Alpha Natural Resources 10-Q 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended June 30, 2008
For the transition period from to
Commission File No. 1-32423
ALPHA NATURAL RESOURCES, INC.
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code:
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
þ Large accelerated filer o Accelerated filer ¨ Non-accelerated filer
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
¨ Yes þ No
Number of shares of the registrant’s Common Stock, $0.01 par value, outstanding as of July 29, 2008— 70,494,861
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
June 30, 2008
(In thousands, except percentages and share data)
(1) Business and Basis of Presentation
Organization and Business
Alpha Natural Resources, Inc. and its consolidated subsidiaries (the “Company”) are primarily engaged in the business of extracting, processing and marketing coal from deep and surface mines, located in the Central and Northern Appalachian regions of the United States, for sale to utility and steel companies in the United States and in international markets.
Basis of Presentation
The accompanying interim condensed consolidated financial statements have been prepared in accordance with U.S generally accepted accounting principles for interim financial reporting. Accounting measurements at interim dates inherently rely on estimates more than at year-end; however, in the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Significant items subject to such estimates and assumptions include inventories; mineral reserves; allowance for non-recoupable advanced mining royalties; asset retirement obligations; employee benefit liabilities; future cash flows associated with assets; useful lives for depreciation, depletion, and amortization; workers’ compensation and black lung claims; postretirement benefits other than pensions; income taxes; revenue recognized using the percentage of completion method; and fair value of financial instruments. Due to the subjective nature of these estimates, actual results could differ from those estimates. Results of operations for the six months ended June 30, 2008 are not necessarily indicative of the results to be expected for the year ending December 31, 2008. These financial statements should be read in conjunction with the audited financial statements and related notes as of and for the year ended December 31, 2007 included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission.
Prior period coal revenues and cost of coal sales have been adjusted to exclude changes in the fair value of coal and diesel fuel derivative contracts to conform to the current year presentation. In addition, prior period trade accounts payable and accrued expenses and other current liabilities have been reclassified to reflect current year presentation. These reclassification adjustments had no effect on previously reported income from operations, net income, current liabilities, or total liabilities.
(2) New Accounting Pronouncements
In May 2008, the Financial Accounting Standards Board (“FASB”) affirmed the consensus of FASB Staff Position (“FSP”) APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) (“FSP APB 14-1”), which applies to all convertible debt instruments that have a ‘‘net settlement feature,’’ which means that such convertible debt instruments, by their terms, may be settled either wholly or partially in cash upon conversion. FSP APB 14-1 requires issuers of convertible debt instruments that may be settled wholly or partially in cash upon conversion to separately account for the liability and equity components in a manner reflective of the issuers’ nonconvertible debt borrowing rate. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years. Early adoption is not permitted and retroactive application to all periods presented is required. The Company is currently finalizing its analysis of FSP APB 14-1 on its consolidated financial statements. The Company expects to have higher interest expense retroactive to the date of the issuance of the convertible notes in April 2008 due to the non-cash interest expense accretion.
In April 2008, the FASB issued FSP No. FAS 142-3, Determination of the Useful Life of Intangible Assets, (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets. This FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The guidance contained in this FSP for determining the useful life of a recognized intangible asset is applied prospectively to intangible assets acquired after the effective date. Additional disclosures required in this FSP are applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. The Company does not expect the adoption of this guidance to have a material effect on its consolidated financial statements.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS 161”), which amends SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”). SFAS 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. The new standard also improves transparency about the location and amounts of derivative instruments in an entity’s financial statements; how derivative instruments and related hedged items are accounted for under SFAS 133; and how derivative instruments and related hedged items affect its financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company is currently assessing the impact of adopting SFAS 161 on its consolidated financial statements.
In December 2007, the FASB issued SFAS 141(R), Business Combinations (“SFAS 141(R)”), and SFAS No. 160, Accounting and Reporting of Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB No. 51 (“SFAS 160”). SFAS 141(R) and SFAS 160 will significantly change the accounting for and reporting of business combination transactions and noncontrolling (minority) interests in consolidated financial statements. SFAS 141(R) retains the fundamental requirements in SFAS 141 while providing additional definitions, such as the definition of the acquirer in a purchase and improvements in the application of how the acquisition method is applied. SFAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests, and classified as a component of equity. These Statements become simultaneously effective January 1, 2009. Early adoption is not permitted. The Company is currently evaluating the impact this guidance will have on its consolidated financial statements.
