You have to take the good with the bad — or do you? What if you could take the good, shed the bad and watch it sink as you float on?
That is what a lot of people think happened in the case of Patriot Coal, currently undergoing Chapter 11 bankruptcy proceedings. Decrying the potential loss of longstanding benefits promised to employees, retirees and their families, members of the United Mine Workers of America assert the company was doomed to failure from the very beginning.
What do they mean? Is it true?
Spinning Off Patriot
On Oct. 31, 2007, Peabody Energy took all of its union operations east of the Mississippi River and some of its non-union operations and spun them off into Patriot Coal. About 61 percent of miners at the new Patriot operations were represented by the UMWA.
"Spin offs happen for many reasons and typically do not happen for only one reason," explained David Beard, managing director of coal and shipping research at Iberia Bank.
Those reasons, he continued, include a more purely focused company. By spinning off Patriot, Peabody escaped legacy liabilities including retiree health care and related experiences by "roughly $1 billion" while reducing expense and cash spending "in the neighborhood of $100 million," according to then-CEO Gregory Boyce.
"The transaction enhances our focus on large, long-lived surface operations and significantly lowers liabilities," Peabody stated in its 2007 annual report. "BTU continues to enhance its focus on business opportunities in strong economies as we sculpt our portfolio to target the very best growth markets."
Things looked good at first. Patriot's stock was offered at $15 in its initial public offering. The company's stock skyrocketed to more than $88 per share at its peak. Board members from Peabody even took positions at Patriot.
In its annual report for 2007, Patriot was highly optimistic about the future of its assets.
"Our company has certain core strengths that make it an excellent vehicle for long-term value creation — strengths that made Patriot Coal an excellent candidate for a spin-off and that attracted me and the other members of our management team to this opportunity," wrote Patriot's then-president and CEO Richard Whiting.
"Coal is a low-cost domestic energy product at a time when oil and natural gas supplies are growing scarcer and more expensive," the 2007 annual report boasts before development of the Marcellus Shale caused availability of gas to skyrocket and its price to plummet. The high demand of coal and "constrained supply and infrastructure," Patriot predicted at the time, produced strong market conditions "that are expected to continue."
However, tucked in the same 2007 report was a warning about the viability of Patriot's business model.
"Because markets fluctuate, Patriot Coal cannot rely on today's strong pricing alone to create stockholder value," the report states. "We recognize the need to be a low-cost producer to excel during all market cycles of both thermal and metallurgical coal."
So if Peabody opted to focus on "large, long-lived" operations, what did they spin off Patriot?
According to Patriot's 2007 annual report, the company had 10 company-operated mines, "numerous contractor-operated mines" and eight coal preparation facilities. Five of those were in West Virginia. At the time, Patriot controlled about 1.3 billion tons of proven and provable reserve, shipping 77 percent of its coal to domestic electric utilities.
The objective was to position Patriot as a "consolidator" in Appalachia.
With all of those coal reserves and purchase agreements, Patriot also received some significant liabilities that were inextricably tied to certain assets.
By December 2007, just two months after forming, Patriot had asset retirement obligations of $134.4 million — including $31.7 million related to inactive mines. It had $216.5 million in federal black lung benefits liabilities and $554.7 million in retiree health care liabilities.
The Coal Act provides for funding of health benefits for UMWA retirees. In connection with the Peabody spin-off, Patriot accepted $603.7 million in liabilities related to the Coal Act, the National Bituminous Coal Wage Agreement and "certain salaried employee retiree health care benefits."
Liabilities, at least as a portion of the entire balance sheet, looked quite different at Patriot than Peabody. In Patriot's first annual report, accrued post-retirement benefit liabilities combined with workers' compensation liabilities totaled about $720 million — or 60 percent of its balance sheet assets, given total assets of just under $1.2 billion.
Peabody, the same year, did not list workers' compensation separately on its balance sheet. However, its post retirement benefit obligations were just about 8 percent of liabilities on its balance sheet.
