The Long and Short
Teck Resources rumored to be exploring a separation of met coal business
Dan Bruzzo, CFA | September 17, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
News recently hit the tape that Teck Resources (TCKBCN: Baa3/BBB-/BBB-) is reportedly weighing a separation of its met (metallurgical/steelmaking) coal business via a sale or spin-off, in a deal that could be valued at as much as $8 billion. Spreads and CDS have sharply tightened over the past two weeks as equity shares traded up on the headlines and rumors. TCKBCN cash bonds are trading roughly 15-20 bp tighter than they were at the beginning of September.
The consideration of a sale coincides with the ongoing strength in commodities pricing that would be supportive of a higher valuation for the unit, as well as the remaining units. We are seeing similar considerations throughout the industry, in particular for those increasingly focused on improving ESG profiles. While the ESG implications of a separation of the coal business would undoubtedly be a positive for the remaining businesses, Teck does not appear to have major ESG concerns at the moment and is among the better positioned in the industry. Meanwhile, the true credit impact of the transaction would be far less certain and dependent on both the type of transaction and the use of proceeds.
Given the reaction in spreads, investors seem to be making some large assumptions about the portion of proceeds going toward significant debt reduction – which is not to say that investors are wrong, just simply stating that too much remains unknown at this point. A sale versus a spin-off would bring direct cash proceeds, which will likely be divided amongst shareholder payouts, acquisitions, and debt reduction at the remaining operations. Alternatively, a spin-off would go direct to shareholders, where only the proceeds of the prospective debt issuance at the newco would be made available to the remaining operations. In either situation it is unclear whether management would be committed to IG ratings at the new and remaining companies. We believe the initial reaction in spreads is overbought with limited details about the nature of the rumored transaction or use proceeds under the various potential outcomes. In short, there is too much uncertainty to justify the move tighter in spreads at this time.
Exhibit 1: TCKBCN move in spreads over past two weeks
TCKBCN generates approximately 38% of revenue from metallurgical coal (roughly 35% of gross profit), with 30% coming from zinc, 27% from copper, and the remaining 5% from energy. Gross profit is slightly more weighted toward copper and zinc production than met coal, with those percentages poised to increase substantially with the targeted completion of the company’s big QB2 copper project scheduled for the second half of next year.
TCKBCN in Canada’s largest natural resource company, with 69% of production in its home nation, 15% in the US, 10% in Peru and 6% in Chile. Similarly, production from Chile will ramp up in the second half of next year with the eventual completion of the QB2 project (currently more than halfway completed).
While TCKBCN has benefited from strong zinc and copper prices since late 2020, met coal and overall exposure to China pose risks to the company’s longer-term credit quality. Approximately 21% of revenue is generated in China, with 14% in Japan, 13% in the US, 12% in its native Canada, 11% in South Korea, and another 9% in the remainder of Asia.
Adjusted gross leverage and net leverage were 2.7x and 2.5x at fiscal year-end 2020, respectively, which remain commensurate with IG ratings. Though shareholder renumeration has remained a priority, management has demonstrated its willingness to suspend repurchases as necessary. TCKBCN has not executed any since early 2020 and will likely resume repurchases only as cash flow comes back on-line.
TCKBCN has a strong liquidity profile with no significant debt maturities until 2030 and just under $6 billion in its two undrawn credit facilities available to them. Although currently free cash flow negative, capital expenditures ($3.6 billion in fiscal 2020) will drop off substantially with the completion of the QB2 project next year, enabling TCKBCN to improve its cash position (currently $369 million on balance sheet).
Prior to the recent move in spreads, TCKBCN bonds were one of the more attractive risk/rewards among metals & mining credits along the IG sector curve. Investors previously appeared well compensated for the limited risk of TCKBCN credit falling to non-investment grade, as bonds did not trade that far off from BB-rated credits within the sector (bonds actually traded wide to some BB issuers MTNA and FCX in certain parts of the curve). The move in TCKBCN cash bond spreads month-to-date has eliminated much of the upside that had been previously available to investors.