Set to report third quarter earnings over the next week, Walter Energy (NASDAQOTH:WLTGQ) and Arch Coal (NYSE:ACI) are both likely to continue struggling. Although the general coal market downturn is one issue, the bigger problem is the ill-timed shift both made into metallurgical coal. The just ended quarter isn't likely to change that.
Big demand, little price
When growth in China was causing a spike in demand for virtually all natural resources, met coal prices shifted into high gear. The long-term picture remains fairly bright, too, since met coal is used in steel making and steel is a basic necessity for building the infrastructure to support economic growth.
However, high prices led to increased production and now the met market is working through a supply/demand imbalance that's led to low prices. Teck Resources (NYSE:TECK), which reported third quarter earnings last week, noted that "Our steelmaking coal sales of 7.6 million tonnes set a quarterly record and demand from customers is strong. However, the current price for steelmaking coal remains below what we believe is required to sustain adequate production in the industry in the long term."
Teck's record sales were more than offset by a 28% decline in met coal prices. Coal was one of the main reasons for the diversified miner's bottom line falling by around 40% year over year. That paints a bad picture for Walter Energy and Arch Coal.
The big switch
Of the pair, Walter Energy made the biggest bet on met coal, paying $3.3 billion for a met coal producer in 2011 that, essentially, made it a pure-play met miner. The transaction boosted the company's debt level from 20% of its capital structure to 50% at the time. However, after met coal weakness required writing off about a third of the purchase price, Walter's debt now makes up around 75% of its capital structure.
Teck's results show that there hasn't been enough of an improvement in the market to turn Walter's bottom line around in the third quarter. The company has bled red ink for four consecutive quarters and will likely do so again in the just ended period.
The big issue to watch at Walter will be its finances. The miner was forced to rework some of its debts and cut its dividend. However, that has provided it with notable breathing room. Still, until met coal prices rebound Walter Energy's balance sheets needs to be closely monitored.
In its 2012 annual report, Arch Coal highlighted the long-term benefits of a met coal purchase made at the market top but also the near term issue of too much debt—"Is Arch's debt level too high for a commodity business? In our opinion, yes."
You should be just as interested in Arch Coal's balance sheet as management is. Fortunately, low-cost Powder River Basin thermal coal is still a large part of the miner's business, so it has a counterbalance to met coal. Unfortunately, met margins are typically much larger than thermal margins, so despite Arch producing more thermal coal, met coal has a bigger impact on the bottom line.
For example, met coal only made up 13% of Arch's 2012 coal volume, but 44% of revenues. Like Walter, Arch has been losing money lately and the third quarter isn't likely to change that trend since met coal prices remain weak. Unlike Walter, however, Arch isn't completely reliant on a met price rebound to keep paying its bills—but turning a profit probably does require such an upturn.
More than the bottom line...
The met coal price drop experienced by Teck Resources suggests another ugly quarter for Walter and Arch. That means that you need to watch both the bottom line and the balance sheet at this pair when they report third quarter earnings. With that caveat, if their balance sheets hold up, upside potential is notable for both.
Looking for more stability? Check out these 9 dividend payers
Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.