Teck’s dilemma: How to pay off a $10-billion debt while metal prices fall all around

Vancouver – For the last few years Teck Cominco (TCK.B-T, TCK-N) has been a reliable, dividend-paying investment option, a major mining company regularly recording double or triple-digit profits by cashing in on strong metal prices and diversified operations.

 

Then Teck made a US$14-billion bet on metallurgical coal. In July the company unveiled a blockbuster takeover bid for Fording Canadian Coal Trust, 60%-owner of the Elk Valley Coal Partnership. Elk Valley is the world’s second-largest producer of seaborne hard coking coal, most of which is high-quality or metallurgical coal. Teck already held the other 40% interest in Elk Valley and operated the company’s six coal mines in British Columbia and Alberta.

 

News of the deal sent Teck’s share price up 6% to almost $43. Since then, however, the mining major’s share price has fallen almost continuously and now sits, shockingly, at just over $6. And with prices for coal, copper, and zinc having fallen through the floor, the blue-chip major now carries a debt load likely greater than its near-term cash flow and is battening down every hatch to try and weather the storm.

 

Teck’s biggest challenge is the debt the company took on in order to pay for Fording. The miner paid US$12.4 billion for the coal company, of which US$9.8 billion came through a debt facility comprising two parts: a US$4-billion loan facility and a US$5.8-billion 364-day bridge loan facility.

 

The US$4-billion loan has a three-year term and is payable in quarterly instalments of US$364 million starting in April 2009. The 364-day bridge loan, however, comes due in full in the third quarter of 2009. In addition, Teck is juggling development and expansion costs at several projects.

 

“Their debt situation? It’s pretty serious,” says Kerry Smith, senior mining analyst with Haywood Securities. “It’s just an incredibly difficult time for them.”

 

In their October 30 Commodity Update, UBS Investment Research analysts described the situation more specifically: “We believe it will not be possible to fully repay the bridge loan of US$5.8 billion, fund the capital requirements, and make the required debt repayments for the term loan.” Simply put: it looks like Teck will be short on cash.

 

It was certainly this concern that pushed investors to drive Teck’s share price down dramatically since early October, when the company still traded above $30 and so claimed a market capitalization of over $14 billion. Indeed, a rumour in early November that Teck was planning an equity offering sent the company’s price down another $5 to its current level. The situation was serious enough that Teck issued a news release clarifying that it was not considering raising money through the markets.

 

So why the cash shortfall? This is a company, after all, that operates some 17 mines around the world, making it a major global producer of copper, metallurgical coal and zinc as well as gold and specialty metals.

 

First, when Teck made its offer for Fording the global economy was still in fine shape, which meant the major assumed it would be able to refinance a significant portion of bridge facility before even using it, thereby seriously reducing its near-term debt obligations. But, as Teck’s senior vice-president of corporate development Ronald Vance said in a recent presentation, the market has deteriorated and “unfortunately…remains relatively thin.” As such Teck cannot even consider refinancing that loan.

 

“For the time being we will focus on making scheduled instalment payments on the term facility and paying down the bridge primarily from the significant cash being generated from our operations and the very significant tax refunds that are coming,” said Vance.

 

Analysts, as noted above, are having a hard time reconciling with that statement past March 2009. Teck’s coal contracts run from April 1 to March 31, so until the end of March the company’s contracts provide complete protection from the falling price of coal. As such Teck and the analysts who follow the company have a high degree of confidence in the company’s earnings and cash flow. For example, in the first quarter of 2009 Teck’s coal business alone is expected to bring in more than $1 billion in ore-tax cash flow.

 

In addition, Teck took advantage of a tax accounting rule that allows for a 30% declining balance depreciation rate that generated a $4-billion tax deduction in 2008 that more than shields the company’s Canadian income for the year. As for the coming tax refunds to which Vance referred, the shield can be carried back three years, allowing Teck to generate a refund for all taxes paid from 2005 to 2007. The refunds are expected to total $1 billion, all expected by the middle of next year.

 

In the near term, there looks to be considerable cash coming in. But two major factors remain: cash going out during that time and cash flow after Teck’s coal contracts are re-negotiated.

