Welcome to Special Situation Investing Episode 67.
Today, we’ll do a deep dive into Teck Resources upcoming coal division spin-off, along with a broad overview of their business model. Teck, is a Canadian based mining company who, according to their website, is focused on providing products which are essential to building a better quality of life for people around the globe. Currently, the company’ profits are split up in the following proportions across three broad business segments: 55% coal, 34% copper, 14% zinc and a three percent loss in energy. Today, Teck sits at an approximate $20 billion market cap, with nearly $6 billion in debt, a $39 share price, and a P/E of 7.
Mohnish Pabrai fans might remember a multi-bagger investment made by the Indian American investor in Teck Cominco during the 2008/2009 global financial crisis. Teck, or Teck Cominco as it was then known, had lost 90% of its value in the course of only a few months when Mohnish loaded up on the stock in what he described as a low risk high uncertainty bet. Within the year he’d captured a 7x return on the stock, selling out of the position before it reached its eventual near 10x return for the year. While the valuation prospect on Teck is different today the case study is still interesting and informative and we’ll be sure to link to Mohnish’s video description of the investment in the show notes.
With that overview out of the way, let’s quickly review the details of the proposed spin-off followed by our perspective on the transaction. First, the spin-off will divide the company in two roughly equal parts with the coal making steel business being spun-out and the remaining metals business to be retained by the parent company. The parent company will be renamed Teck Metals and, as the name implies, will include the copper and zinc metal mining business with the copper business being the company’s growth engine. The spin-out will be renamed, Elk Valley Resources or EVR, and will retain the steel making coal business.
Up to this point it looks like a typical spin-off transaction. You separate two unrelated business via a spin-off so that investors can specifically allocate their capital and so that each management team is maximally incentivized to create value. This is also the point where the spin-off takes a very unusual turn.
To begin, the spin-off will be obligated to pay out 90% of its free cash flow for at least a decade post spin.
These payouts are detailed in what the company calls the “Transition Capital Structure” or TCS. Under the TCS, Teck Metals will receive 87.5% of EVR’s free cash flow with the remaining 2.5% split between steel makers POSCO and Nipon Steel Corp. Nipon Steel Corp will receive the majority of the 2.5% payment as it invested $1.025 billion in the EVR spin-off in exchange for a 10% stake in the company. POSCO will end up with a 2.5% stake in the company and both entities will retain their previously agreed upon steel take-off agreements once the spin-off is complete. As is always the case with these transactions, you could go further into the weeds but the key takeaway is that EVR must pay out 90% of its free cash flows to Teck Metals, Nipon Steel, and EVR for at least a decade following the spin-off and can only retain its free cash flow once specific payout thresholds are met.
Now, on to our summary of the spin-off. It appears to us, and again this is only our opinion, that there is a great deal of pressure on public companies to divest themselves of coal. Teck’s annual report, shareholder letter, and press releases are littered with carbon neutrality pledges, stakeholder affirmations, and green energy electrifications and while these protestations are fine in their own right, they aren’t related to a profit and loss statement. In other words, ESG pledges are ethical and ideological statements not accounting statements but in this case it would appear that ideology trumps accounting.
Framing the spin-off through the lens of environmental, social, and governance pressures allows us to properly understand the nature of the deal itself. It’s as though a highly paid husband went to his highly paid wife, divorce papers in hand, saying “it’s not the money I don’t like it’s you.” Upon inspection of the divorce papers the wife realizes that, post divorce, she is obligated to pay 90% of her income to her X husband for a decade or more to help him “transition” into the next phase of his life. Harsh as the analogy may appear it’s also pretty close to the actual terms of the spin-off.
Moving past the analogy, how specifically do the terms of the spin-off and the transition capital structure benefit Teck Metals? First off, Teck Metals is no longer associated with “dirty” coal, they merely receive checks from a third party who, themselves, are in the coal business. Second, if capital investment is required to maintain the coal business that capital expense is on EVR and not Teck Metals.
