Arch Coal Lures Lenders With Coal in Ground: Corporate Finance

Black Thunder Coal Mine in Montana
Black Thunder Mine in Wright, WY, owned by Arch Coal Co. is located within the state's Powder River Basin. On Sept. 27, 2011, the state of Montana and Arch Coal, Inc. went to court against environmental groups seeking to derail company plans to mine a 1.3 billion ton reserve in from the nation’s most productive coal region, the Powder River Basin. Photographer: Matthew Brown/AP Photo

Lenders are allowing Arch Coal Inc. to borrow $1 billion without the typical level of restrictions, helping the company overcome plunging energy prices as it cuts spending after two quarters of cash outflows.

The fourth-largest U.S. producer of coal, saddled with $4.1 billion of debt, will use proceeds of a term loan to refinance obligations and eliminate maturities until 2016 while increasing liquidity. The company is reducing its revolver by $1 billion and loosening restrictions on the existing credit line.

Lenders said they are interested in financing St. Louis-based Arch Coal because of the yield the loans offer and the collateral, such as its mines, supporting the borrowing. The company is cutting expenses to limit the damage from a collapse in U.S. coal prices, which fell 17 percent in the first quarter from the average a year earlier.

“Arch is doing a number of things to save cash flow,” Evan Mann, a New York-based analyst at Gimme Credit LLC said in a telephone interview. “This new term loan helps its capital structure and gives them more liquidity. So even if they have a small free cash flow shortfall, it’s not a big deal.”

The company needs about $700 million of earnings before interest, taxes, depreciation and amortization to break even, Mann said. Gimme Credit is projecting a free cash flow shortfall, after $26 million of dividends, of approximately $100 million in 2012, he wrote in a May 4 report. Free cash is money available to pay debt, to reward stockholders with dividends and buybacks, or to reinvest the company.

Free Cash Flow

Arch Coal reported negative free cash flow of $38.3 million in the first quarter and $144.3 million in the final three months of 2011, according to data compiled by Bloomberg.

It posted a net loss of $7.6 million during the first quarter, compared with net income of $59.4 million in the comparable year-ago period, according to a May 1 regulatory filing. Adjusted Ebitda totaled $179.8 million during the period, down from $191.4 million in the first quarter of 2011.

Kim Link, a spokeswoman for Arch Coal, didn’t immediately return a phone call seeking comment.

“Severe weakness in U.S. thermal coal markets” affected results, Arch Coal Chief Executive Officer John Eaves said in the filing. Arch Coal expects coal consumption for power generation to decline by at least 75 million tons in 2012, compared with 2011, because of “unfavorable weather trends” that have reduced power demand and contributed to a natural gas surplus, he said.

‘Perfect Storm’

Central Appalachian thermal coal futures, the U.S. benchmark, averaged $60.20 during the first quarter, down from an average of $73.58 in the year ago period and down from a high of $143.25 in July 2008.

“It’s like a perfect storm,” Mann said. “The three main challenges are the really mild winter, a lethargic economy and on top of that, with gas prices being so low, those utilities that can burn gas have opted to burn gas instead of coal because gas is so cheap.”

Cheap gas has undercut power producers’ revenues because it drives down wholesale electricity prices, squeezing margins for plants that run on nuclear, renewable and coal power.

Moody’s Investors Service changed its outlook for the U.S. coal industry to “negative” from “stable” on May 7, citing weak prices and a drop in power demand, and said it expects a 5 percent decline in prices for coal deliveries in 2013. The U.S. Energy Information Administration expects the industry to see a

10.9 percent decline in coal consumption this year and Moody’s expects U.S. coal demand from power plants to plunge by 100 million tons by 2020, the ratings company said in the report.

Coal Loses Share

While coal remains the leading source of power in the U.S., it has fallen to 37 percent of U.S. electricity generated during January and February, combined, from 46 percent a year ago, Energy Department data show.

“The U.S. coal industry is in the midst of a restructuring that will cause some players to exit the market and others, like Arch, to pare back operations until market conditions improve,” Eaves said in the filing.

