Westmoreland - Transformational Deal Leaves The Company Exposed To Excessive Leverage

Investors in Westmoreland Coal Company (WLB) are very pleased with the company's announced deal to acquire coal operations of Sherritt International in Canada, in a deal which will more than double the company's operations.

While the deal looks solid in terms of multiples, the high leverage incurred following the deal and the great cost of using leverage makes this deal very risky, especially if coal prices fail to rebound.

I remain on the sidelines.

The Deal

Westmoreland announced that it entered into an agreement to acquire the Prairie and Mountain coal mining operations of Sherritt International.

The company will pay $435 million for the operations which include seven thermal producing coal mines in Alberta and Saskatchewan, a 50% interest in a working carbon plant, as well as the Char production facility.

Chairman Keith Alessi commented on the rationale behind the deal, "This is an historic event for Westmoreland. The acquisition of Sherritt's coal operations represents a transformational opportunity to acquire seven producing coal mines, which are highly complementary to our existing operations and expertise. This acquisition will more than double our business."

With the deal, Westmoreland will more than double its annual revenues and diversify its customer base as well as geographical base. The deal will make the company the 6th largest producer of coal in North America.

The company will control the mining rights of 654 million tons of coal, based on annual production of around 22 million tons of low-sulfur thermal coal in the Prairie operations. The mountain operations produce roughly 4 million tons of coal, but hold reserves of just 22 million tons. All combined operations generated estimated revenues of $736 million in 2012.

The deal is obviously subject to normal closing conditions including regulatory approval. The deal has already been approved unanimously by the board of Westmoreland and is expected to close in the first quarter of 2014.

Valuation

Back in October, Westmoreland released its third quarter results. The company ended the quarter with $45.5 million in cash and equivalents, as well as $343.5 million in total debt. Factoring in debt reserves, the company operates with a net debt position of $285 million.

The net debt position will increase towards $720 million following the deal, yet the company has fully committed financing in place from BMO and Deutsche Bank.

Revenues for the first nine months of the year came in at $500.7 million, up 13.4% on the year before. The company posted a loss of nearly $1 million, compared to a $4.6 million loss last year. Profitability was under pressure as debt servicing costs remain very high. The company paid $30.1 million on its debt position in the first nine months of this year alone.

At this pace, annual revenues are seen around $670 million with earnings seen breaking even.

Factoring in the big jump in Westmoreland's shares, the company is valued around $265 million at a share price of $18 per share.

Given the financial difficulties, Westmoreland does not pay a dividend.

Some Historical Perspective

Shares of Westmoreland were offered to the general public as recent as May of 2011. Shares more than halved in the months following the offering to lows of $8 in October of 2011. Solid momentum this year, with shares trading up 91% year to date have resulted in a steady recovery to $18 per share.

Between 2009 and 2012, Westmoreland has increased its annual revenues by 35% to $600.4 million. The company posted modest losses in recent years, although shareholders have seen quite some dilution with the outstanding share base increasing significantly.

Investment Thesis

The reported deal is huge for Westmoreland which will more than double its annual revenues. Including the assumption of debt, Westmoreland has been valued around $500 million before the deal has been announced. This values the company at 0.75 times trailing annual revenues of $660 million. Note that current production of the own activities total 25 million tons, with another 553 million tons in reserves.

The $435 million price tag for the acquired assets consists out of a $293 million cash consideration and $142 million in capital lease obligations. This values the acquired activities at just 0.6 times annual revenues, which is a sizable discount to Westmoreland's own valuation. The activities produce 27 million tons in coal and have a total of 676 million tons in reserves.

The combined production will make the company a more sizable producer. Even with estimated production of roughly 50 million tons, the company still produces only a quarter of production being generated by market leader Peabody Energy (BTU). The market leader in North America produces around 200 million tons in coal per annum.

The deal is huge for Westmoreland and makes the company an even greater leveraged bet on a rebound in coal prices. The increase in leverage is a key risk, yet the deal looks nice in terms of comparative valuations. The increase in leverage will come at a great expense, as the company is paying effective rates of around 12% on its debt already. To counter these arguments, Westmoreland is defending the built up in leverage by the usage of long-term contracts, creating less price risks.

All in all, the deal looks nice in terms of comparative valuations. Westmoreland is acquiring assets at 0.6 times annual revenues, while even establishing a good export base to Asia. In comparison, industry leader Peabody Energy is valued at $10.5 billion including both equity and debt. This values the company at 1.3 times 2012 annual revenues.

Yet the real concern in this deal is the leverage, given that debt is already tremendously expensive for Westmoreland. This creates obviously a really nice opportunity if coal prices rebound, but this works both ways. I believe the deal is nice, but a little too big for the company the size of Westmoreland, especially when financed with all new debt.

Therefore, I remain on the sidelines.

Source: Westmoreland - Transformational Deal Leaves The Company Exposed To Excessive Leverage

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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