Update on CEIX and CCR

On March 12, 2018, I had penned a note “Why CCR 14% yield is solid” on this site. For background, you can read it here.

On February 7, 2019, Consol Energy (CEIX) and its MLP, Consol Coal Resources (CCR) released Q4-2018 results and provided  initial guidance for 2019.  Based upon the cash flow generated by CEIX, CCR’s annual dividend of $2.05 seems extremely secure for several years, in my opinion.  What is unclear to me is why CEIX even needs a publicly traded MLP because, in my view, it would be far better-off consolidating CCR via a cash or stock deal and simplifying its structure and “story”.  This will, of course, require a deal that is fair to both CEIX and CCR holders.

In any event, to simplify discussion and analysis, I will treat CEIX/CCR as a single entity by “consolidating” the GP and MLP.  This is easy to do – – CCR, the MLP, is nothing more than a legal entity that has an undivided interest in CEIX’s coal-mining operations and serves as a dividend-paying vehicle for CEIX.  The debt on CCR’s balance sheet is owed to CEIX so it cancels out in consolidation.  Furthermore, 60% of CCR stock is owned by CEIX.  Henceforth, all the figures in the discussion below will pertain to a consolidated entity, CEIX.

CEIX produces and sells approximately of 27-28 million tons of coal annually and as of 12/31/2018, controlled 698 million tons of coal reserves or 25 years of full-capacity production in the Northern Appalachian region (NAPP).  In addition, it owns/controls 1.6 billion tons of Greenfield Reserves which may or may not ever see light of day so I discount this to zero.  It also owns a marine terminal in Port of Baltimore which is served by two major railroads and is a key asset.  In 2018, CEIX sold approximately 70% coal to US customers (mainly electric utilities) and the rest was sold in the export market.  Following are some key operational and financial statistics:

2015 2016 2017 2018
Tons Sold 22.9 24.6 26.1 27.7
Avg Price 56.36 43.31 45.52 49.28
Avg Cash Margin 15.23 16.51 19.97
Total Revenue and Income 1,421,720 1,230,862 1,411,903 1,532,015
Total Costs and Exp 978,694 1,165,847 1,242,106 1,344,402
Pretax Income 443,026 65,015 169,797 187,613
Taxes 125,605 14,565 87,228 8,828
Net Income 317,421 50,450 82,569 178,785
Cash Flow from Ops 291,693 329,107 248,110 413,525
Capital Expenditure (143,053) (53,600) (81,413) (145,749)
Free Cash Flow ($000) 148,640 275,507 166,697 267,776

2018’s free cash flow of $268 million equates to a 23% FCF yield on a combined equity market cap of $1.2 billion (100% of CEIX common stock and 40% of CCR’s units).

While this level of FCF yield seems unreasonably high for a viable business, the fact of the matter is that many coal companies are trading at similar FCF yields.  And I think it would be naive to think that this is due to something that investors don’t know or don’t understand.

My take is that there are two main reasons for the pessimistic, low valuation.  One, coal is a commodity business and using a single year’s cash flow to value it doesn’t really make much sense (to me, anyway).  And two, there is very little argument that coal is a dying business, being replaced by other fuels and renewables.  Its remaining life, however, is a wide-open question.

According to International Energy Agency, global coal demand will remain stable through 2023:

Air quality and climate policies, coal divestment campaigns, phase-out announcements, declining costs of renewables and abundant supplies of natural gas are all putting pressure on coal. As a result, coal’s contribution to the global energy mix is forecast to decline slightly from 27% in 2017 to 25% by 2023.

According to U.S. Energy Information Administration, coal-fired generation will continue to decline through 2050:

Generation from both coal and nuclear is expected to decline in all cases. In the Reference case, from 28% share in 2018, coal generation drops to 17% of total generation by 2050. Nuclear generationdeclines from a 19% share of total generation in 2018 to 12% by 2050. The share of natural gasgeneration rises from 34% in 2018 to 39% in 2050, and the share of renewable generation increases from 18% to 31%.

If CEIX generates even close to the free cash flow it is generating currently, and uses a large portion of it to pay down debt and buy back stock, the long thesis plays out nicely over the next 2-3 years.  I don’t need coal to hang in there for decades for this investment to work out ..

On 2/7/19, CEIX released Q4 earnings and provided guidance for 2019.  And I have a lot of confidence in management’s guidance due to strong earnings visibility.

Here’s why (excerpt from Q4-2018 press release):

“Taking advantage of this sustained demand, we have contracted greater than 95% in 2019, 53% in 2020 and 28% in 2021, assuming a base annual production rate of 27 million tons. This contracted position includes a mix of sales to our top domestic customers and to the export thermal and export metallurgical markets, maintaining our diversified market exposure. With our solid 2019 contracted position, our primary focus is now on maximizing margins for any remaining 2019 sales and continuing to build on our contract portfolio.”

Using guidance and a few assumptions, I estimate that CEIX will generate free cash of $150-$210 million in 2019:

2019 Guidance ($mil) Low High
EBITDA 380 440
Interest (70) (70)
Taxes (11) (17)
Capital Expenditure (145) (145)
Free Cash Flow 154 208

At the end of Q4-18, CEIX had cash balance of $265 million.  Adding to that, my free cash flow estimate and subtracting some mandatory cash outlays, I expect the company to end up with $210-$240 million of excess cash and use the bulk of it to (1) pay down its high-coupon 2nd Lien notes via open market purchases (2) buy back CEIX stock and (3) buy back CCR stock.  During Q4 conference call, management also indicated that it is working on a comprehensive refinancing of its debt and if that were to occur soon, then most of its excess cash could be used to just buy back stock.

Cash – Beginning (mil) $265 $265
Cash+Free Cash Flow 419 473
Term Loan B Pay-down for 2018 (110) (110)
Term Loan B Pay-down for 2019 (77) (104)
Dividend to CCR Unit holders (22) (22)
Ending Cash – 2019 $210 $237

CONCLUSION:  You don’t earn double-digit dividend yield without taking risk. However, with 95% of 2019 and 53% of 2020 production already contracted, I feel pretty good about the risk/reward proposition in CCR.  I am not quite as comfortable with owning CEIX, however, because (1) I really don’t see any reason why investors would assign a higher valuation to this business in future and (2) there’s no telling what management chooses to do with excess cash and, in my experience, most managements don’t get as excited about shrinking balance sheets as they do about indulging in m&a.


Ticker: ,