Ordinarily, a company maintains a capital reserve in the form of cash or revolving credit facilities to provide for unexpected capital expenses, this is similar to the savings account that most individuals maintain. By divesting the operational side of the coal business Teck Metals can redirect capital reserves they once maintained against it or can maintain lower reserves reasoning that the same surplus is not required in the new capital structure. To put it plainly, the transition capital structure converts the operational coal portion of Teck into a royalty stream. The royalty model comes with all of the benefits previously discussed on this show and those same benefits are likely motivators behind the spin-off’s transition capital structure.
Now that we’ve covered the terms of the spin-off here is how we would invest, if we chose to do so. Beginning with remaining company, Teck Metals, we don’t anticipate a significant change in the share price. At $39 a share and a P/E of seven the company is fairly valued relative to other miners. With Teck Metals retaining the majority of EVR’s free cash flow even a slight drop in that cash flow will be offset, valuation wise, by the companies lower cost structure and in our opinion will be a wash. Teck Metal’s assertion that copper is a growth industry in the “age of electrification” is probably a correct one so not only is Teck Metals downside protected by solid valuation but the long term potential for growth is reasonably assured.
Switching gears to the spin-off, the valuation picture looks bleak. EVR’s coal business is sound and routinely throws off high margin free cash flow, so that isn’t a problem, but the transition capital structure does represent a valuation challenge. Teck shareholders will receive 1 EVR share for every 10 Teck shares owned, resulting in 51.9 million EVR shares outstanding. According to the spin-off announcement, Nipon Steel’s $1.02 billion investment in 10% of EVR gives an implied EVR valuation of $11.5 billion post spin. If we divide the $11.5 billion implied valuation by 51.9 million EVR shares we get an implied per share valuation of $221 for post spin-off EVR stock. With the spin-off announcement promising a paltry 20 cent base dividend coupled with 90% of the companies free cash flow being siphoned off to the transition capital structure there isn’t much left in EVR to support that valuation. In fact, for the reasons just stated, we would expect heavy selling pressure on the stock post spin-off.
There is one other consideration that must be worked out before deciding how to invest. A yet to be clarified part of the spin-off announcement offered shareholders the ability to optimize for either a cash distribution or stock payout. In other words, through something like a Dutch Tender offer shareholders can opt for more cash or more stock at the spin-off’s completion. The cash payout will be 39 cents per each Teck share held so either 10 x .39 cents in cash or one share of EVR stock at an implied $221 value or some combination of both. Again, details around this part of the spin-off have yet to be clarified but based on the options presented, and even against heavy EVR selling pressure, we would opt to maximize stock over the cash payout. The stock, beaten down though it may be, is unlikely to trade below the cash payout and will retain the upside that always comes with equity ownership.
Two final items are worth noting. The first is that the company has announced a plan to normalize Teck Metals share structure over the six years following the spin-off. Essentially, Tamagami Mining Company, SSM Resources, and Dr Norman B. Keevil have large controlling stakes in the company via the 10-to-1 super voting rights bequeathed to their class A shares. In exchange for a one time 1% Teck Metals shareholder dilution, the legacy two tier voting structure will be eliminated and leave the company with a single share structure and a non-minority controlled governance.
Second, Teck does have a solid record of shareholder returns. For all the seemingly critical aspects of this write-up Teck’s management did return $2.4 billion to shareholders in 2022 via buybacks and dividends which equates to more than 10% of their $20 billion market cap. For the above two reasons, and others, we agree with most analyst’s bullish opinion of the stock. It’s a well managed company, with a track record of shareholder returns, that’s moving toward a normalized shareholder structure and is about to convert half of itself into a 10 plus year coal royalty stream.
Our overall assessment of the spin-off is that investors can expect a reasonable return on their Teck investment if they maximize for shares of EVR versus cash at the spin-off and then sell those share post spin. On the other hand, owners of Teck Metals will hold an operational mining company and a coal royalty streams that is limited to around ten years. The operational miner will have all of the cost challenges that go with a capital intensive business in an inflationary environment and those pressures could limit Teck Metals returns over the coming decade.
If investors want exposure to a coal royalty along with other raw commodities they should consider NRP as an alternative investment. At the time of this writing it trades below five times earnings, has a management team with a proven track record of value creation, and is a pure play royalty model without the capex risk that goes with an operational business.
In either case we hope that listeners of the show are now better armed to make their own investment decision after having there research jump started by ours.
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Here’s a couple of our favorite podcasts from over that last week. Enjoy.