2Q08 Results Far Exceed Expectations; Reiterating Buy Rating, Raising Target Price to $171
Investment Summary
Walter Industries’ 2Q08 results left no doubt where future earnings are headed. EPS of $0.94 was well above Street expectations, as key business drivers continued to strengthen. Strategic initiatives remain on track, and visibility into future earnings potential has materialized. We’ve raised our 2008 and 2009 estimates, and with it our target price from $150 to $171, which is based on a multiple of 10x our 2009 EPS forecast of $17.16. We recommend investors continue to scale into positions, particularly below the $100 share price level.
Discussion
An exceptional quarter for Natural Resources. Production volumes from Mine #4 and Mine #7 came in just above the high end of company guidance of 2.8MM – 3MM tons for 1H08. Per ton costs were in line with our forecasts, but the average selling price of almost $111 was well above our $95 prognostication. The combination of strong production, expected costs and higher selling prices translated into the bulk of the upside in our model. (Our revenue and EPS forecasts were $321MM and $0.61; actual results were $370MM and $0.94.)
Key business drivers continued to strengthen. The markets for both types of coal remain strong, but particularly so for metallurgical coal. With the upcoming negotiations for 2H09 and 1H10 set to commence in October, we expect Walter Industries’ overall realized average per ton selling prices to rise substantially from average current contract prices. Further, we continue to expect a strong (and strengthening) environment for thermal coal as some of the existing supplies are pulled into the met market to be used for blending purposes with higher grades to stretch limited supplies.
Strategic initiatives remain on track. The Southwest A panel in Mine #7 is expected to begin production in August, meeting previous company guidance. Additionally, the critical infrastructure requirements for the Mine #7 East expansion have now been completed, and preparation is underway to begin long wall operations there in 2009. Outside of production-related plans, the timetable for the separation of the Home Building and Financing segments was reconfirmed (by the end of 2008).
Raising our estimates. We’ve made several adjustments to our forecast model to account for 1) the increased share count due to the recent equity offering, 2) reduced expectations surrounding interest expense, 3) modestly higher anticipated COS for the natural gas business in 3Q08, 4) higher expected production volumes in 2009, and 5) higher anticipated contract prices on 2H09 / 1H10 tons (we’ve raised our selling price estimate from $250 to $300 per short ton). Our new estimates are as follows: for 2008, EPS is raised from $5.77 to $6.17; for 2009, EPS is raised from $15.00 to $17.16.
Valuation – Despite the increased level of announced M&A activity in the coal space and more intense market focus on metallurgical coal producers, the shares of Walter Industries continue to trade a significant discount to the overall coal peer group. Most perplexing is that despite higher profitability than peer companies with much higher overall exposure to lower-priced thermal coal, the shares of Walter Industries continue to disappoint from a valuation perspective. We consider the discount unwarranted, particularly given the solid operational performance seen in recent quarters and expected future diversification of the overall risk profile as the company ramps up a third long wall operation. Our investment opinion is that if strong earnings growth continues to show itself on a go-forward basis, the market will recognize the valuation disconnect between Walter Industries and its peer group, and that the gap will close. The separation of the non-natural resources businesses should also bring with it additional investor interest as a stand-alone natural resource pure-play. We have raised our target price from $150 to $171 (based on
10x our upwardly revised 2009 EPS estimate of $17.16) and are reiterating our Buy rating on WLT shares. We recommend investors continue to scale into positions, particularly below the $100 share price level.
Risks - global economic conditions, natural disasters, mining conditions, labor disruptions and foreign exchange exposure. |
