Recommendation

I recommend shorting shares of Westshore Terminals Investment Corporation (“Westshore”) with a price target of $14, over 30% below today’s price of $20. The company’s high operating leverage is unequipped to tackle the unprecedented competition from nearby terminals and Westshore will have to reduce loading rates to maintain throughput or risk losing volumes. It has historically relied on one customer for nearly 60% of its throughput and every indication is that the customer is going to cut its reliance on Westshore. Challenging industry trends in the U.S. thermal coal sector further bolster the thesis. Scenario analysis suggests that the risks skew heavily to the downside and there is a material risk of a permanent loss of capital. Although the primary valuation technique was discounting future cash flows, even applying today’s 8x multiple to the base case EBITDA run-rate post-Teck renegotiations suggests a downside of over 70%.

Business Description

Westshore operates a coal storage and loading terminal in Roberts Bank, B.C. The facility was officially opened in 1970 with a throughput capacity of 5.5 million tonnes (mt), but capital investment programs since then have increased its capacity to 33mt per annum (mtpa) today. Westshore shipped a little over 30mt of coal in 2018. The company receives handling charges from its customers on a throughput basis – getting paid a fixed fee per tonne loaded – and does not take title to the coal it loads. 

Westshore has historically enjoyed several competitive advantages. It is the largest coal loading facility on the North American west coast. Three major railways service the terminal: Canadian Pacific, CN Rail, and BNSF. Of the three B.C.-based coal terminals (the other two being Neptune and Ridley), it has the highest deep-water berth and coal storage capacity. Finally, because its assets have a long-life and require only marginal maintenance capex, the business is capital-light.

Figure 1. Comparison of West Coast Coal Terminals

The combination of its advantages has resulted in a business with fantastic returns. Shareholders have enjoyed an 11.6% annualized total shareholder return over the last ten years. It also offered a high average shareholder yield[1] of 5.7% during that period.

But the business is not without a few blemishes. It has historically suffered from material customer concentration risks. Teck Resources (TSX: TECK.B, NYSE: TECK) has accounted for an average of 61% of coal throughput over the last eight years; the top three customers accounted for an average of 91%. Westshore also handles a significant amount of thermal coal (42% of total throughput in 2018), which is arguably less desirable than met coal because North American thermal coal exports are inherently less competitive in the seaborne markets and can quickly become uneconomic to export.

The market has largely shrugged off these concerns. The forward EV/EBITDA multiple and P/E ratio for Westshore has averaged 12.2x and 19.5x, respectively, over the last ten years. Currently, Westshore is trading at a forward EBITDA multiple of 8.0x and P/E multiple of 11.2x[2].

Institutional investors currently make up 25% of the shareholder base, the largest being Burgundy Asset Management’s ownership with a 13% stake. James Pattison and other insiders also owns about 34% of shares, resulting in a free float of roughly 36 million shares, or roughly 53% of total shares outstanding. Short interest is at 1.8% of total shares outstanding and 3.4% on the free float[3].

Thesis

Despite a track record of delivering strong shareholder returns, I believe that Westshore presents a compelling short opportunity today. Even though the market is aware of the risk that an upcoming contract renegotiation with Teck poses to future earnings, it otherwise believes that it is “business as usual”. Sell-side analysts are assuming a long-term throughput of 30-33mtpa and a consistent 2% pricing growth. Instead, I believe that Teck’s actions are a symptom of an underlying industry shift. Westshore’s historically high returns have invited competition that will erode its profitability going forward. Furthermore, the company’s operating leverage makes it fragile and inflexible. All of this results in a stock that has a meaningful risk of a permanent loss of capital with limited upside.

