Coal Miners Are The New Sub-Prime: The Vultures Are Circling The Slag Heap

By Timothy Puko, Matt Wirz and Matt Jarzemsky at The Wall Street Journal

Hedge funds are betting that some of the largest U.S. coal companies are heading for the financial slag heap.

The coal industry is in a prolonged slump with a long list of causes topped by sluggish demand and competition from cheap natural gas, which have pushed prices to historic lows. Many investors have abandoned the sector. Eight coal-mining companies traded on the New York Stock Exchange are down an average of 29% in the last year. The conditions are ripe for hedge funds that target distressed investments. They are first betting against the stock and debt of mining firms such as Walter Energy Inc., then snapping up the bonds when their prices fall as low as 40 cents on the dollar.

The endgame: swapping that debt for controlling shares of the companies if they go bankrupt. Once coal prices rebound, mines and other assets can be sold at a profit.

“People see blood in the water, and that presents an opportunity,” said Ted O’Brien, president at Doyle Trading Consultants LLC. He said he is advising more than a dozen investment firms that specialize in risky debt that have bought or are considering buying coal-company bonds.

So-called vulture funds have used these tactics in other ailing industries, like air travel and paper manufacturing, generating average annual returns of 7.5% from 2011 to 2013, compared with an average of 3.4% for all hedge funds, according to HFR Inc. But an improving economy has left them with few new targets this year, and returns are down. More of the funds are descending on big coal as declining coal prices finally catch up with mining companies that borrowed heavily to spur growth.

Walter Energy is a particular favorite of distressed-debt investors, including Apollo Global Management LLC, Brigade Capital Management LP, Caspian Capital Management and Knighthead Capital Management LLC, people familiar with the matter said.

Walter owns some low-cost mines that produce metallurgical coal, the type used to make steel and the hardest hit in the recent downturn. Those mines could be profitable immediately if they aren’t saddled with Walter’s debt, analysts said.

The funds have been buying up much of a $1 billion bond secured by Walter’s assets for 85 to 90 cents on the dollar, people familiar with the matter said. The holders would have first claim to Walter’s assets in a bankruptcy. Meanwhile, the bonds yield as much as 14% at current prices.

Several of the funds had also sold short the company’s unsecured bonds, a wager that their value will fall. The bonds have lost 58% since June 30 and trade for 27 cents on the dollar.

Alpha Natural Resources Inc. and Arch Coal Inc. have also seen heavy interest from distressed-debt buyers, people with knowledge of the matter said. Along with Walter Energy, the companies have a combined debt of $12.2 billion, according to Morningstar.

Companies that produce commodities regularly ride out ups and downs in prices. However, some investors believe large mining companies are too weak financially to survive unless business turns around within one to three years.

Their individual debt levels are between 22 and 37 times higher than their earnings before interest, taxes, depreciation and amortization, compared with a ratio of less than 6 to 1 for other coal-mining firms on the NYSE, according to FactSet.

Walter, Alpha and Arch produce large amounts of metallurgical coal. Prices for this type of coal have dropped nearly two-thirds since 2011. Economic growth is slowing in China and Europe, reducing demand for steel, even as output has risen.

Coal miners are also under pressure from cheap natural gas, which competes with another type of coal for use in the power sector. Stricter regulations on power-plant pollution has also hurt coal demand.

Walter is on pace to deplete its cash reserves within 18 months, according to the research firm CreditSights Inc. Arch and Alpha have enough cash to last at least 3.6 years.

Fear that the cash will run out before coal prices rebound has flushed many traditional investors, like mutual funds, out of the companies’ stocks and bonds.

Since Sept. 1, investors have sold about $286 million of Walter’s $350 million second-lien bonds, which would have second claim on assets in a default, says MarketAxess. Hedge funds like Apollo have bought the bonds, betting that, in the event of a bankruptcy, they will be exchanged for stock in the reorganized company, investors say.

The company has already begun restructuring more-junior unsecured bonds. Walter announced on Nov. 18 it had exchanged $52 million face amount of the junior bonds for $5.2 million in cash and 3.9 million shares, valued at $11.4 million on the day of the announcement.

Electron Capital Partners LLC has in the last year short-sold shares of Walter, Alpha and Arch. Short-selling a stock involves borrowing shares, selling them and pocketing the difference if they decline before being returned to their owner. The fund closed out the last of its bets this summer because the stocks had fallen so close to zero, said Jos Shaver, managing partner at Electron.

Mining executives acknowledged the bleak conditions in the coal market but said they had raised enough cash to weather the downturn.

“I think it’s a huge overreaction to where we are today,” said Walter Scheller, chief executive at Walter Energy.

In September, Alpha reached an agreement with creditors to extend the deadline to pay debts and open additional credit lines of about $1.1 billion.

“Given where prices are, where costs are, where debt levels are, I wouldn’t be surprised to see more restructuring,” throughout the industry, said Kevin Crutchfield, Alpha’s chief executive. “We have every belief [Alpha is] going to get through this just fine.”

An Arch spokeswoman didn’t return requests for comment.......


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