much in the medium term (around 27-28mt/yr). TECK has already notified WTE that it intends to ship less than 19mt once the contract expires (this was disclosed in WTE’s recent annual report), and indeed TECK has been quite vocal about its alternate plans: it has prioritized increased the capacity of its own fully-owned loading facility, the Neptune Terminal, located in WTE’s backyard of Vancouver harbour, a mere 40km away:

TECK has committed to spend the capital necessary to get capacity at Neptune from its current 12mt/yr up to at least 18.5mt/yr by 2021 (fully permitted for this amount already), and maybe to as much as 20mt/yr. At the moment, Neptune only handles 6mt/yr – largely because TECK is locked into the WTE contract for now – but once the expansion is complete, there is simply no reason to think TECK wouldn’t maximize handling at its own, fully-owned and operated facility, Neptune. Indeed, TECK management has been quite vocal on numerous investor calls (see the most recent call, for example) regarding the rationale to make the investment ($85mm+) to expand Neptune. It has been driven both by a desire to control their own infrastructure – and thus maximize flex deliveries around surge pricing, and also because, frankly, WTE has underperformed their expectations (eg by commingling high value met coal with other clients’ thermal coal; or prioritizing the shipment of other clients’ lower-value thermal coal instead of TECK’s high value met coal during peaks in the market). Given the volatility in global coal prices, these operational missteps, even if of a matter of days delay in delivering to customers, can be hugely impactful to the PnL of the business. Another important reason motivating the move is simply that TECK feels WTE is charging them too much (much higher than equivalent Australian or East Coast ports would, for example), and thus has gained far too much value out of TECK over the 10-year contract.

Thus, post March 2021, at a bare minimum TECK will rededicate as much WTE throughput towards Neptune as Neptune can handle. Assuming TECK can successively execute on the capex over the next 1.5yrs (and they have already started the project), this to me would mean at least 15mt/yr going towards Neptune (at 80% utilization) – meaning an incremental 9mt/yr on top of the 6mt/yr already going there. This would clearly come out of WTE’s volumes, reducing TECK volumes at WTE from 19mt down to 10mt/yr on an annualized basis. And once Neptune is built, these volumes will never come back (thus permanently raising the risk profile, and lowering the multiple, of WTE as an asset). Thus, even just this highly plausible scenario could see WTE lose 1/3 of its annual volumes, for good, in under 2 years, and permanent raise the cost of capital for WTE as a whole.

High fixed costs are a double-edged sword

Part of the reason WTE has been such a good earner until now is also the reason it could all fall apart in a hurry in the near future – namely, the cost structure of the business.

Looking at the above, it’s quite clear most all the costs are fixed, not variable:

• administrative costs: clearly mostly if not entirely fixed;
• depreciation: entirely fixed;
• terminal leases & fees: there is a fixed portion payable no matter what volumes are (about 60% of the total); then the balance varies depending on volumes about 17.6mt/yr. So still, mostly fixed;
• salaries & wages: we don’t know precisely how much is fixed or variable, but evidence suggests this too is mostly fixed. For example, look at a chart of tonnage loaded versus total salaries & wages over the last eight years:

Annual tonnage has moved around a fair bit, but salaries and wages have only kept going up (the jump after 2016 was due to a new union contract), and in general show zero sensitivity to annual declines in volume. In my subsequent calculations I am estimating 70% of salaries are fixed, though this should be conservative based on the above.

The obvious corollary to all this is simply that lost volumes will have a much bigger downside impact on WTE’s financials than even the percentage decline in volumes would suggest. Hence if or when TECK moves its volumes away, WTE could be losing ~33% of its volumes (10mt out of 30mt) but – as we shall see – a much, much larger % of its earnings power.

Putting it all together – EBITDA ~50% lower post TECK expiry, CPE restructuring

Let’s take a look now at what the post-2021 WTE business could look like, adjusting for what I think happens at CPE and TECK. A few notes on my base case assumptions:

• TECK: as discussed above, I contemplate only 10mt of the 19mt currently at WTE, moving to Neptune from Mar21; the remaining 10mt I estimate will be restruck at current WTE ‘average’ rates (CAD 11.5/t);
• CPE: I’m giving substantial credit for the planned ramp in volumes, estimating 9mt/yr from the current 4.6mt/yr rate (versus CPE’s goal to get to 10.5mt by 2022). In return for this/to make this economic through the cycle, as discussed, I envisage a cut in the loading rate to CAD 7/t (ie slightly more than the 30% cut I discussed conceptually earlier);
• Others: no changes in tonnage nor estimated rates on the rest of WTE’s customers (this is also actually bullish as a number of these customers are also swing thermal coal producers)
• Costs: 70% fixed costs share for salaries/wages (this could be generous); and depreciation rises to maintenance capex levels (20mm CAD/yr).

 

All in all, and because of the very high fixed cost nature of the assets, the decremental margins on lower volumes (throughput in this scenario falls to 25mt/yr from 30.5mt/yr in 2018) are very high. As a result, EBITDA falls from ~195mm to 99mm (-49%) and the business is doing barely 50mm of FCF sustainably in this base case. Even allowing for the unlevered balance sheet and some continued reduction in the share count between now and then, this implies a near 25x P/FCF multiple for a somewhat stranded asset post TECK’s pivot and CPE’s restructuring, far more exposed to lower-quality, swing producers and thus deserving of a lower rating from the market. I think a fairer price would be somewhere between 10-15x FCF in this scenario – implying at least 40% downside in my base case – and there are clearly many scenarios where earnings fall a lot farther than this (TECK moves more volumes away; renogotiated rates on the balance are lower than 11.5/t; or CPE goes into liquidation/production decline post B/K).

What I like best about this trade, though, is that the sell-side is so asleep at the wheel. Most analysts don’t seem to be considering what even happens beyond next year, and if they do, they assume the gentle escalators WTE has enjoyed in recent years simply continue – they seemingly cannot countenance what is right in front of them (probably because it is still 2yrs away). But given the importance of the TECK contract to WTE, this could really be renegotiated/announced in some form much sooner than March 2021 (thus making clear the fundamentally lower earnings power of the go-forward business), and is why this is such a compelling short in the near-term. That, and also you get full exposure to the consequences of the impending CPE bankruptcy filing.

Disclosure: short WTE CN