1) The market does not fully appreciate the erosion of Westshore’s moat

Many factors suggest that Westshore’s competitive advantage as the premiere west coast coal loading facility is quickly eroding. Competition from nearby terminals, Neptune and Ridley, is ramping up. Whereas Westshore accounted for nearly 60% of total west coast coal capacity in 2012, its share today stands at 54%.  An inflection point will occur by 2021 when Westshore is projected to account for less than half of total capacity. Teck and Canpotex, the owners of the rival Neptune Terminal, have already embarked on a C$470 million capital investment program to expand capacity by almost 50% to 18.5mtpa; the expansion project has been permitted since October 2018. Meanwhile, AMCI and Riverstone Holdings, private equity specialists in natural resources, acquired a 90% stake in the competing Ridley Terminals from the Canadian federal government in July 2019. There is a strong likelihood that the new owners push for greater utilization via lower rates – Ridley operated at only 57% of total capacity with an average loading rate even higher than that of Westshore’s. Ridley has also previously announced plans to grow capacity by 4mt, from 16mtpa to 20mtpa, and even another possible expansion to 28mtpa.

Figure 2. Location and Capacity of Competing West Coast Coal Terminals

Source: Company filings, Teck Resources Investor Presentation, proprietary estimates

In contrast to the growing supply of export capacity, thermal coal producers are struggling to stay profitable, cutting production, and consolidating. Since peaking at 715mt in 2010, total U.S. and Canadian thermal coal production has contracted at an average annual rate of 3.7% to 526mt in 2018[4]. Westshore’s thermal coal producing customers, located in the Powder River Basin (PRB), are hit particularly hard. This is because coal for the PRB has a lower average heat quality versus the coal from other North America basins[5]. When sending coal over long distances, the heat quality needs to be high enough to justify the transport costs. Therefore, U.S. thermal coal producers are considered swing suppliers in the seaborne coal markets – selling into the market when other suppliers cannot meet demand – due to their distance from end customers in Asia versus producers in Indonesia and Australia. Consequently, their exports can become uneconomical in just slightly challenging pricing environments.

The current situation with Westshore’s second largest customer, Cloud Peak, provides good insight into this precarious dynamic. In the first quarter of 2019, Cloud Peak realized an average of ~US$53/t for the coal it exported through Westshore at an average cost of ~US$56/t. In other words, Cloud Peak is making a loss on each tonne of coal exported. It only realized gross margins of 8% on its coal exports in 2018. Indeed, Cloud Peak filed for Chapter 11 this May, and is likely to use it as an opportunity to renegotiate its existing transport agreements with Westshore and BNSF. Otherwise, Cloud Peak cannot afford to continue to export. This is not unprecedented – Cloud Peak temporarily halted coal shipments to Westshore altogether in 2015 when prices were uneconomical[6].

More broadly, producers in the Powder River Basin are shrinking and consolidating. Recently, Peabody Energy and Arch Coal have agreed to combine their PRB operations; the entity will control roughly two-thirds of coal in the basin. A spate of bankruptcies in the basin over the last year, including those of Westmoreland Coal, Cloud Peak Energy, and Blackjewel, further highlight the trend.

The shifting industry dynamic will significantly weaken Westshore’s future earnings power. First, growing capacity limits the bargaining power Westshore traditionally held over producers looking to export coal to Asia. Secondly, Westshore’s pricing power is also hindered by the thin margins producers are receiving for their exports. Current bankruptcies and closures also jeopardize Westshore’s base of thermal coal producing customers. Additionally, a more consolidated base of U.S. coal producers will yield greater negotiating leverage. To sum up, as the supply curve shifts right and demand curve shifts left, prices will invariably scale down.

Finally, even though Westshore does not directly take title to the coal it handles, it is still indirectly exposed to seaborne coal pricing volatility through its customers’ shipments. Given the volatility of thermal coal exports, this revenue stream is lower quality than that of met coal exports. And, as I will soon illustrate, thermal coal will likely grow from ~40% of total Westshore shipments to ~50%-60% by 2022, significantly diluting the quality of Westshore’s future earnings.