In 2006, before spinning off Patriot, Peabody's postretirement obligations were almost double 2007's figures as a percentage of its balance sheet. Post-spinoff, Peabody's retirement and worker's compensation obligations were just 10 percent higher than Patriot's despite having nearly 10 times the total assets.
Phil Smith, a spokesman for the UMWA, said Patriot continued to pay benefits to miners who not only never worked for Patriot Coal, but worked at mines that were never active under the existence of Patriot Coal Smith said liabilities from closed mines had been transferred to Patriot in its formation.
Patriot, saddled with numerous liabilities from the start, faced the same problems as any coal company. It was sensitive to coal prices and ability to renew coal supply agreements.
Several coal companies operate both in western coal regions and eastern coal regions. Lately, eastern coal markets have been pressured by geologic and regulatory challenges. Many analysts have as a result predicted decreased productions in the east while western coal production grows.
Patriot's operation, however, was heavily tied to domestic electricity production where natural gas has become a major contender and was also exclusively eastern coal — primarily in the Appalachian and Illinois basins.
Not long after Patriot was formed, it purchased Charleston-based Magnum Coal, which Arch Coal had spun off a year and half earlier. Both companies were largely composed of union mines and carried with them significant long-term obligations.
It seems Patriot was interested in acquiring Magnum, even though Peabody hadn't been. According to a June 17, 2008, U.S. Securities and Exchange Commission filing, "Prior to the spin-off, Peabody and Magnum had held preliminary inconclusive discussions about a possible acquisition of Magnum by Peabody."
"In early November 2007, Mr. Paul H. Vining, president and chief executive officer of Magnum, contacted Mr. Richard M. Whiting, president and chief executive officer of Patriot, to discuss the possibility of an acquisition of Magnum by Patriot. Mr. Whiting informed Patriot's board of directors of the acquisition opportunity and was authorized by the Patriot board to conduct preliminary discussions with Magnum regarding the possible transaction."
Patriot purchased Magnum for about $709 million in Patriot stock. That purchase included legacy liabilities of about $500 million, said Mark Schroeder, senior vice president and chief financial officer, speaking on a conference call regarding the acquisition.
"They do have legacy liabilities, like Patriot has legacy liabilities," Schroeder said. "We're very familiar with how to work with those, how to control those costs. We are not afraid of legacy liabilities and yes, they do. I think their number is in the $500 million range."
Despite seeking to become a consolidator, Magnum would be Patriot's only major acquisition.
Fast forward five years to 2012 and things now look grim for Patriot. Earlier this year, Patriot Coal filed its first quarter statements reporting a $75 million net loss, verifying rumors of financial trouble.
Patriot's balance sheet in the first quarter of 2012 showed accrued post retirement benefit costs of nearly $1.4 billion as of March 31. Total assets were $3.6 billion.
In the first three months of 2012, Patriot sold 79 percent of its coal to domestic and global electricity generators — a market increasingly squeezed by record-low natural gas prices, a warm winter and increased regulations on coal-fired power facilities.
"In recent years, the demand for coal has decreased, in large part because alternative sources of energy have become increasingly attractive to electricity generators in light of declining natural gas prices and more burdensome environmental and other governmental regulations for the use of coal," Patriot wrote in an SEC filing following the bankruptcy. "At the same time, our liabilities have been increasing as we face sharply rising costs to comply with such regulations, the costs associated with our labor-related legacy liabilities and the increasing burden of selenium water treatment."
Beard said the sudden depression of coal prices, fueled by lower demand due to the weather and increased natural gas supplies, caught many analysts off-guard.
"There are two schools of thought (about) which generated low gas and coal prices," Beard said. "One is too much supply on the gas side. The other is weak demand from weather. The truth is both contributed to the current pricing/production situation."
A number of other incidences threatened the long-term viability of Patriot.
