Cutting Costs Won't Solve All of Alpha Natural Resources' Problems

In what has remained a stubbornly miserable market for coal stocks, Alpha Natural Resources (NYSE: ANR  ) stands out, perhaps, as one of the less-bad names this year. While coal companies like Arch Coal, Peabody, Cloud Peak, Walter Energy, and James River have seen double-digit stock price declines in the past year (with the last two down nearly 50%), Alpha Natural has somehow squeaked out a tiny gain as of this writing.

To be sure, Alpha Natural's management deserves praise for the cost cuts that they have already achieved and the benefit of the doubt with respect to additional targeted cost cuts for 2014. The problem, though, is that I don't see how any coal company, and particularly a met-coal company like Alpha Natural, can cost-cut its way back to prosperity.

Unless European and Brazilian steel mills get moving again with respect to product and seaborne thermal-coal prices improve, it seems likely to me that the cost cuts will simply keep Alpha Natural in the game. For the stock to work, you must believe that better coal prices are coming soon, or at least that the Street will believe that, and production guidance doesn't seem to be pointing in that direction.

A balanced coal producer...sort of
Alpha Natural is the third-largest U.S. coal producer, with significant reserves in the Appalachian region and Powder River Basin. While metallurgical coal is around 20% to 25% of shipments, it generates substantially more of the company's earnings before interest, taxes, depreciation, and amortization (more than 60%.)

So while Alpha Natural looks fairly diversified in terms of its coal shipments (more than 40% from the Powder River Basin, slightly less than 40% from eastern thermal coal mines), it really is quite reliant on strong met-coal markets for its earnings and cash flow.

Familiar problems and limited opportunities to change them
Alpha Natural made what I thought was a pretty savvy and well-timed acquisition of Foundation Coal back in 2009 but then followed that up with the very pricey acquisition of Massey at what proved to be nearly the top of the cycle. To frame how bad of a deal that has turned out to be, Alpha Natural needed met-coal prices to average around $250/ton for that deal to be accretive. That break-even point has fallen some since then, but with spot prices below $150/ton, Alpha Natural isn't even close to benefiting from that deal.

Alpha Natural isn't alone here. Arch Coal took on a heavy debt to get back into Appalachian coal only to see utilities in the U.S. shift toward natural gas and Powder River Basin coal. Walter Energy, too, was an active deal-maker that has since seen prices move against it in the met-coal markets.

In the face of tough pricing, Alpha Natural has tried to get tough about costs. A $150 million/year cost reduction plan started in 2012 seems to have gone well and management is targeting another $200 million in cost cuts, with the large majority (80% plus) coming from mine-operating costs. Alpha has also idled high-cost mines and looked to be smarter about its longwall operations. Even so, relative to other North American met-coal producers like Arch, Walter, and Teck Resources, Alpha Natural is still one of the higher-cost producers.

Making matters worse, pricing just isn't picking up. Alpha Natural has priced 86% of its 2014 Powder River Basin coal and 59% of its eastern thermal coal at prices lower than its 2013 prices -- albeit not significantly lower. The vast majority of Alpha's anticipated met-coal production for 2014 is still not priced, but with met-coal producers like Teck still talking about increasing production, the Street's expectation of a recovery in met-coal prices (the recent average estimate was about $170/ton) may be too optimistic.

Marcellus doesn't matter much
It is certainly worth noting that Alpha Natural Resources controls about 20,000 net acres of natural-gas-rich properties in the Marcellus. These properties are being developed through a joint venture with Rice Energy and the results so far have been respectable.

Alpha's management has been pretty adamant that they see more value in developing/operating the acreage than selling it, but it does remain a marketable asset on the balance sheet. Although this gas acreage does generate some much-needed EBITDA and cash flow, it's not really a significant asset in the bigger picture -- it certainly isn't enough to offset the financial pressures that persistently low met-coal prices would create.

The bottom line
It might be tempting to look at a stock trading at less than half of its reported book value and think, "How can it get worse?" Unfortunately, it just doesn't look like Appalachian thermal coal is likely to recover any time soon, and betting on a met-coal recovery has been a bad bet for going on three years now.

There was hope earlier this year that coal-to-gas switching had peaked and that utility demand would work down the stockpiles and boost prices. That hasn't really worked out, as you might imagine from the fact that companies are signing up 2014 production at prices at or below 2013 levels.

I'll concede that Alpha Natural Resources looks undervalued on a book value, NAV, and EV/EBITDA basis, and could be undervalued by as much as 20%. That said, owning a high-cost operator strikes me as the wrong play (unless you really believe met-coal prices are going to improve sharply) and I just can't muster that much enthusiasm for Alpha's shares today, even though management has in fact done very well with its cost-cutting efforts.

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