 

First, let’s look at the question hanging over it all: coal prices. Teck’s financial situation beyond March depends in very large part on the price it can obtain in its upcoming coal contract negotiations. Predictions are all over the map.

 

In 2008 coal hit a new record price of US$300 per tonne. There is consensus that the price is falling, but the question is how much. UBS analysts foresee a price close to US$180 per tonne. Canaccord Adams analyst Orest Wowkodaw downgraded his 2009 coal forecast to US$150 a tonne. TD Securities analyst Greg Barnes also sees a US$150-per-tonne coal price. Teck, for its part, has not named a price but in presentations highlights 2009 revenues using US$250 per tonne coal.

 

“If Teck can get a decent coal price that will help a lot but there are a lot of people out there who aren’t expecting that,” says Smith. “At the same time – coal contracts are long-term relationships, so I can’t see Teck’s customers grinding them down to save a few million dollars when they want to be able to buy that coal for another 20 or 30 years.”

 

The other major factor is expenses. Like every mining company facing a shortfall Teck says it is looking to contain mine operating costs, which could generate small savings. More importantly, however, the company expects more significant savings from reductions to sustaining capital and development expenditures.

 

The company’s normalized annual sustaining capital expenditures, considering 100% ownership of Elk Valley, come in around $600 million. But Vance said the company has been investing considerably in sustaining capital in recent years, which should make it possible for its operations to survive the coming year on reduced budgets.

 

Elk Valley was to contribute $250 million to annual expenditures but that included plans to expand production capacity over the next few years. “If market conditions don’t justify that expansion, we will reduce capital commitments accordingly,” Vance said.

 

As for development, at the two mines where expansion projects are almost complete work will continue as usual. That means Andacollo, in Chile, will quadruple its copper production by late 2009 and Highland Valley, in BC, will boost copper and molybdenum production by 15% next year.

 

Teck is also working to advance three major copper projects: Quebrada Blanca, Galore Creek, and Relincho. “While we remain very encouraged by the quality of these potential development projects, we have a high degree of discretion over the rate at which they progress and most importantly over the money we spend,” says Vance.

 

At the same time Vance stressed that Teck is confident that current copper prices are unsustainable because the current level makes a large percentage of the world’s production uneconomical. As such the company sees a medium-to-long term outlook for copper that’s “as attractive as any of the base metals” and so still enjoys its copper commitments.

 

The biggest capital costs savings, however, stem from a recent decision to defer the investment decision at the Fort Hills mine until 2009 and to put the Sturgeon Upgrader portion of the project on hold indefinitely. Fort Hills is an oil sands development project in Alberta, in which Petro-Canada (PCA-T, PCZ-N) holds 60%, UTS Energy (UTS-T) holds 20%, and Teck holds the rest. The partners said they are deferring the mine development decision until “a cost estimate most consistent with the current market environment can be established.”

 

In his mid-November Teck update Wowkodaw estimated the decisions will save Teck $1.3 billion in 2009 and $1.1 billion in 2010.

 

One cost savings option that is piquing investor interest is the possibility of cancelling the annual $1-per-share dividend. It would save Teck $500 million but it’s not a step the company is yet willing to take.

 

“The current dividend is something the Board will take up – without any doubt it’s something they are keeping a close eye on,” says Vance. “The Board will be weighing concerns and making an appropriate decision at the time.”

 

Finally, Teck is openly discussing the possibility of selling its gold assets. As Vance put it, while this option has been in the table for some time “one key factor in the past was that we really didn’t have any immediate use of the cash – obviously that situation has now changed.” He admits it is not the most opportune time to be selling anything but says the company is in discussions with several interested parties.

 

Wowkodaw concluded his recent Teck analysis with this statement: “With hindsight, the recent acquisition of Fording using cash (financed by US$9.8 billion of debt) now appears to be a catastrophic misstep by the company given the accelerating global economic crisis and the ensuing breakdown in steel demand.” Comparing that sentiment to Teck’s share price jump on news of the Fording deal in July shines a harsh light on a new economic reality for the world’s miners, large and small.