Owning and operating coal mines requires a lot of up front capital. You need to buy or lease the mine, and you need to buy or lease the equipment. It doesn’t matter how much coal is pulled out of the mine or how much you get paid for the coal, those costs don’t go away and they don’t go down. Debt costs raise the bar even further due to the interest being paid.
Debt hurts
For example, long-term debt accounted for about 75% of Walter Energy, Inc. (NYSE:WLT)’s capital structure at the end of the second quarter. For comparison, long term debt made up about 55% of industry giant Peabody Energy Corporation (NYSE:BTU)’s capital structure. Clearly, Walter Energy, Inc. (NYSE:WLT) isn’t in as solid a financial position, which helps explain why it had to trim its dividend to a token penny a share and amend a credit facility to improve liquidity.
Walter Energy, Inc. (NYSE:WLT), which focuses on metallurgical coal used in steel making, has been taking aggressive actions to deal with the steep drop in met coal prices. For example, it’s closed or is in the process of closing mines. And it plans to cut full-year 2013 capital spending to about $150 million, less than half of what it spent in 2012. Peabody Energy Corporation (NYSE:BTU) trimmed its budget by a similar amount, but didn’t have to cut its dividend or amend credit facilities.
One expense that didn’t go down for Walter Energy, Inc. (NYSE:WLT) was interest costs. The company paid about $53 million in the first and second quarters. That amounted to 10% of revenues in the first quarter, but because the top line headed lower, 12% in the second quarter. At Peabody Energy Corporation (NYSE:BTU), interest expense was about 6% of sales in both the first and second quarters despite a top line drop.
Walter Energy, Inc. (NYSE:WLT) started the year projecting coal sales of between 11.5 million and 13 million tonnes. It is now projecting just 11 million tonnes, down about 6% year over year. Looking at lower volume and weak pricing, met coal pricing was down over 20% from the year ago period in the second quarter, Walter Energy’s bottom line is likely to be in the red all year.
Investors should probably avoid Walter Energy, Inc. (NYSE:WLT) and the anchor of high debt that is holding it back. Although Peabody Energy Corporation (NYSE:BTU) is projecting weak coal pricing and low demand to lead to a drop in third quarter earnings, and perhaps even a share net loss, it has the financial liquidity to maintain its dividend and make it through this rough patch. It’s a far better option than Walter. With a yield of only about 1.9%, however, it won’t excite most income investors.
The best of both worlds?
Debt at Rhino Resource Partners, L.P. (NYSE:RNO) makes up just a third of the partnership’s capital structure and debt payments represented just 3% of sales. Although Rhino Resource Partners, L.P. (NYSE:RNO) has also had to reduce production and focus on controlling costs, debt hasn’t been a big issue.
Yet the company’s decision to trim its quarterly distribution by about 8% in late 2012, and Wexford Capital, the general partner, making the choice to stop taking incentive distributions both look like warning signs of financial weakness. They aren’t. The money that would have otherwise gone to Wexford and sustaining a slightly higher dividend have been put to work on growth projects in coal and expansion into oil and natural gas.
These efforts should allow the company to prosper over the long term. For example, oil and gas revenues jumped almost 300% between the first and second quarters. That should add nearly $2 million to the top line through the rest of the year, helping to offset weakness on the coal side. And, Rhino Resource Partners, L.P. (NYSE:RNO) is on track to start production at a new mine in 2014. That mine already has enough sales commitments that it will add to the top and bottom lines when it opens in the middle of next year.
Rhino Resource Partners, L.P. (NYSE:RNO) “remains poised to ramp up production” when conditions warrant. With low debt and growth projects in the works, it remains in growth mode. Income investors and those seeking a turnaround should take a look at this high-yielding coal play. With coal market weakness likely to last at least through the end of this year, it’s better to focus on a financially strong participant than a company with lots of leverage like Walter.
The article 1 High Yielding Coal Stock That Might Make Sense originally appeared on Fool.com is written by Reuben Brewer.
Reuben Brewer has a position in Rhino Resource Partners. The Motley Fool has no position in any of the stocks mentioned.
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