Warrior Met Coal, Inc. (HCC) Q3 2017 Earnings Report, Transcript and Summary

Good afternoon. My name is Keith, and I will be your conference operator today. At this time, I would like to welcome everyone to do Warrior Met Coal Third Quarter 2017 Financial Results Conference Call. [Operator Instructions]. Before we begin, I've been asked to note that today's discussion may contain forward-looking statements and actual results may differ materially from those discussed. For more information regarding forward-looking statements, please refer to the company's press release and SEC filings. I've also been asked to note that the company has posted reconciliations of the non-GAAP financial measures discussed during this call in the tables accompanying the company's earnings press release, located on the Investors section of the company's website, at www.warriormetcoal.com. Here today to discuss the company's results are Mr. Walt Scheller, Chief Executive Officer of Warrior Met Coal; and Mr. Dale Boyles, Chief Financial Officer. Mr. Scheller, you may begin your remarks.

Thanks, Operator. Hello, everyone, and thank you for taking the time to join us today to discuss our third quarter 2017 results. After my remarks, Dale will review our results for the quarter in additional detail, and then you will have the opportunity to ask any questions you may have. It's hard to believe it's been less than a year for us as a public company. I hope that many of you are following us have a clearer idea of how we work and why our approach is distinct from other U.S. producers. From the onset of our journey with Warrior, we've done a lot of work putting together an operating assets and a capital structure that would serve our investors well, both in times that are good and in times that are not as good. The year-to-date has certainly been a memorable one for our industry, and we're all rapidly getting a taste for how Warrior can perform in periods of favorable pricing environments. After a strong pricing environment in the second quarter, market prices moderated somewhat in the third quarter. Overall, conditions were still very favorable to us and we moved to once again capitalize on the price opportunity for hard coking coal that has followed from this year's supply disruptions to U.S. and Australian suppliers and higher Chinese demand. As a result, our financial results for the third quarter remained quite strong. We generated net income of $120 million and adjusted EBITDA of $107 million. The key drivers behind our performance continue to be our highly flexible mine plan, a highly variable cost structure in areas like labor, royalties and logistics and a clean balance sheet. This allows us to provide for an agile operational response to movements in the index price for hard coking coal and take advantage of opportunistically of market conditions. Our sales volume for the third quarter was 2.1 million short tons, significantly higher than any other quarter this year. We capitalized on demand opportunities with existing customers and in the spot market to sell down extra inventory on hand from the higher-than-expected production performance in the first half of this year. A few of the spot sales were to potential new customers including some in Asia. As a result of these actions, we reduced our inventory level from 612,000 short tons at the end of the second quarter to 137,000 tons at the end of the third quarter. Our realized average selling price was $144 per short ton, compared to the Q3 industry average index price of $155. This represents a net 7% discount to the average index price for the third quarter, which is a little lower than normal for us in a quarter and includes a 2% reduction for normal quality adjustments and demurrage. The other 5% difference is primarily attributable to the timing of the shipments in the quarter. It's important to note that index prices rose during the quarter, averaging $133 per short ton for June, $151 for July, $179 for August and $185 per short ton for September. A large portion of our shipments occurred in earlier in the quarter at the lower index prices, including the two vessels that were not loaded at the end of the second quarter because of Tropical Storm Cindy. Over the long term, we expect our price realizations to be within 2% to 3% of the industry index average as this methodology continues to evolve in the industry and as our pricing methods with customers also continues to evolve. Since the industry has moved away from the quarterly benchmark price to the new average index price methodology, our pricing methods with customers has evolved, as well. Basically, we price according to three categories of customers. The first category are those customers who like using the new quarterly index average index pricing method that replaced the quarterly benchmark. The second category are those customers who price based on the average of an index price for some period of time before loading the vessel, or based on the average index price both before and after the loading of a vessel. The third category are those customers who prefer to know their fixed price now and will buy at a spot price on the day the sale is negotiated for delivery and from which actual delivery may be later in the quarter. We have continued to make progress in the ramp up of mining operations toward the nameplate capacity of our assets, which is approximately eight million short tons of met coal. We added another 67 miners and one continuous miner during the third quarter and we expect to add approximately 50 more miners and another continuous miner by the end of year depending upon the timing of the longwall moves. Our total production for the third quarter was 1.6 million short tons, an increase of nearly three times over the prior period in 2016. A planned longwall move scheduled for late in the third quarter slipped into the early part of the fourth quarter. Production in the third quarter fell modestly compared to the second quarter of 2017 as we were nearing the end of the mining of that longwall panel. At the ed of those panels, the rate of production and clean tons per foot is reduced, equipment is nearing rebuild and mining conditions can be more challenging, which accounts for the decrease in production from the second quarter. That longwall move was completed successfully by the end of October and is now up and running well. As we've previously stated, production numbers fro the second half of 2017 will not be as high as the first half, especially in the fourth quarter, reflecting the need for three longwall moves based on our current mining plan, which will reduce our total output. Production for the fourth quarter will be the lowest of this year because of the lost tons from the longwall moves. We still have two more longwall moves to complete in the fourth quarter. Accordingly, our fourth quarter will include significant capital spending on new equipment orders as well as repairing and rebuilding existing equipment. These expenditures fall within our updated guidance and we will remain on track through the end of this year. It's important to point out that having three longwall moves in a quarter is quite unusual and primarily a result of timing and location factors in the mine plans when two of the longwalls were restarted in late 2016. The timing of these moves will naturally be spread out more in 2018 and going forward because the new panels are of different lengths and the rates of advance are somewhat different depending upon the geology at each mine. I would like to thank all our employees for the work they have been doing to achieve the successful outcomes in 2017. especially around these longwall moves that are tightly bunched together and which lay the groundwork for even greater progress in 2018. our top priority is to work safely, as that is the first and most important step to working efficiently and ultimately achieving success in the marketplace. Before I turn it over to Dale, I'd like to comment on the completion of our $350 million notes offering and our approximately $600 million special dividend announcement last week. We believe this moderate amount of leverage is appropriate given the current condition of the capital markets, allows us to maintain our financial flexibility and reflects our commitment to returning significant value to all of our stakeholders. The company was well positioned to capture outsize profits in a premium pricing environment this year, and we are pleased that provided the opportunity to pay a sizable special dividend. Warrior has capitalized on its strength this year by selling a high-quality product in a strong price environment with a low and variable cost structure that has resulted in strong free cash flow conversion. We have significantly invested in the operations with our production ramp up in CapEx spending. We have strong balance sheet with a moderate amount of leverage, but without the legacy liabilities or other significant debt to fund as compared to others in our sector. In addition, we expect to have minimal cash taxes following the favorable IRS ruling we received in the third quarter, which you will hear more about from Dale. The results we have achieved year-to-date demonstrate how differentiated Warrior's business model is compared to others in the sector. And consistent with these results, we are demonstrating our commitment to returning cash to shareholders in accordance with the capital allocation program we announced earlier this year. I'll now ask Dale to address our third quarter financial results in greater detail.

