Energy & Elections
We don't intend to dive into politics or political forecasting, but we can say that the election of a potential Republican administration would likely benefit the coal industry, and Westmoreland Coal WLB in particular, by slowing/stopping EPA clean air and climate change-related rules. (We have a Buy rating on WLB.) Any improvement in the regulatory environment will immediately affect the power generation sector, and Westmoreland would enjoy secondary benefits. If utility companies have more flexibility in carbon emissions, they'll slow or even stop the closure of coal-fired power plants. For Westmoreland, the ideal situation would be a federal offer to support investment in emission-scrubbing technology that reduces carbon output and extends the life of existing coal-fired plants. That would be a win-win opportunity for coal companies and green activists, something we rarely see. Westmoreland would obviously be poised for success if the problem of carbon emissions was mitigated by federal government efforts. Clean coal technology, and its widespread acceptance, is the Holy Grail of the industry.
On the other hand, Westmoreland is unlikely to enjoy support from either a Clinton or Sanders administration. Secretary Clinton has made it clear that she'd like to bankrupt the remaining coal companies, but we wonder one question: Is she willing to accept rolling blackouts to get her wish? Again, we're not trying to be political here. It's just a fact of economics that replacing base-load coal-fired power generation in America would be exceedingly expensive and would take years to accomplish. If coal usage was eliminated before the replacement of coal-fired power plants with other sources of energy, this nation's lights wouldn't stay on 24/7. Still, a President Clinton could pressure Westmoreland's top and bottom lines without bankrupting the corporation. That is indeed a political/macro risk. Either she or Senator Sanders would almost certainly continue Obama policies that have weighed on the coal sector. Investments in subsidized wind and solar energy directly undercut the demand for coal. Right now, coal is burned because it's affordable and efficient. Subsidized wind and solar power generation wouldn't cost consumers directly, and windmills and solar panels are seen as the "clean" options. Thus, given a choice between coal and wind/solar power for the same price, consumers would choose the latter. The only common complaint about windmills and solar panels is the Not-In-My-Back-Yard (NIMBY) issue. Almost nobody wants to look at a wind/solar farm from his/her home! Finding suitable environmentally-practical and publicly-acceptable locations for clean energy developments can thus be difficult. By contrast, coal-fired power plants have already been constructed. NIMBY aside, a Democratic administration wouldn't be good news for Westmoreland.
We believe that Westmoreland Coal shares remain unnecessarily undervalued because of the company's name: It includes the word "Coal." These days, those four letters represent a burden for a coal business all by themselves. From a financial viewpoint, Westmoreland is also somewhat risky. The company's deleveraging cycle is just beginning, and the coal industry is obviously not the best sector for growth. We think that Westmoreland would be the last major coal company to survive any future political campaign against coal. The firm's sales to base-load power producers offer a degree of security not enjoyed by competitors. In addition, Westmoreland's mine-mouth operations can't be beaten on price. For investors and portfolio managers, Westmoreland's stock represents a solid value/contrarian opportunity.
It's important to understand that the major bankrupt U.S. coal mining businesses (Alpha Natural Resources, Arch Coal, James River Coal, Peabody Energy and Walter Energy) shared two key similarities but are unlike Westmoreland Coal:
- Failed mergers/acquisitions. We'll use Alpha Natural Resources as an example. Alpha Natural Resources purchased Massey Energy in 2011 for $7.1B in cash and stock. At the time, Massey was hemorrhaging cash in the middle of the last great coal boom, a period when losing money in coal was a very difficult feat to "accomplish." Some of Massey's losses can be attributed to the company's expenditures related to the Upper Big Branch mine disaster, but the business was also poorly-managed. We'd call Massey a generally backward company headed toward bankruptcy by the end of 2010. In bankruptcy, Alpha Natural Resources could have acquired the best Massey mines for almost nothing without assuming Massey's debts and legal liabilities. Instead, Alpha paid $7.1B for the pleasure of being sucked under due to a terrible acquisition. By the time of Alpha's own 2015 bankruptcy, most of the ex-Massey mines were closed. Operational inefficiencies and further safety concerns ensured that the Massey deal would be a failure.
- Market-based contracts. All of the bankrupt coal companies cited above utilized market-based pricing. Contracts were typically short-term, and much of the coal was sold on the spot market. This business model is very profitable during periods of rising coal prices, but losses will be magnified during times of low coal prices. The only way to succeed long-term with this risky sales and pricing strategy is to have absolutely no debt and unusually flexible operations. Unfortunately for the companies cited above, neither of these conditions applied. They were all inflexible, debt-laden businesses doomed to bankruptcy as soon as their boards signed off on the unwise M&A deals.
By contrast, 90% of Westmoreland Coal's tonnage is sold under cost-protected contracts. Most of these customers' contracts don't expire for years, and the other customers are being contacted to discuss fresh deals. A few of the power generation units currently supplied by Westmoreland will be closed in the next couple of years, but Westmoreland has time to find new buyers for that coal or to slightly reduce production capacity. The 13.8M tons of coal that Westmoreland sold in 1Q16 represents neither the bare minimum tonnage necessary to support the business nor the maximum available capacity. Unlike many coal companies, Westmoreland has some flexibility to adjust production without closing mines or heavily increasing capital expenditures. The mine-mouth surface operations preferred by Westmoreland executives are easier to adapt than traditional underground mines.
In summary, Westmoreland faces many obstacles in the future. Some of these obstacles represent legitimate business threats, including additional increases in burdensome power plant emission regulations that directly affect the demand for coal. Other obstacles for Westmoreland are based in market psychology and the tendency for investors to punish every company in a sector for the financial sins of the majority. Westmoreland isn't similar to most other coal companies, but the firm will face intense scrutiny because it's in a terrible sector of the market. Market psychology has evolved to see coal as yesterday's energy source, and traders treat coal companies as businesses unworthy of investment. Unlike buggy whip manufacturers, though, there remains significant demand for coal. The U.S. is likely to generate at least 30% of the country's electricity supply for the foreseeable future. In addition, new steel production still requires metallurgical coal in most situations. Thus, the need for coal isn't going away. Companies like Westmoreland that have stable cash flows and generally efficient operations are much better prepared to succeed in the contemporary environment than massive, highly-leveraged businesses like pre-bankruptcy Arch Coal and Alpha Natural Resources. The company's future profits also hinge on the political situation in Washington D.C. We have no idea which presidential candidate would be the best or the worst for the coal industry, but we do believe that another Democratic administration would be a negative for Westmoreland's stock price. On the contrary, the election of a Republican administration would be a good sign for Westmoreland and other coal companies. Time will tell who wins the White House but until then, we suggest cautiously buying Westmoreland's shares.