Arch Coal’s total coal sales fell 16 percent, to 35.5 million tons, missing estimates of 39.5 million tons by JPMorgan Chase & Co. analysts. The company reduced full-year coal guidance by 25 million tons, to 136 million to 142.5 million from 151 million to 168 million tons earlier, JPMorgan analysts wrote in a May 1 report.

Peabody Energy Corp., Alpha Natural Resources Inc., and Consolidated Energy Inc. are larger than Arch Coal, based on sales, Bloomberg data show.

Arch Coal cut its quarterly dividend by 73 percent, to 3 cents a share from 11 cents, saving $68 million a year, it said in the May 1 filing.

New Loan

It’s seeking lender commitments by today for the six-year term loan that will support a tender for $450 million of 6.75 percent notes due in 2013 and pay down borrowings under a line of credit. In a revolving credit money can be borrowed again once it’s repaid; with a term loan, it can’t.

The debt is being offered with an interest rate of either

5.75 percent or 4.5 percentage points more than the London interbank offered rate, whichever is greater, according to data compiled by Bloomberg. Three-month Libor, the rate banks charge each other, was fixed at 0.47 percentage point yesterday.

The debt may be sold at 98.5 cents to 99 cents on the dollar, the data show, reducing proceeds for the company and boosting the yield for investors.

Lender demand is strong and Arch Coal may be able to borrow on more favorable terms, according to two people familiar with the transaction who declined to be identified because the deal is private. The loan is senior secured, meaning it is repaid ahead of any subordinated debt in the event of a default.

Asset Sales

The new borrowing will be covenant-lite, the company said in a May 2 regulatory filing, meaning the loan will not contain any financial maintenance covenants.

The loan terms allow Arch Coal to retire as much as $500 million of the new debt at par with asset-sale proceeds in the first 12 months from closing.

“I would expect Arch to focus on selling mines that are less profitable due to logistical reasons,” Kip Penniman, an analyst at KDP Investment Advisors Inc. in Montpelier, Vermont, wrote in an e-mail. “Those mines may be further away from the company’s primary preparation plants, or may incur incremental expense if Arch were to redeploy machinery to more productive mines.”

‘Challenging Conditions’

Fitch Ratings downgraded Arch Coal to B+ from BB- on May 2, and said it expects leverage “could be above 6.5 times until the domestic steam coal market achieves balance.” Moody’s cut Arch Coal’s corporate family rating to B1 from Ba3 and put the company on watch for a possible downgrade while Standard & Poor’s lowered its grade similarly, to B+ from BB-, on May 3.

“The negative outlook reflects our expectation that credit metrics will remain weak through 2013 while the domestic coal market will continue to face challenging conditions for the foreseeable future,” Moody’s analysts wrote in a May 2 report.

The company’s shares sank to their lowest level since July 2002, to $7.60 on May 8. They traded at $8.25 at 11:56 a.m. in New York.

Arch Coal’s $500 million of 7.25 percent bonds due in October 2020 are down 15.3 percent this year, while a Bank of America Merrill Lynch Index of all high-yield U.S. coal companies has lost 2.1 percent. Its $600 million of 8.75 percent notes due 2016 traded yesterday at 100.75 cents on the dollar to yield 8.52 percent, according to Trace, the bond price reporting system of the Financial Industry Regulatory Authority.

“Arch’s senior bonds are yielding less than 9 percent,” Penniman said. “These bonds are not distressed and we place a relatively low probability that Arch will have difficulty servicing its debt.”

The 8.75 percent bonds are the next maturity Arch Coal has to address if it successfully tenders for the 6.75 percent notes, according to data compiled by Bloomberg.

“Not having refinancing risk looming over their head will give people some comfort,” GimmeCredit’s Mann said. “Operationally it’s going to be difficult for everybody in the industry. They’re all scaling back,” he said. What Arch Coal is doing “is defensive and prudent. No one else has done that.”


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