Thanks, Walt. Warrior's results for the third quarter continued to track as we expected, reflecting not only favorable market pricing conditions and customer demand, but also the fundamental strength of our financial and operational structures. For the third quarter of 2017, net income was $120 million, or $2.27 per diluted share, compared to a loss of $34 million, or $0.64, in the third quarter of 2016. Adjusted EBITDA was $107 million in the third quarter and was dramatically higher than the adjusted EBITDA loss of $6 million in the third quarter of 2016. for the 9 months ended September 2017, adjusted EBITDA totaled $431 million. Total revenues for the third quarter of 2017 were $312 million, which included met coal sales of 2.1 million short tons at an average selling price of $144 per short ton. Total revenues in the quarter exceeded the third quarter of 2016 by $259 million, on a 279% increase in sales volumes and an 80% increase in average net realized selling prices. Our third quarter net price realization was 93% of the industry average index price. As Walt noted earlier, our price realization was lower than normal and was primarily affected by the timing of shipments in the quarter. Mining cost of sales was $189 million, or 63% f mining revenues, in the third quarter, compared to $52 million in 2016 driven primarily by the significantly higher sales volumes in 2017. cash cost of sales per short ton, FOB port, was $90 in the third quarter, compared to $87 in the same period of 2016, but the increases in the per-ton values being primarily attributed to the price sensitive components of wages, transportation and royalty costs. All three of our longwall operations were running in the third quarter of 2017, along with our 8 continuous miner units. In late August 2016, the longwall operations in Mine No. 4 were restarted and operate for approximately one month in the third quarter in 2016. The second longwall in Mine No. 7 was restarted in October 2016. SG&A expenses were about $9 million, or 3% of total revenues, in the third quarter and double the amount in the same period of 2016, reflecting the expenses of being a publicly traded company in 2017. these expenses include incremental independent auditor expenses, legal expenses, D&O insurance expenses and stock compensation expenses. SG&A expenses were higher in the third quarter compared to the second quarter of 2017 primarily due to higher legal and professional fees associated with completion of the private letter ruling. Depreciation and depletion expenses for the third quarter of 2017 were 423 million, or 7.5% of total revenues, compared to the same amount in 2016. There were no transaction and other expenses in the third quarter. These expenses total $13 million year-to-date in 2017 and consisted primarily of non-recurring professional fees in connection with the initial public offering in April. Interest expense was $640,000 in the third quarter included interest on our equipment promissory note plus amortization of our ABL facility of debt issuance costs. Year-to-date interest expense totals $2 million. The company recognized an income tax benefit of $38 million in the third quarter of 2017, which results in a year-to-date tax benefit of approximately $3 million. I want to take a minute to note the successful outcome of our request for a private letter ruling, or PLR, from the Internal Revenue Service. As you know, a key asset at the time of our IPO was our $2-plus billion of NOLs and other tax credits and our belief that they would drive significant cash conversion. In late September we reported that the IRS issued a PLR that favorably impacts our analysis of our ability to use the NOLs for federal income tax purposes. Prior to the PLR, we applied an annual limitation on the utilization of NOLs pursuant to section 2382 of the IRS code and accordingly, expected to pay a significantly higher amount of income taxes for 2017. upon the issuance of the PLR, we believe that our NOLs will not be subject to the annual limit of Section 382, as previously applied in 2017. after applying the revised method to the year-to0date and full year 2017 expected results, we believe that our effective income tax rate will be approximately 2% for the full year, before applying any refundable alternative minimum tax credits and excluding the effect of any changes in the valuation allowance for deferred tax assets. As we evaluated the availability of our refundable AMT credits, which are based on capital expenditures to be placed in service