First, it faces obligations to treat selenium in water. A U.S. District Court ordered one Patriot subsidiary to install a selenium treatment facility projected to cost about $55 million. Another selenium facility Patriot was ordered to construct is estimated to cost $25 million.
The three mines where selenium cleanup is described as a major concern for investors in SEC filings — Hobet, Catenary and Apogee — were all major operations of Magnum Coal.
Adding to Patriot's problems, earlier this summer it became known that the company had submitted a legal complaint in the U.S. District Court for the Southern District of West Virginia claiming that "hundreds of thousands of tons" of coal originally contracted were never picked up or paid for by Keystone Industries LLC, a privately owned coal company based in Florida. Keystone, Patriot said, intended to resell the coal it purchased from Patriot, but breached its contact by not taking "a single ton of coal yet."
Patriot also sued Bridgehouse Commodities Trading Ltd. for breach of contract in U.S. District Court for the Southern District of West Virginia. Bridgehouse, which is headquartered on the Isle of Man, buys and sells coal.
Around the same time those two lawsuits were being filed, Whiting, the man who was put at Patriot's helm after the spin off, announced he was stepping down as president and CEO.
This year, Patriot has taken a number of initiatives to adapt to the harsh coal market.
"We have reduced thermal coal production by over four million annual tons, delayed expansions under our met build-out program, implemented major cost reduction initiatives, and worked with our customers to better meet their changing requirements," results from the first quarter stated. "We have reduced the work force at our properties by about 1,000 employees and contractors since the beginning of 2012, and to tighten control, we have assumed full operation of several mines and facilities formerly managed by contractors, including the Kanawha Eagle mining complex."
Just last week, Patriot Coal announced it would be reducing metallurgical coal production due to "further weakening demand."
"The production cuts will occur at three southern West Virginia mine complexes — Kanawha Eagle, Rocklick and Wells — over the next 60 days," the company stated. "In total, a 250 employee and contractor positions will be impacted by these actions."
Efforts to reverse course were not successful, following much bankruptcy speculation. The company officially filed July 9 and was delisted from the New York Stock Exchange on July 10.
"The coal industry is undergoing a major transformation, and Patriot's existing capital structure prevents it from making the necessary adjustments to achieve long-term success," said Patriot chairman and CEO Irl F. Engelhardt when the bankruptcy was announced. "Our objective is to use the reorganization process to address important issues in an orderly way and make the company stronger and more competitive."
Patriot obtained $802 million of debtor in possession financing and has up to 120 days to file its reorganization plan but has announced it would likely request an extension, which is routinely granted for up to 18 months given the "size and complexity" of the restructuring.
The company has insisted that its mining operations will continue, pointing to major companies that have come out of the process stronger than before, such as General Motors and Delta Air Lines.
Stronger Company, Stronger Employees?
The reason Charleston residents have been seeing so many union members downtown lately is leaders fear a stronger company will not mean better-off employees. The UMWA is convinced Patriot will use bankruptcy court to reject its current collective bargaining agreement or impose new terms and conditions of employment.
In filing to the court, Patriot cited "substantial and unsustainable legacy costs," including health care benefits and pensions owed to retirees and widows.
"Patriot's filing showed very clearly that the company intends to attempt to get out of its obligations to active miners, retirees, widows and dependents," the UMWA said in a handout.
According to the UMWA, about 90 percent of the retirees receiving benefits from Patriot never worked a single day for that company; the union says they are former employees of subsidiaries at Peabody and Arch. The UMWA estimates approximately 22,000 retirees, their dependents and surviving spouses receive health care benefits from Patriot that could be at risk.
Smith, with the UMWA, said that even had the market fared well, Patriot had been doomed from the start.
"It was a bubble created to burst," he said.
A Peabody Energy spokesperson said Peabody felt "confident that Patriot was a viable company" at spinoff, but that "the world and Patriot have changed significantly" since.