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(3) Earnings Per Share
Basic earnings per share are computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share are computed using the treasury method by dividing net income by the weighted average number of shares of common stock and dilutive common stock equivalents outstanding during the period. Common stock equivalents include the number of shares issuable upon exercise of outstanding options less the number of shares that could have been purchased with the proceeds from the exercise of the options based on the average price of common stock during the period and the number of shares of common stock from the dilutive effect of the 2.375% convertible senior notes due 2015. The convertible senior notes due 2015 become dilutive for earnings per share calculations when the average price for the quarter exceeds the conversion price of $54.66. The average price of our shares during the second quarter of 2008 was $68.45 and accordingly we added 1,059,716 and 529,858 shares to second quarter and year-to-date dilutive earnings per share calculations, respectively. Restricted shares which have not vested at the end of the reporting period are excluded from the calculation of basic earnings per share.
The computations of basic and diluted net income per share are set forth below:
Inventories consisted of the following:
(5) Income Taxes
A reconciliation of the statutory federal income tax expense at 35% to income before income taxes and minority interest and the actual income tax expense is as follows:
For the three month period ended June 30, 2008, the Company has concluded that it is more likely than not that deferred tax assets, net of valuation allowances, currently recorded will be realized. The amount of the valuation allowance takes into consideration the Alternative Minimum Tax system as required by SFAS No. 109, Accounting for Income Taxes (“SFAS 109”). The Company monitors the valuation allowance each quarter and makes adjustments to the allowance as appropriate. In the second quarter, the Company recognized a benefit for a portion of the valuation allowance that existed at the beginning of the year, based on recent positive evidence regarding the ability to realize its deferred tax assets in the future.
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(6) Long-Term Debt
Long-term debt consisted of the following:
On October 26, 2005, Alpha Natural Resources, LLC (“ANR LLC”), entered into a senior secured credit facility with a group of lending institutions led by Citicorp North America, Inc., as administrative agent (the “Credit Agreement”). The Credit Agreement originally consisted of a $250,000 term loan facility and a $275,000 revolving credit facility. The revolving credit facility includes borrowing capacity available for letters of credit.
In March 2008, the Company and its subsidiary, ANR LLC, entered into two amendments to the Credit Agreement. One of these amendments increased the amount available under the revolving credit portion of the facility from $275,000 to $375,000. The other amendment, among other things, removed Alpha Natural Resources, Inc. from the application of most of the restrictive covenants and added exceptions to certain other covenants relating to payment of dividends and distributions.
On April 7, 2008, the Company completed a public offering of $287,500 aggregate principal amount of 2.375% convertible senior notes due 2015. The notes bear interest at a rate of 2.375% per annum, payable semi-annually in arrears on April 15 and October 15 of each year, beginning on October 15, 2008. The Notes will mature on April 15, 2015, unless previously repurchased by the Company or converted. The Company used the net proceeds from this offering and concurrent offering of common stock, in part, to repurchase $175,000 aggregate principal amount of the 10% senior notes due 2012, co-issued by ANR LLC and Alpha Natural Resources Capital Corp, resulting in a $14,669 loss on early extinguishment of debt. The notes are convertible in certain circumstances and in specified periods (as described in the Supplemental Indenture) at an initial conversion rate of 18.2962 shares of common stock per $1,000 principal amount of notes, subject to adjustment upon the occurrence of certain events set forth in the Indenture. Upon conversion of notes, holders will receive cash up to the principal amount of the notes to be converted, and any excess conversion value will be delivered in cash, shares of common stock or a combination thereof, at the Company's election.
Since the Company retired its $175,000 10% senior notes and the 2.375% convertible senior notes due 2015 issued by the Company are not guaranteed by the Company’s subsidiaries, separate financial information with respect to the Company and its subsidiaries are no longer required.
On July 1, 2008, our $287,500 aggregate principal amount of 2.375% convertible senior notes due 2015 became convertible at the option of the holders and will remain convertible through September 30, 2008, the last trading day of the current fiscal quarter. The notes became convertible because the Company’s common stock exceeded the conversion threshold price of $71.06 per share (130% of the applicable conversion price of $54.66 per share) for at least twenty trading days within the thirty consecutive trading days ending June 30, 2008. As a result of the notes becoming convertible, in the second quarter of 2008, the Company is required to fully amortize the deferred debt issuance costs in the amount of $8,904 incurred with the issuance of the notes. In addition, the Company reclassified from long-term to short-term the $287,500 aggregate principal amount of 2.375% convertible senior notes due 2015 that became convertible on July 1, 2008 and will remain convertible through September 30, 2008. As of July 31, 2008, no holders have converted their notes.
