Walter Energy More Risky to the Downside? 

Walter Energy (WLT) has some unsecured bonds that are quoted in the upper 20's, i.e. about 28 cents on the dollar. More specifically, Walter has an 8.5% coupon bond that matures in 2021 yielding 44%! Since bonds are senior in the capital structure to the equity, what does this say about the share price of Walter? Yet, despite this evidence of severe financial distress, Walter stock has doubled from its low price to above $3 per share. At that price, the market cap is roughly $220 million. However, Walter has a whopping $3.2 billion of debt on its balance sheet. Some investors evidently believe that the company's cash balance of $615 million is enough to tide the company over to better times. However, it's not just the sheer amount of debt, but also the associated interest expense of about $300 million per year. Make no mistake, if coking coal prices were to recover meaningfully from the current benchmark price of $119 per metric tonnne, that would be quite good for the stock. Perhaps even better for the bonds trading at 28 cents on the dollar. 

The current yield on the 8.5% bonds of 2021 is 35%, add 20 bond points to the overall return and an investor could achieve a 1 year total return of 35% + (20/28= 65%), or 100%. Investors in the stock might point out that the stock price could move up by more than 100%, and that's certainly true. The problem arises on the flipside of the story. If coking coal prices languish in the $120 tonne area for an extended period, interest expense, cash SG&A and other expenses will eat away at the $615 million cash balance fairly quickly. That's why the unsecured bonds are trading at such a deeply distressed level, because there's a real chance the company will have to file for bankruptcy in the next 1-2 years. In bankruptcy, Walter has an additional $1 billion of liabilities on the balance sheet that become a significant problem as well. Investors in the stock should realize that in a bankruptcy, Walter's $3 stock would be worth virtually zero. In fact, the bonds that are trading in the 20's indicate that distressed debt investors believe those bonds will not be paid in full. Those bonds (along with the other unsecured bonds) could easily be exchanged into the vast majority of new equity in the post-Chapter 11 company. 

Bondholders Are the Key Investors Now

One way in which the existing stock could be maintained would be to massively dilute the company with billions of new shares issued to the unsecured bondholders in exchange for their bonds. That way, there's no bankruptcy, but the dilution would be so severe that the existing stockholders might be left holding shares at $0.10 instead of $3 bucks, thereby giving control of the company to one or more classes of bondholders. The unsecured bondholders are not necessarily the group that would get the vast majority of equity, I simply cite this as an example. Bondholders more senior in the capital structure than the unsecured holders could possibly get newly issued shares and/or warrants without even giving up their debt claims.

Conclusion:

The key point here is that investors in Walter Energy's stock are swimming with the sharks now and should be careful. The type of investors who are trading the bonds are giant hedge funds like Apollo Global Management. Professional investors are also now active in Alpha Natural Resources (ANR) and Arch Coal (ACI). Large hedge funds have access to far greater legal and financial firepower than retail investors. Therefore the stocks of many of the coal companies, especially Walter Energy, will remain quite volatile for an extended period. The coal stocks are for professional traders and investors, not retail investors looking for a quick double from 3 bucks.