2) Teck has signaled a long-term strategic shift away from Westshore

Teck is currently contracted to ship 19mtpa through Westshore until March 2021, and every indication is that Teck plans to cut their reliance on Westshore for exports afterwards. Teck and Canpotex have already embarked on a large capital investment program to upgrade throughput capacity at their jointly-owned Neptune terminal to over 18.5mtpa. Teck’s management believes it can even get capacity to over 20mtpa. The expansion is scheduled for completion in the second half of 2020, around half a year before Teck’s contract with Westshore expires.

Teck has multiple reasons for expanding Neptune’s capacity. Management has been openly displeased at the service quality of Westshore Terminals, pointing to operational issues in which Teck’s high-quality met coal has been contaminated with lower-quality thermal coal from U.S. producers. Teck’s management also believes that Westshore has periodically prioritized lower margin thermal coal shipments over Teck’s high margin met coal shipments. Finally, dumper outages have negatively affected ability to timely export coal. Due to the volatility of seaborne met coal prices, the opportunity costs here is significant. Neptune presents Teck the chance to lower transportation costs, control the supply chain, and maximize shipments during surge prices.

Figure 3. Teck Management Commentary on Westshore and Neptune

On the advantages of exporting through Neptune

“One is the absolute reduction in cost per tonne, forever, for the limited cost compared to what we had at Westshore, and second, the consistency of ability to deliver when prices are high, where we won’t be cut off by thermal coal buyout from the U.S. So these two things in themselves are worth like hundreds and hundreds of millions of dollars to us.”

Don Lindsay, CEO of Teck Resources, 3-Apr-2019 (emphasis added)

On operating issues at Westshore and the imperative to move to Neptune

“It’s quite frustrating and costly to us to suffer bad service and not be able to get metallurgical coal onto a boat which has very large margins because Westshore is, we feel at times, prioritizing U.S. Powder River Basin thermal coal with margins of, in many cases, a few dollars a tonne. It is difficult for us, I think, to let that situation perpetuate any longer than we have to. As Ron says, we have a contract until March 2021, but after that the switch to using Neptune as our number one port, and maybe switching to using Westshore and Ridley more to handle the balance, should I think improve the reliability of our ability to get coal onto a boat in a timely fashion, particularly when prices are high, which is to some extent when we’ve seen [Westshore’s] service level drop.”

Andrew Golding, SVP Corporate Development at Teck Resource, 24-Jan-2019 (emphasis added)

Why pay a margin to someone else?

“But the advantage of Neptune, obviously is, we own it, so it’s a cost of service facility. We’re not paying a profit margin to another supplier or transportation provider. And it gives us the flexibility to move the coal when we can take advantage of various price moves or different customers.”

Ronald Millos, CFO of Teck Resources, 28-Nov-2018 (emphasis added)

Bulls may argue that Teck has long relied on Westshore for coal exports and the current posturing is merely a negotiating tactic in advance of contract renegotiations. This argument is plausible but unlikely. Instead, the more likely explanation is that Teck did not have an imperative to control its coal export supply chain until demand for seaborne coal broke out in 2007. When Teck acquired its 46% interest in Neptune in January 2003, it only had 8mtpa of capacity, and all three west coast ports had significant unused capacity[7]. The growth of Asian demand for coal post-2007 changed this dynamic, and previously underutilized terminals reached almost full capacity. Neptune was underinvested and Teck had no choice but to rely on Westshore for shipments, resulting in a 10-year take-or-pay contract that has been highly lucrative for Westshore. Since then, realizing the strategic advantages that Neptune poses, Teck has been working to improve Neptune’s capacity and efficiency. In 2009, Neptune could only fulfill roughly 40% of Teck’s met coal production. Today, Neptune can do nearly 50%. By 2021, almost 70% of Teck’s coal production can be exported through Neptune. 