The Credit Agreement places restrictions on the ability of ANR LLC and its subsidiaries to make distributions or loans to the Company. The net assets of ANR LLC are restricted, except for allowable distributions for the payment of income taxes, administrative expenses, payments on qualified debt, and, in certain circumstances, dividends or repurchases of common stock of the Company.
All of the Company borrowings under the Credit Agreement are at a variable rate, so the Company is exposed to the effect of rising interest rates. As of June 30, 2008, the Company has a $233,125 term loan outstanding with a variable interest rate based upon the 3-month London Interbank Offered Rate (“LIBOR”) (2.80% at June 30, 2008) plus the applicable margin (1.75% at June 30, 2008). To reduce the Company's exposure to rising interest rates, effective May 22, 2006, the Company entered into a pay-fixed, receive variable interest rate swap on the notional amount of $233,125 for a period of approximately six and one-half years. In effect, this swap converted the variable interest rates based on LIBOR to a fixed interest rate of 5.59% plus the applicable margin defined in the debt agreement for the remainder of our term loan. The Company accounts for the interest rate swap as a cash flow hedge and changes in fair value of the swap are recorded to other comprehensive income (loss). The critical terms of the swap and the underlying debt instrument that it hedges coincide, resulting in no hedge ineffectiveness being recognized in the income statement during the quarter ended June 30, 2008. The fair value of the swap at June 30, 2008 was $13,452 which was recorded in other liabilities in the condensed consolidated balance sheet and the offsetting unrealized loss of $10,425, net of tax benefit, was recorded in accumulated other comprehensive loss. As interest expense is accrued on the debt obligation, amounts in accumulated other comprehensive loss related to the derivative hedging instrument are reclassified into earnings to obtain a net cost on the debt obligation of 5.59% plus the applicable margin.
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(7) Asset Retirement Obligation
At June 30, 2008 and December 31, 2007, the Company has recorded asset retirement obligation accruals for mine reclamation and closure costs totaling $92,743 and $91,199, respectively. The portion of the costs expected to be incurred within a year in the amounts of $8,395 and $8,179 at June 30, 2008 and December 31, 2007, respectively, are included in accrued expenses and other current liabilities. These regulatory obligations are secured by surety bonds in the amount of $146,554 at June 30, 2008 and $142,471 at December 31, 2007. Changes in the reclamation obligation were as follows:
(8) Share-Based Compensation Awards
Share-based compensation expense measured in accordance with SFAS 123(R) totaled $11,586 ($8,918 net of tax or $0.13 per diluted share), which includes a $4,463 charge relating to stock grants to employees on May 1, 2008, and $1,393 ($1,048 net of tax or $0.02 per diluted share) for the three months ended June 30, 2008 and 2007, respectively. Share-based compensation expense measured in accordance with SFAS 123(R) totaled $14,575 ($11,215 net of tax or $0.16 per diluted share) and $4,064 ($3,085 net of tax or $0.05 per diluted share) for the six months ended June 30, 2008 and 2007, respectively.
As of June 30, 2008 and 2007, approximately 51% and 61%, respectively, of share-based compensation expense is reported as selling, general and administrative expenses, included in the Corporate and Eliminations category for segment reporting purposes (Note 14), and approximately 49% and 39%, respectively, is reported as a component of cost of sales, included in the Coal Operations and All Other segment for reporting purposes (Note 14). As of June 30, 2008 and 2007, approximately $202 and $192, respectively, of share-based compensation costs was capitalized as a component of inventories. Under SFAS 123(R), the Company is required to report the benefits of income tax deductions that exceed recognized compensation as cash flow from financing activities. The excess tax benefits during the three months ended June 30, 2008 and 2007 were $1,056 and $0, respectively, and $1,790 and $0 for the six months ended June 30, 2008 and 2007, respectively.
Stock option activity for the six months ended June 30, 2008 is summarized in the following table:
The aggregate intrinsic value of options outstanding at June 30, 2008 was $47,623 and the aggregate intrinsic value of exercisable options was $12,654. The total intrinsic value of options exercised during the three months ended June 30, 2008 and 2007 was $3,525 and $70, respectively, and for the six months ended June 30, 2008 and 2007 was $5,573 and $70, respectively. Cash received from the exercise of stock options during the three months ended June 30, 2008 and 2007 was $1,412 and $120, respectively, and $3,128 and $120 during the six months ended June 30, 2008 and 2007, respectively. As of June 30, 2008, $2,278 of unrecognized compensation cost related to stock options is expected to be recognized as expense over a weighted-average period of 1.53 years. The weighted average grant date fair value of options outstanding at June 30, 2008 and 2007 was $7.35 and $7.53, respectively.