each tax year, we elected to forgo bonus depreciation and accelerate the use of the AMT credits over the next three years. This election effectively reduces the estimate 2% annual cash tax rate to a small benefit for 2017. in addition, we expect that our NOLs will be less than the amounts previously disclosed due to the change in the application of Section 382 as a result of this ruling. We now expect the federal NOLs to total approximately $1.8 billion to $2.0 billion. We plan to provide an updated estimate of our NOLs by the end of this fiscal year. Turning to cash flow. During the third quarter, we generated $82 million of free cash flow, which was a result of cash flows provided by operating activities of $116 million, less cash used for capital expenditures of $34 million. Year-to-date free cash flow was $280 million. CapEx spending in the third quarter of $34 million was more than the company spent in the first half of the year and now totals $63 million year-to-date. As we have previously indicated, our spending is back-end loaded this year due to the longwall moves, long lead times and timing of equipment deliveries from key vendors. We believe spending in the fourth quarter could be higher than any previous quarter this year. Cash flows used in financing activities were $3 million in the third quarter of 2017 and $198 million year-to-date. Our net working capital increased by about $23 million from the second quarter of 2017 on higher accounts receivable of $36 million, a tax refund receivable of $17 million and higher accrued expenses of $9 million, offset primarily by lower inventories, of $37 million. Coal inventory decreased from 612,000 short tons at the end of the second quarter to 137,000 short tons at the end of the third quarter 2017, as we capitalized on a strong pricing environment and customer demand in the third quarter. Our total available liquidity as of the end of the third quarter was $334 million, consisting of cash and cash equivalents of $234 million and $100 million available under our ABL facility. We currently do not have any outstanding borrowings under the ABL facility. On October 25, 2017, the board of directors of the company declared a regular quarterly cash dividend of $0.05 per share to be paid on November 10 to stockholders of record as of November 3. Now let me address our announcement last week that we completed a private offering for $350 million of 8% senior secured notes due 2024. We intend to use the net proceeds of the offering, together with cash of hand of approximately $260 million, to pay a special cash dividend of approximately $600 million, or $11.21 per share, to our stockholders on a pro rata basis. The board declared this special dividend to be paid on November 22 to stockholders of record as of November 13. While our cash balance at the end of the third quarter was $234 million and we expect to use approximately $260 million of cash on hand for the special dividend, we believe we will generate more than enough cash for use in running our day-to-day operations on a go-forward basis. This initiative makes good on our commitment to excess cash above and beyond the current requirements of the business to return value to our shareholders. As we have indicated previously, we're significantly investing in the ramp-up production this year toward our nameplate capacity and spending over $100 million in CapEx. I would note that while we are adding a bit of debt to our balance sheet, is a modest amount of leverage, less than 1 times of LTM adjusted EBITDA and it does not in any way conflict with our growth opportunities. As we have previously stated, our goal is to seek to optimize our capital structure to improve returns to stockholders while allowing flexibility to pursue selective strategic growth opportunities that can also provide compelling stockholder returns. And a word on our outlook for the remainder of 2017. given the results of our first three quarters and the three longwall moves underway in the fourth quarter, we are updating our previous guidance for the full year of 2017. as noted in our press release earlier and as follows. Coal sales of 6.1 million to 6.3 million short tons; coal production of 6.2 million to 6.5 million short tons; cash cost of sales, FOB port, of $89 to $95 per short ton; capital expenditures of $97 million to $110 million; and SG&A expenses of $29 million to $31 million. We expect to finish 2017 strong and continue to capitalize on the current strong pricing environment. I'll now turn it back to Walt.

