December 1, 2009

Cloud Peak Energy...not so Peak Value

Rio Tinto IPO of Cloud Peak Energy (CLD), sort of a spin off, came with no great fan fare. The IPO has gone down some 10% so far. There are good reasons why the stock is down. Some are due to industry dynamics and other, in my opinion, is due to the corporate structure of the mines.

Industry Dynamic
Demand
Coal demand is growing. There is no secret that coal is under pressure from environmentalists and regulators due to global warming issues. CLD mines thermal coal used by utilities for electricity generation. The US generated 50% of its electricity from coal. So there is no escaping coal no matter what politicians say or do. Coal will be still be used during my lifetime and even during my sons lifetime. Coal demand will grow as long as we use electricity.

Supply
There is a glut of supply right now evident by increasing stock piles at utilities, but I reckon that will be short lived:

  • Miners are cutting coal production in 2010 due to decrease in demand that will stabilize pricing
  • Mountain top mining in the states is in jeopardy as a source of cheap thermal coal due to environmental issues.
  • Mountaintop mining in West Virginia, Kentucky, Virginia, Tennessee and parts of Pennsylvania and Ohio accounts for 6 percent of U.S. coal production.
  • The end of mountaintop mining in Appalachia would remove about 70 million tons a year from the market, increasing demand for coal from Colorado, Montana and Wyoming.
  • EPA has been holding mining permits with more frequency under new president.Natural gas pricing, is it firms up then utilities that switched to nat gas will switch back to the cheaper fuel, coal.
On balance the downturn in coal is cyclical rather than permanent. So when a distressed seller like Rio Tinto, it needs cash to repair it over leveraged balance sheet, off load its coal business at these levels, it piqued my interest.

Transaction Specific Issues

My issue is with how the split off is structured. There are many issues that makes me hesitate pursuing this business.
  • Rio Tinto still owns some 49% of the mines. However its ownership is at the limited partnership level rather than the holding company CLD. The public owns 100% of the holding company which in turn owns 51% of the limited partnership. That will make for conflict of interest between the public holders of CLD and Rio.
  • Pretty much CLD is controlled by Rio as its board of directors is made of RIO executives. Moreover, CLD is governed by agreements that needs Rio's consent.
  • Funds from operation will go to Rio and the holding company, CLD, but not to shareholders. I would rather see RIO and the public holders get the same treatment makes for better alignment of interest.
  • Tax reimbursement agreement where CLD pays Rio any tax savings due to higher assets base level making depreciation and amortization higher thereby reducing taxes on income.
  • Debt that got loaded onto CLD'd balance sheet to pay Rio for the assets is a bit high and will saddle the CLD with interest payments for some time to come.Most of the proceeds of the IPO goes to Rio.
So as you can see the deck is stacked in favour of Rio at the expense of CLD holders. However, there are some good qualities for CLD being low cost producer, cheap, and good reserves.

In conclusion, I will wait for a better entry point or when Rio floats the reset of its ownership in these mines.

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