James River: A Bargain in the Coal Bin?
Why are we bullish on shares of James River Coal (JRCC; recent price, $15)? First, we think that the improving supply and demand environment in the coal industry will begin to support increasing coal prices and, later, higher production volumes, which should help drive growth in revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization).
Second, we believe management's continued focus on tightening cost control and improved productivity should help profitability metrics improve and expand EBITDA margins. Third, by our analysis, the company's improved liquidity has removed the selling pressure on the shares, allowing the stock to trade closer to peer valuations.
Out of Bankruptcy
Finally, we find the stock's valuation compelling. We have a 5 STARS (strong buy) recommendation on the shares.
James River, which emerged from Chapter 11 bankruptcy proceedings in May, 2004, produces steam and industrial coal through six mining complexes in eastern Kentucky and southern Indiana. It also supplies coal to a third-party synfuel (synthetic fuel produced by chemically altering coal) plant and receives fees for handling, shipping and marketing the synfuel product. The company's six mining complexes contain 15 underground mines, 11 surface mines, and 11 preparation plants.
As of Dec. 31, 2006, James River controlled approximately 273 million tons of proven and probable coal reserves. It produced 12.3 million tons of coal in 2006, including coal produced in company mines operated by contract mine operators, and purchased another 786,000 tons for resale. Of the coal produced from company-operated mines in 2006, approximately 69% of produced tons came from underground mines and the remaining 31% from surface mines.
James River sells coal obtained from three primary sources: company-operated mines, mines that are operated by independent contract mine operators, and other third parties. In 2006, 89.3% of the total sales volume of 13.1 million tons was obtained from company-operated mines; 4.7% was obtained from mines operated by independent contractors; and the remaining 6.0% was purchased from other third parties.
The company has a broad customer base of primarily electric utilities. In 2006, James River sold 88% of its coal to utilities, with 72% of its 2006 revenue from seven long-term contracts to sell coal to electric utilities. In 2006, Georgia Power accounted for approximately 25% of revenues, and South Carolina Public Service Authority 16%. In Central Appalachia, the company ships most of its coal by train; in the Midwest, coal is shipped by both train and truck.
Thanks in large part to improved productivity, tighter cost control and rising realized price per ton sold, James River has begun what we view as a turnaround and has started to narrow its losses per share over the last three quarters. We believe this trend will continue as supply and demand levels in the global coal market improve over the next six to 12 months, which in turn should support higher coal prices. Production cutbacks, the idling of unprofitable mines and transportation slowdowns due to scheduled summer railroad maintenance will help reduce supply, in our view.
We expect demand to increase, as electricity generation expands during the summer burn season and growing Asian economies consume greater amounts of energy and increase their imports. China, for example, has recently become a net importer of coal, driving other Asian countries to search for new suppliers of coal, while India is also expanding its consumption of coal. Domestically, electric utilities have already started to reduce coal stockpiles as consumption increased with a higher number of heating days at the end of winter.
Margin Expansion Expected
Under these improving industry conditions, James River's 2008 volumes and realized prices will increase, by our calculations, which should drive revenue growth.
As the company continues to drive further productivity improvements by closing high-cost mines, reducing the number of outside contract miners, and decreasing turnover and retaining more experienced miners, production cost per ton should decline. We see EBITDA margins expanding and losses per share narrowing due to these actions.
A recent refinancing has improved James River's liquidity and debt expense, which has helped to alleviate some of the bearish sentiment on the stock, in our view. On Feb. 26, 2007, the company entered into a $35 million revolving credit agreement and a $100 million term credit agreement. After repaying prior revolving debt agreement and letters of credit and satisfying bank covenant agreements, James River has approximately $34.9 million in available liquidity from this transaction, by our calculation.
When combined with the $15.7 million cash on hand, James River has nearly $50.6 million in total liquidity, or $3.18 per share. In our view, this should help remove any overhang on the stock resulting from liquidity concerns, and allow the shares to trade closer to peer valuations.
Industry Consolidation on the Way
We also believe James River could benefit from future potential industry consolidation as larger producers seek out small to midsize producers for their expansion efforts. Many larger competitors have indicated that they may look for producers that have high-quality, long-term reserves but that are also stressed by current pricing conditions relative to their average cash cost of production, have debt or liquidity issues that could limit the speed of their production or expansion, or might have cash flow issues.
We expect revenues to decrease 2.1% in 2007, led by a projected 1.7% decline in average realized price, and a 1.3% decrease in total shipment volume as James River looks to take some production volume off the market in an effort to sell only its highest-priced coal, limit unprofitable production, and reduce excess inventories. We see Central Appalachian (CAPP) coal volume declining 2.7% in 2007 and Midwestern volume rising 3%, as we believe management will look to remove some less-profitable CAPP coal from production and focus on higher-margin Midwestern coal. We see 2008 revenue rising about 19% on higher production volume and improved prices.
