Fitch Ratings said Sept. 30 that without a restructuring of its heavy debt load, Arch Coal (NYSE: ACI) may be headed for bankruptcy.
Arch Coal, one of the largest coal producers in the U.S., has been trying in recent months to rework its debt, some of which was incurred in the 2011 takeover of International Coal Group. Other major U.S. coal producers – Alpha Natural Resources, Patriot Coal and Walter Energy – have had to seek Chapter 11 bankruptcy protection this year. Patriot was formed last decade in part from high-cost, unionized Central Appalachia operations contributed by Arch.
Fitch said it has taken the following rating actions on Arch Coal:
- Issuer Default Rating (IDR) affirmed at ‘C’;
- Senior secured revolving credit facility downgraded to ‘B-/RR2’ from ‘B/RR1’;
- Senior secured term loan downgraded to ‘B-/RR2’from ‘B/RR1’;
- Second lien secured notes downgraded to ‘C/RR6’ from ‘B-/RR2’;
- Senior unsecured notes affirmed at ‘C/RR6’ from ‘C/RR5’.
Roughly $5.4 billion in principal amount of debt and commitments are affected by this action. The downgrade follows Fitch’s assessment of lower recovery values for coal assets in light of recent transactions and prospects for prolonged weakness.
Fitch downgraded Arch Coal’s IDR on July 6 to ‘C’ following announcements of exchange offers which Fitch considers Distressed Debt Exchanges (DDE) in accordance with Fitch’s DDE criteria. The offers have been extended four times, most recently through Oct. 26. On July 28, term loan lenders delivered a letter to the term loan administrative agent (the Agent) directing the Agent to refrain from executing documentation relating to the Exchange Offers. On Sept. 16, a holder of senior unsecured debt filed suit in state court in Manhattan, seeking a declaration that the exchange is permissible without consent and an order barring the term loan lenders from blocking the restructuring. There has been no judgement on the matter as yet, Fitch added.
Procedurally, if the exchanges are executed as proposed, Fitch would lower the IDR on Arch to ‘RD’, reflecting the DDE. Subsequently, assuming no change to current assumptions, Fitch expects to upgrade the IDR on Arch to at most ‘CCC’.
Fitch said it believes Arch’s current capital structure is unsustainable and that restructuring is necessary. “Failure to execute a restructuring outside of court would likely result in bankruptcy,” Fitch said.
Fitch sees sliding value for Arch Coal’s assets
Fitch’s analysis is based on a going concern enterprise value of nearly $2.5 billion (down from $3.2 billion) derived from a $400 million EBITDA (down from $537 million) and a 5.5x multiple (down from 6x). Under this valuation, and the current capital structure, the first-lien senior secured debt including full utilization of the $250 million revolver, has superior recovery given default, but the second lien and unsecured debt have poor recovery prospects. Under these assumptions, should the exchanges occur as currently structured, the recovery for the first lien creditors would drop from 89% to 83%.
Fitch is assuming a fairly slow recovery even though the coal price slide began in earnest in 2012. As such, Fitch does not anticipate earnings to reach its $400 million EBITDA case through 2017. At an EBITDA assumption of $330 million, under the current capital structure, the senior secured debt has a superior recovery at 73%. Under the $330 million EBITDA assumption, should the exchanges occur as currently structured, the recovery for the first lien creditors would drop from 73% to 68%.
A substantial portion of domestic coal production is in restructuring, Fitch noted. Alpha Natural, Walter Energy, James River Coal (which was dismembered a few months ago in bankruptcy) and Patriot Coal, together, accounted for about 13% of U.S. coal production in 2013 and Arch accounted for an additional 13%. Recently, coal assets have changed hands at very distressed values involving little or no cash paid for them given the need to invest in capital and fund mine reclamation expenditures as well as legacy pension and other post-retirement liabilities.
In contrast to other restructuring companies, Arch benefits from relatively low exposure to employee legacy liabilities and, as of Dec. 31, 2015, only six of its 5,000 employees belong to a union. It turned over the unionized mines to Patriot last decade. Self-bonding of $458.5 million, $177.7 million surety bonds, and $3.5 million in secured letters of credit support reclamation obligations as of Dec. 31, 2014. These would need to be assumed or replaced in the event of asset sales or an acquisition.
Fitch points to tough coal market as a drag on Arch
“Steam coal demand in the U.S. is currently suffering from heavy competition from very low natural gas prices; supply has been disciplined, but stocks are on the high side and prices are soft,” Fitch wrote. “Lack of new coal-fired power plant builds and shuttering obsolete plants is expected to result in a 10%-15% decline in coal production over the medium term. The U.S. steel industry is currently suffering from import competition which weighs on domestic metallurgical (met) coal consumption.
“Globally, both met and steam coal markets are in excess supply and prices are weak. Coal producers have been running for cash with a focus on reducing costs which has delayed price recovery. In particular, Fitch believes the hard coking coal bench mark price could average about $105/tonne (t) and the Newcastle steam coal benchmark could be below $60/t over the next 12 months versus current prices of $89/t and $67.80/t respectively. U.S. exports, which peaked at 125 million tons in 2011, are challenged by rail transport to port and the strong U.S. dollar. Fitch expects U.S. exports to drop back into the 50 million ton range over the medium term.”
Fitch said that Arch Coal benefits from large, well-diversified operations and good control of low-cost production. Globally, Arch is the sixth largest coal producer based on volumes. The company sold 134 million tons of coal in 2014. As of June 30, 2015, roughly 97% of expected 2015 steam coal production volumes are committed and priced. Assuming no change in sales volume for 2016, about 47% of steam tons are committed and priced. The company has the third largest coal reserve position in the U.S. at 5.1 billion tons.
At June 30, 2015, cash on hand was $440 million, short-term investments were $250 million, and $123 million was available under the company’s credit facilities. The $200 million accounts receivable facility has a stated maturity in December 2017. The $250 million revolving credit facility matures in June 2016. Revolver covenants include a maximum net senior secured leverage ratio of 5:1 from June 30, 2015 with step-downs thereafter and a minimum liquidity of $550 million through Dec. 30, 2015. Fitch expects cash and short-term investments to provide sufficient liquidity through 2017, Fitch said.
Cash burn is expected to continue absent substantial recovery in metallurgical coal prices. Under the current capital structure, guidance for cash interest expense is $360 million to $370 million and for capital expenditure, $130 million to $140 million for 2015. Fitch expects cash burn of at least $200 million per year through 2017.