It doesn’t look that dirty…

Hey look guys, it’s a post on investing in coal, a sector so beaten up that victims of the mob pity it. I’ll never be a mob guy, but I think I’ll start telling people that I’m in waste disposal. That’ll make me a badass.

Specifically, one of my readers asked me about Walter Energy (NYSE: WLT), one of the largest coal producers in the U.S. It currently trades at a hair under $5, which is the lowest it’s been since the mid 1990s. I’m intrigued, so I figured I’d take a broader look at investing in coal.

But first, Walter Energy. Because hey, some guy with the last name of Walter, we remember you.

Upon a quick look at the balance sheet, it’s obvious the company has a debt problem that compares to the average debt blogger.. The current debt to equity ratio is north of 50%, which to any contrarian investor is a huge red flag. It owes more than $2.9 billion on equity of just $5.6 billion. That’s… bad.

Immediately, my first thought is the company is headed for bankruptcy. And upon further digging, I’d say the market agrees with me. The company’s 2020 maturing bonds have a 22% yield to maturity, even though they had an original coupon of ‘just’ 10%. The company isn’t on its death bed just yet, but the vultures are beginning to circle.

The good news? None of the debt matures until 2019, at the earliest. And even then, there’s only $350 million due. The heavy lifting doesn’t start until 2020, when the company is forced to either repay or refinance $1.35 billion in debt. That’s gonna be rough.

I’m too lazy to look, but there’s gotta be some debt covenants this company is getting close to breaking. Covenants are sort of mini contracts inside of the debt obligation that trigger a default if a company were to break them. Usually they cover things like debt to equity ratio, or something called debt coverage ratio, which essentially measures whether the company is capable of paying creditors.

I’d avoid it, because there’s just too much debt. However, I’ll admit there’s some major upside in the name if it recovers. It could easily be a $20 stock if the prices of coal double.

Which brings us to the second reason this stock is so beaten up, the price of coal is in the crapper.

There are two different kinds of coal – the kind that’s burned to produce power, and the kind that’s burned in the production of steel. Walter sells most of its coal to the steel industry, which, up until about a year ago, was a good business because of China. Now that the country has slowed down, so have prices.

I’m bearish on China for one simple reason. It’s in a credit fueled bubble. There is no way I’d invest a nickel in the country directly as this point. The nation created enough economic stimulus in five years (from 2008 to 2013) to recapitalize the entire United States banking system – about $1.5 trillion worth of it. The country went on a credit fueled orgy of construction, building entire cities that now sit empty. And most of it isn’t reported by Chinese officials because it was all quasi-government entities that did all the lending.

Coal needs a fresh new bull market in steel to recover. It’s not going to get it, at least not any time soon. And certainly not from China.

Besides, Walter’s operations are just too damned expensive. It made a slight operating profit in 2012 (before write downs), and didn’t even get close to breaking even in 2013. And this was when metallurgical coal prices were much higher. It’s working on bringing costs down, but still has a ways to go to even sniff profitability.

I spent an hour or so the other night trying to find an alternative to Walter, and I really couldn’t. The coal miners who actually have production and a solid balance sheet haven’t sold off as much. And there are plenty of small companies that trade at right around book value that, y’know, don’t actually produce any damn coal. There just isn’t much to choose from when you’re investing in coal.

The best solution I can come up with for investing in coal is Teck Resources (TSX: TCK.B), which gets about half its earnings from the dirty fuel.

Teck isn’t exactly in contrarian territory quite yet, but is getting close. The current price is $23.61, and the company has spent time regularly over $40/share before. The company has a better amount of debt ($8 billion to equity of over $18 billion), which excludes the $2.4 billion in the bank. It trades at a 20% discount to its tangible book value, and unlike Walter Energy, actually makes money.

Teck is a far better place to hide while you want for coal prices to recover. I’m not really interested until it gets a few bucks cheaper, but it’s a far better choice than Walter. There’s a small chance Teck goes bankrupt, but only after years of a crappy coal market. There’s a very real possibility that Walter goes bankrupt within the next couple years.

Anyway, I’d avoid the whole sector. It’s plenty contrarian, but there aren’t a lot of companies in the space with clean balance sheets. Too much debt makes me nervous, especially during a turn around.

Tell everyone, yo!