We expect EBITDA margin to expand to 8.5% in 2007, as Central Appalachian cash cost per ton declines 2%. We forecast higher productivity reflecting decreases in employee turnover and labor costs, partly offset by some commodity cost inflation and potentially higher regulatory costs. We see further operating margin expansion in 2008 to 9.4%, driven by increased operating leverage and lower selling, general, and administrative expenses as a percentage of sales. We forecast operating losses per share of 97 cents in 2007 and 75 cents in 2008.
Stronger Global Demand
We believe coal inventories, which were almost 20% above normal levels at the end of March, will decline as we head into the summer season and then decline further by the end of the year after production cutbacks and increased demand reduce utility stockpiles. Indeed, The Energy Information Administration (EIA) forecasts a nearly 15 million ton decline by the end of 2007, though we believe the reduction could reach twice that amount based on lower production and strong global demand levels.
We expect strengthening domestic demand by electric utilities should help reduce stockpiles. Electricity generation is up strongly since last year, with heating degree days rising 13.8% year to date vs. last year. We believe this implies rising demand levels will continue to burn off inventory. We think this should, in turn, support steady increases in coal prices, and therefore, coal producers' revenues, as supply and demand begin to approach more normalized levels later in 2007 and into 2008.
In addition, we believe that as we approach the summer driving season, which has historically elevated oil and gas prices, coal prices will also rise.
Coal spot prices are highly correlated to oil and gas prices, since coal is a cheaper alternative fuel for electric utilities, which consume almost 90% of coal production. In 2006, coal cost $21.62 per megawatt hour (MwH), while oil and natural gas were $80.61/MwH and $81.58/MwH, respectively. With natural gas prices already high, we expect that utilities will continue to focus on coal as their main fuel source, which should support demand.
Asia Looks to the U.S.
Global demand should also support domestic prices. China has become a net importer of coal, driving other Asian countries to search for new coal suppliers and look to the U.S. for a greater portion of their coal imports. India is also expanding its coal imports as its energy consumption grows. These developments, we think, are helping support global demand, which should have a positive influence on domestic coal prices and long-term contracts through 2009.
We believe we are already seeing the effects of these events on supply. According to the EIA, U.S. coal production declined 2.3% and railroad cars loaded declined 1% year to date through Apr. 28. An Appalachian production decline (down 8%) helped Central Appalachian spot prices increase almost 7% year to date through Mar. 23, according to the EIA. At the same time, we believe demand is rising, as electric utilities increase their use of coal with the onset of warmer weather and as a result of a decrease in nuclear power generation due to scheduled maintenance in the last quarter. We expect Powder River Basin spot prices to increase due to the recent shipment delays. Many coal producers are reporting that they are receiving calls from utility customers to ship more coal than previously scheduled.
We believe a confluence of events, plus production cutbacks, should remove 5 million to 10 million tons of production near term and 30 million to 40 million tons through 2007. The late blast of cold at the end of the winter season increased demand, and the late snowstorms in the Midwest and Powder River Basin delayed rail shipments. Union Pacific, for example, indicated that a Wyoming storm prevented more than 160 trains from being loaded with Powder River coal.
Reduced Appalachian Production
Furthermore, certain producers shut down or idled production at unprofitable mines due to strikes, lower production targets, or in response to demand levels. Production may be curtailed in parts of the Central Appalachian region as a federal judge's ruling revoked permits for four CAPP surface mines and also blocked permits on two new mines. This could reduce production by 5% to 10% out of the region, implying a reduction of approximately 10 million to 20 million tons annually.
We view James River's valuation as compelling, as the stock is trading at nearly a 25% discount to peers on an enterprise value/EBITDA basis, despite the company's substantial high-BTU, low-sulfur reserves that could support 22 years of production based upon current production levels. Additionally, based upon our calculations, we see cash costs per ton declining and cash flow improving over the next two years, which adds to the company's appeal, in our estimation.
Our 12-month target price of $18 represents a combination of two valuation metrics. In terms of relative valuation, we apply a target multiple of 8.0X to our 2007 EBITDA estimate, a 5% discount to peers, to arrive at a value of $18. We believe this discount is appropriate based on the company's comparatively small reserves and small market capitalization. Our discounted cash flow (DCF) model indicates an intrinsic value of about $17.
Chairman, CEO Are the Same
We have a generally favorable view of James River Coal's corporate governance. Some of the practices we view positively are that the board is controlled by a majority of independent directors; the audit, compensation and governance committees are entirely comprised of independent outside directors; the company does not have a poison pill; and officers and directors have a vested interest in James River, owning a combined 3.4% of the outstanding stock.
However, an area of concern for us is that the chairman of the board and the CEO roles are filled by the same person, which we believe presents a potential conflict of interest. Although the board is composed of independent directors, we have some reservations about the fact that it is classified into three classes, which we think tips the balance of power to incumbent management since it makes it more difficult to change control.
Risks to our recommendation and target price, in our view, include lower-than-expected coal prices, productivity declines, increased supply costs, lower-than-expected demand trends, and weaker-than-expected U.S. economic activity. Other risks include liabilities and fines associated with potential civil or criminal lawsuits by regulatory bodies or others due to regulatory violations or mine fatalities.
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