"As Patriot has indicated in its filings with the bankruptcy court, these changes included Patriot's acquisition of Magnum Coal Company, which had substantial assets and liabilities, and significant changes made in Patriot's capital structure," the spokesperson said. "We've also seen decreased demand for coal due to sharp declines in natural gas prices, the softening of the global steel markets, and more burdensome environmental and other governmental regulations that have all occurred post spin."
But Beard, the analyst with Iberia bank, said UMWA's argument that Patriot was built to fail is faulted.
"From my point of view, the UMWA's argument is analogous to telling someone who has missed their mortgage payments that somehow the seller fraudulently sold them the house five years ago, meanwhile the home owner put in an addition and lost their job due to weak economic conditions," Beard said.
Beard said Patriot's actions following the spin-off weighed more heavily on it having to turn to bankruptcy.
"We do not feel PCX was set up to fail. The company was quite viable when they were spun out," Beard said. "... However, the spin off occurred five years ago. PCX also took on additional debt, additional legacy liabilities and another below market contracts through acquisitions which occurred after the spin out."
Sen. Jay Rockefeller, D-W.Va., has been the only member of the West Virginia delegation to come out in support of the UMWA workers as the bankruptcy proceeds.
"Generations of West Virginia coal miners have dedicated their careers to making Patriot and the entire coal industry a success. … I am therefore troubled that Patriot has indicated that it is reviewing pension and health care benefits as potential sources savings as it restructures. …" Rockefeller said in a letter to Patriot's CEO. "… Any efforts to strip these coal miners of their earned benefits through the bankruptcy process would be severely unjust."
Rockefeller also sent a letter of support to UMWA leadership.
The reason the UMWA's obligations are at risk is that secured bondholders get paid first under bankruptcy law. Unsecured bondholders such as pension contracts are paid with remaining assets, often not in full.
So why aren't pensions and union contracts secured contracts?
"Well if that were the case, no bank would lend much money on an unsecured basis to any company, especially a coal company," Beard explained. "Furthermore, without loans, no investor would want to spend 100 percent of the value of the company in cash (equity). Therefore, without loans, there would be no company to pay wages, benefits and pensions. Thus the loans need to be secured and pensions/wages are unsecured."
Of course, if the entire coal industry has been pressured, perhaps Arch and Peabody's finances are similarly strained?
"Peabody's diversified global platform continues to deliver solid cash flows and earnings in a choppy market environment," Boyce, Peabody's chairman and CEO, said in second quarter results announced last month. "While we see some bright spots within the global coal markets, there remain macroeconomic and industry challenges that Peabody is well positioned to weather given our global position and financial strength."
Boyce continued, citing that despite "significant headwinds" experienced in the second quarter of 2012, the company was looking forward to improved sales volume as China coal imports reached record levels, global metallurgical coal sales increased and natural gas prices have begun to rebound.
"Peabody's projected 2012 U.S. production remains fully contracted, and 2013 production is 70 to 75 percent priced based on targeted current-year volumes," the company stated.
Is this simply because Peabody's stakes largely lie west, while eastern coal faces increased market challenges? Perhaps. Arch Coal, with significant assets in Appalachian coal, posted a loss a $436 million in the second quarter. Arch does, however, expect better results in the second half.
"We expect to see better balance in the second half of the year in the domestic thermal market given the ongoing rationalization of coal supply, increasing U.S. power demand, reduced coal-to-gas switching concerns and growing U.S. coal exports," president John W. Eaves said.
Arch Coal's second quarter results, however, do reflect several mine closings. Given that the company squeezed those costs into second quarter earnings reports, third and fourth quarter results are expected to be more optimistic. Revenues for the first half of 2012 were up 13 percent over last year at Arch.
That's not to say that Peabody and Arch came out unscathed. According to SEC filings, Peabody listed around $150 million in potential liability related black lung benefits. Arch put its potential liability at about $64 million.