Thanks, Dale. Before we move on to Q&A, I would like to provide a reminder of expected fourth quarter production and a brief update on how we are looking at the marketplace. While we have successfully completed one of the three longwall moves in the fourth quarter so far, we still have the other two moves to complete this quarter. As we have previously indicated, production in the fourth quarter will be the lowest of the year. However, we believe it will meet or exceed our targets and guidance for the full year. The completion of these longwall moves in the fourth quarter will position the company well heading in to 218 as we strive for production levels near our nameplate capacity. As we liquidated most of our extra inventory in the third quarter, our sales volume will be lower than the third quarter. It will still reflect good demand from our customers and should be equal or near our production levels for the fourth quarter. While we have successfully captured the upside and the strong pricing environment so far this year, we remain cautious about global pricing in the fourth quarter and further into 2018. most recently, prices have remained at elevated levels near $180 a metric ton, despite improving supply conditions in the U.S. and Australia leading to expectations that the fourth quarter industry index average price could be approximately $180 per metric ton. Near-term global pricing may be largely dependent upon Chinese demand and policies being implemented during the winter season. The full impact of China's 2+26 policy that began in October to reduce air pollution remains to be seen. The policy requires coke plants to increase coking times and operate blast furnaces under 50% utilization from mid-November through the winter season. These changes could reduce demand for coke and hard coking coal and create volatility in the seaborne markets heading into 2018. we've seen recent price expectations for 2018 range from $135 per metric ton to $150 per metric ton, well below where prices are today. In that price range, we expect to maintain good margins with strong cash conversion. In closing, we are pleased with our results for the third quarter and we believe we are on track to meet or exceed our goals for the remainder of the year. With that, we'd like to open the call for questions. Operator?