There are a few hurdles in Teck’s plan to ramp up capacity at Neptune. The first is rail access: the bridge entering the Neptune terminals must occasionally be lifted to allow container ships to pass through, constraining rail capacity. However, CN is taking advantage of a government spending initiative to expand access into the area to Neptune terminals and estimates this could increase train frequency by as much as 50%. Furthermore, CP’s Senior Vice President has acknowledged Teck’s plan to expand Neptune and did not hint at any potential rail issues, instead stating that it is “good business for Teck, and that it gives them a higher degree of diversification in terms of outlets, but frankly, it’s not bad business for us either.” Another potential challenge is smoothly ramping up loading volumes at Neptune. Neptune’s annual record for coal throughput was 7.6mt in 2017 and ramping this up to 18mtpa+ without operational disturbances is a significant although not insurmountable challenge.

Nevertheless, it is clear that Teck fully intends to use Neptune as its primary port for the long-term. Why continue to send the bulk of your coal shipments to Westshore when you own 46% of a nearby port? Even if Westshore is able to renegotiate a favorable contract in the short-term, it will face steadily declining shipments from Teck as Neptune becomes more ramped up. As a result, Westshore will have to rely on thermal coal producers or new coal mines (a rare event) to replace the loss of Teck’s throughput.

3) Westshore has high operating leverage and is unequipped to respond to the shifting competitive landscape

Westshore runs a high fixed-cost structure. This operating leverage has historically been a boon to shareholders in good times – any increase in loading rates or coal shipments falls through to the bottom line. For instance, even though Westshore’s coal shipments contracted by 6% from 2014 to 2015, its EBITDA margins nevertheless grew by 4% because they were able to increase loading rates because they were able to increase loading rates from ~C$10/t to ~C$11/t.

But leverage can also magnify losses. A majority of Westshore’s leverage come from its work force. Salaries, wages, and benefits make up 72% of its operating expenses and over 90% the labor force is unionized. Other fixed expenses include depreciation, lease payments to the Vancouver Fraser Port Authority for the right to use the terminal, administrative and management payments to Westar (a subsidiary of the Jim Patterson Group), and director fees. In 2018, fixed expenses accounted for nearly 90% of total operational expenses[8].

The bulk of these expenses can be counted on to grow. Union agreements at a minimum generally keep wages tied to inflation and the fixed portion of Westar’s administrative and management fees have a built-in 3% escalator per annum. The head office is lean too with just six individuals handling management and administrative roles. At the minimum, Westshore will find it challenging to cut its expenses in line with projected throughput contraction.

Additionally, Westshore’s assets are inflexible. It is solely built for coal storage and loading. While it has the potential to ship other dry bulk commodities, the endeavor would involve significant capital investment and face heavy competition with nearby terminals and ports with similar capabilities, such as the Alliance Grain Terminal (grains), Pacific Coast Terminals (sulphur, bulk liquids), Neptune Terminals (coal, potash), Longview port (eight terminals), Grays Harbor port (four terminals), etc.

As a result, Westshore is fragile and unequipped to tackle the deterioration of its competitive position and volume loss of a major customer.

Valuation

My base case assumptions for Westshore include:

• Post-March 2021, Teck renegotiates a 9mtpa take-or-pay contract with Westshore with a loading rate of C$10/t with a 3% annual escalator. Of the 27mt met coal production forecasted for 2021[9], Teck ships a total of 9mt through Westshore, 13mt through Neptune, 3mt through Ripley, and ships 1mt to the east coast.
• Given Cloud Peak’s current economics (losing money on every tonne of coal shipped), Westshore has to choose between cutting rates or losing production volumes. I assume that coming out of bankruptcy, Cloud Peak renegotiates an 8mtpa take-or-pay contract with a loading rate of C$7/t with a 3% annual escalator. This is conservative – there is even a chance that Cloud Peak does not continue to produce coming out of bankruptcy.
• Riversdale Resources’ Grassy Mountain mine, a met coal project that reserved 4.5mpta of capacity at Westshore until 2030, begins production in H2 2022 and achieves steady-state production rate of 4.5mtpa. Although management has guided production for Q1 2021, the project is still being permitted and construction is estimated to take 21 months afterwards. I expect the timeline for the project will likely be pushed out given the current public and regulatory scrutiny on coal’s environmental impact (Riversdale originally expected the mine to be open in late 2018).
• Signal Peak and other customers’ shipments kept at 2018 levels, rates are escalated by 2% per annum.
• Salaries, wages, and benefits remain fixed and there’s a two year lag time before Westshore is able to lower these expenses in response to throughput reduction.
• Discount rate of 5.4%, backed out from the current risk-free rate, estimated equity risk premium, and benchmarking beta from comparable companies. This rate is arguably too conservative given the increased riskiness of Westshore’s business and lower quality of future earnings. Sell-side analysts have a discount rate ranging from 7.0% to 8.5%.

Figure 4. Summary Operating and Financial Figures

The above assumptions reflect the precarious positioning that Westshore is facing: eroding competitive advantage, volume loss of a major customer, and high operating leverage. EBITDA margins contract from its 2018 level of C$194 million to a run-rate of ~C$100 million in 2021. A DCF with these assumptions results in an estimated value per share of C$19, a 12% downside from today’s prices. However, I also looked at four other possible scenarios (Modest Winner, Blue Sky, Modest Loser, and Bear) and suggest that the risks skew heavily to the downside. More optimistic assumptions for Westshore’s future range in an implied value range of C$20 to C$28 per share, whereas more pessimistic ones range from 60% downside to a complete loss of capital.

Figure 5. Probability-Weighted Target Price Calculation (WACC: 5.4%)

A probability-weighted valuation suggests a target share price of $14, a 33% downside to today’s prices.

Using the discount rate that sell-side analysts suggest, 7.0%, suggests a nearly 50% downside to today’s prices.

Figure 6. Probability-Weighted Target Price Calculation (WACC: 7.0%)

Even applying today’s 8x multiple to the base case EBITDA run-rate post-Teck renegotiations suggests a downside of over 70%. And given that thermal coal’s share of total shipments is projected to grow to nearly 60%, it is reasonable to expect that Westshore’s multiples de-rate in future.

Key Risks

Coal prices: Seaborne coal prices are volatile, and there remains a risk that a spike in thermal coal prices results in better-than-expected performance at Westshore. Going long a basket of U.S. thermal coal producers to hedge some of the risk may be warranted. In the event that thermal coal prices spike, and there is more room for Westshore to negotiate higher rates, the long basket of thermal coal producers would offset the short position in Westshore.

New coal mines: New coal projects outside of Riversdale’s Grassy Mountain could come online to fill in the gap that Teck leaves post-March 2021, although the likelihood is low given the hurdles that new coal projects face, including scarcity of financing, increased regulatory scrutiny on environmental impacts of coal mining, and prolonged overcapacity of the sector.

Takeout risk: A financial buyer could find Westshore’s assets compelling given its low leverage and high cash flow generation and end up paying a premium to today’s prices to purchase the company. However, I believe this risk is sufficiently captured in the “Blue Sky” scenario.

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[1] Shareholder yield is similar to dividend yield but accounts for share repurchases as well

[2] Source: FactSet; multiples on broker consensus figures

[3] Source: International Industry Regulatory Organization of Canada (IIROC), 18-Jul-2019

[4] Source: Wood Mackenzie

[5] Source: Wood Mackenzie, EIA

[6] As a result, Westshore had to cut their dividends and the stock de-rated to a 7.9x P/E multiple

[7] Source: British Columbia Ministry of Energy and Mines, 2004

[8] Only the fixed portion of lease payments and administrative and management payments to Westar are included; Westshore also pays participation and incentive fees to the VFPA and Westar

[9] Source: Broker consensus estimates