Peabody Energy: Unfavorable Hedges Obscure A Solid Underlying Business
Summary
Peabody Energy is hampered by its hedges, which may have a negative $400 million impact in 2015.
It would be around cash flow breakeven without hedges, which is a good result given the weak coal markets.
With hedges rolling off and fixed commitments decreasing, Peabody could improve cash flow by $740 million by 2018 without a change in coal prices from realized Q1 2015 levels.
High debt levels remain a concern, although the next significant maturity isn't until November 2018.
Peabody offers substantial upside if it can get through the next couple years without significant additional damage to its balance sheet.
Peabody Energy (NYSE:BTU) has been under continuing pressure as the coal markets remain weak. News such as the Patriot Coal bankruptcy (again) and Walter Energy's (NYSE:WLT) struggles have contributed to rather poor sentiment around the industry.
Peabody does have problems in that it is likely to burn cash over the next two years and also has a pretty massive debt load. However, unlike many other coal companies, Peabody's core business is actually relatively healthy right now, and is around breakeven cash flow despite the continuing weakness in the coal markets. Quite a few other coal companies require a significant improvement in coal prices to stop burning cash.
However, Peabody is hampered by unfavorable hedges, which may have a negative $400 million impact in 2015. In future years, these hedges roll off and some of Peabody's fixed payments also roll off, so 2018's cash flow could potentially improve by $740 million with flat coal prices from realized Q1 2015 levels.
Reduced Fixed Commitments
Due to significant payment commitments ending after 2016 and 2017, Peabody's required EBITDA level to reach cash flow breakeven will decrease significantly in 2017 and 2018.
In 2015 and 2016, it appears that Peabody Energy requires approximately $1.03 billion EBITDA in order to reach cash flow breakeven. In 2017, this drops to $755 million as the final $275 million federal lease payment is in 2016. The final $75 million Patriot settlement payment is in 2017, so 2018's required EBITDA level to reach cash flow breakeven decreases to $680 million.
This is contingent on capital expenditures remaining at current low levels though, as well as no dividend increases and interest costs remaining at current levels.
Hampered By Hedging
Peabody Energy is currently being seriously affected by currency and commodity hedges that are locking in rates that are significantly unfavorable to current market prices. Without the unfavorable hedging variance, Peabody's underlying business is actually quite solid and around cash flow break even.
The key effect is with its Australian dollar hedges. The Australian dollar has weakened significantly versus the US dollar, so even though the benchmark price of metallurgical coal has continued to fall in US dollars, it has rebounded significantly in Australian dollars. The margins for metallurgical coal in Australian dollars are therefore quite reasonable. However, as Peabody has hedged 66% of its Australian currency, the finances of its Australian mining operations are acting more like US metallurgical coal operations (which are generally troubled) than Australian ones. Peabody had a negative $74 million impact from its Australian currency hedges in Q1 2015. The company also has diesel hedges that are at unfavorable rates as well. This resulted in a negative $30 million impact in Q1 2015.
Without hedges, Peabody would have delivered $270 million in adjusted EBITDA in Q1 2015. Even with lower adjusted EBITDA in Q2 2015, this would put it on track to be near cash flow breakeven for 2015 (without hedges) despite continued weakness in both thermal and coal markets. Similar results in 2018 would result in around $340 million in positive cash flow.
The below table illustrates Peabody's estimated adjusted EBITDA using Q1 2015 coal prices and the forward diesel and Australian dollar rates from the end of Q1 2015 combined with its hedge positions. As the hedges roll off, Peabody's adjusted EBITDA will rise from $630 million in 2015 to $1.02 billion in 2018 without any change in pricing from Q1 2015.
As mentioned before, the required EBITDA to reach cash flow breakeven goes down in 2017 and 2018, so Peabody may improve cash flow by $740 million in 2018 compared to 2015 levels without coal prices changing.
Debt And Liquidity
Peabody may burn approximately $600 million over the next two years, which would use up most of its available cash. It would still have over $1.5 billion in liquidity though, and likely should be cash flow positive in 2017 and beyond.
Peabody's next significant debt maturity is $1.5 billion coming due in November 2018. As shown by the high interest rates on its 10.0% Senior Secured Second Lien 2022 Notes, refinancing that debt could be challenging (or at least very costly) if coal markets remain mired in a slump. Peabody's ability to generate positive cash flow by 2017 will probably help it out with the refinancing though.
Conclusion
Peabody is a company with a high amount of debt, and sentiment towards coal companies is very negative right now. However, it should benefit greatly from reduced fixed payments and the rolling off of unfavorable hedges. Those factors alone should improve Peabody's cash flow by $740 million per year by 2018 without any change in coal prices.
Peabody offers considerable long-term upside if it can maneuver through the next couple years without incurring large amounts of additional high-interest debt.
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