[Operator Instructions] The first question comes from Dave Gagliano, with BMO Capital Markets.

Thanks for taking my questions. I just had a quick one looking into 2018 related to the volumes. I understand obviously we've got the longwall move in the fourth quarter. We've had two quarters of close to two million tons of volume each quarter. How should we be thinking about quarterly run rate volumes after we come out of the fourth quarter? That's my first question. And then, the somewhat related question, can you tie in your volume expectations for 2018 into the commentary you just made with regards to the pricing outlook commentary that you made, as well?

This is Walt. Our run re, as we look into 2018, our goal is to get back to that nameplate capacity by the end of 2018, of 8 million short tons a year. We won't hit the ground running at that rate right at the beginning of the year. We still have two CM sections to get up and running at full capacity, one of them is being added between now and the end of the year, the other will start up after the beginning of next year as well as some of our units are not at top efficiency at this point. So we still have some growth to do, but our expectation is we'll be able to get – we'll get to that nameplate capacity late next year. And that's right in line with where we see the pricing for next year. We think that's a good range to be in.

Is there a obviously there is sensitivity to price. Is there a certain specific basin benchmark index price that we should be thinking about it would start to scale it back if things do really decline meaningfully at some point?

No, we've never talked about where our breakeven price is. And even in the price ranges that we're talking about , the company will do quite well financially.

Right, okay, perfect. And congrats on another good quarter in terms of execution thanks.

Thank you.

Thank you. The next question comes from Jeremy Sussman, with Clarkson.

Hi, good afternoon and thanks for taking my questions.

Good afternoon, Jeremy.

Walt, you guys have had, as Dave said, another solid quarter. I think costs have averaged a bit under $88 a ton through three quarters, which is I think kind of reiterated guidance of $89 to $95. I know you have a few moving parts with the longwall moves, but what would it take to get to, say, the midpoint or even the high end of the cost guidance?

Jeremy, what you have to remember is all those labor dollars, all those fixed costs just get spread across fewer tons in the fourth quarter with three longwall moves. So it's not about us spending more money; it's just about us mining less tons in the fourth quarter with the three moves. So that's what's going to drive that cost number and determine exactly where we end up in that range.

Okay. That's helpful. And maybe if I sort I shift gears on to the CapEx front. How should we kind of – once you get to kind of that eight million ton run range kind of back half of or towards the end of next year, is there sort f a right level of maintenance CapEx, maybe on a dollar per ton basis? Or how should we kind of be thinking about that on really a go-forward basis?

What we've said in terms of maintenance capital, it's going to be about $65 million a year in straight maintenance capital and then we don't have a budget finalized for next year, but we'll be looking at where the pricing is expected to be and looking at other discretionary items to determine whether or not this is the right time to be deploying additional capital on things like new set of shields on things like beginning to develop torquacity at Mine No. 4, things like that will determine how much above that $65 million rate that we will go. So it's about the coal price and about the timing on those types of projects.

Very helpful. I’ll move on thanks.

[Operator Instructions] The next question comes from Karl Blunden, with Goldman Sachs.

Hi, good morning guys, Karl Blunden here. Thanks for taking my question. Just a follow-up on the comments that were just made. As you think about the timing and the cost of the shield replacement, can you help us think through that and how flexible is that investment from a timing perspective.

Well, the timing in investments really goes to when we want to put those new shields in service. Heat shields last about 65 or 70,000 cycles. A cycle is every time the shield moves three foot. So we have some time left and some variability as to when we could do that. And we look at whether or not the new shields would make us even more efficient if we brought them online a little earlier. So the timing of that, we could begin to put money into those next year, have them delivered in 2019, and put them in service right at that point. Or if we needed to, we could delay that a little bit.

Gotcha. Thanks, guys. Just one more on the cost side of things. As you think about the operating costs and how those flex in volatility met coal price environment, how should we think about the lag as met coal prices potential come down? What's the lag there between that and then royalty costs and then also labor? And is there a reference that we should look at? You're charging customers based on three different methodologies. What's the methodology used in those contracts that we can refer to?

Well, the royalties will happen real-time on a month-by-month basis, and the rail rates will also happen real-time on a month-to-month basis. Labor lags about two quarters. So when it hits a point where it would step back, that would lag two quarters. When it hits a point where it would step back up, that would also lag two quarters.

That’s helpful. Thanks very much.

Thank you.

At this time, there are no further questions. I would now like to turn the call back over to Mr. Scheller for any closing comments.

Well, that concludes our call for this afternoon. Thank you again for joining us today. We appreciate your interest in Warrior Met Coal.