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Restricted Stock Awards
Non-vested share award activity for the six months ended June 30, 2008 is summarized in the following table:
On May 1, 2008, the Company granted 25 shares of stock to all employees, except executive officers, at a grant date value of $48.59 per share subject to a ninety day hold before the shares could be sold. The fair value of non-vested restricted share awards is based on the closing stock price on the date of grant, and, for purposes of expense recognition, the total number of awards expected to vest is adjusted for estimated forfeitures. As of June 30, 2008, there was $11,124 of unamortized compensation cost related to non-vested shares, which is expected to be recognized as expense over a weighted-average period of 1.99 years.
Performance Share Awards
2008 Granted Awards
The Company granted 165,045 performance share awards in the first six months of 2008. Recipients of these awards can receive shares of the Company's common stock at the end of a performance period which ends on December 31, 2010, based on the Company's actual performance against pre-established operating income goals, strategic goals, and total shareholder return goals. In order to receive the shares, the recipient must also be employed by the Company on the vesting date. The performance share awards represent the number of shares of common stock to be awarded based on the achievement of targeted performance and may range from 0 percent to 150 percent of the targeted amount. The grant date fair value of the awards related to operating income targets is based on the closing price of the Company's common stock on the New York Stock Exchange on the grant date of the award and is being amortized over the performance period. The awards related to strategic goals do not meet the criteria for grant date pursuant to SFAS No. 123(R), Share-based Payments (as amended) (“SFAS 123(R)”). The fair value of the awards related to total shareholder return targets is based upon a Monte Carlo simulation and is being amortized over the performance period. For executive officers of the Company to receive these performance share awards, the Company must achieve a pre-determined EBITDA level during the performance period in addition to the criteria set for all other employees participating in the plan. The Company reassesses at each reporting date whether achievement of each of the performance conditions is probable, as well as estimated forfeitures, and adjusts the accruals of compensation expense as appropriate. At June 30, 2008, the Company assessed the operating income and total shareholder return targets as probable of achievement. As of June 30, 2008, there was $2,575 of unamortized compensation cost related to the performance share awards for 2008. This unamortized compensation cost is expected to be recognized over the periods ending December 31, 2010.
(9) Derivative Financial Instruments
Derivative financial instruments are accounted for in accordance with SFAS 133, which requires all derivative financial instruments to be reported on the balance sheet at fair value. Changes in fair value are recognized either in earnings or equity, depending on whether the transaction qualifies for hedge accounting and if so, the nature of the underlying exposure being hedged and how effective the derivatives are at offsetting price movements in the underlying exposure.
The Company accounts for certain forward purchase and forward sale coal contracts that do not qualify under the “normal purchase and normal sale” exception of SFAS 133 as derivatives and records these contracts as assets or liabilities at fair value. Changes in fair value of these coal derivative contracts have been recorded as an (increase) decrease in fair value of certain derivative instruments, net, and included as a component of costs and expenses in the consolidated statements of income. At June 30, 2008, the Company had unrealized gains (losses) on open purchase and open sales contracts of $69,338 and ($58,471), respectively. The unrealized gains of $69,338 in open purchases are recorded in prepaid expenses and other current assets. The unrealized losses on open sales contracts are recorded in accrued expenses and other current liabilities and other liabilities in the amount of $44,946 and $13,525, respectively.
The Company has utilized interest rate swap agreements to modify the interest characteristics of a portion of the Company's outstanding debt. The swap agreements essentially convert variable-rate debt to fixed-rate debt and have been designated as cash flow hedges. Changes in the fair value of interest rate swaps designated as hedging instruments of the variability of cash flows associated with floating rate and long-term debt obligations are reported in accumulated other comprehensive income (loss). These amounts are subsequently reclassified into interest expense in the same period in which the related floating rate debt obligation affects earnings.
The Company is also exposed to the risk of fluctuations in cash flows related to its purchase of diesel fuel. The Company has entered into diesel fuel swap agreements and diesel put options to reduce the volatility in the price of diesel fuel for its operations. The diesel fuel swap agreements and put options are not designated as hedges for accounting purposes and therefore the changes in fair value of these diesel fuel derivative instrument contracts have been recorded as an (increase) decrease in fair value of certain derivative instruments, net, and included as a component of costs and expenses in the consolidated statements of income. These diesel fuel swaps and put options use the NYMEX New York Harbor #2 Heating Oil futures contracts as the underlying commodity reference price. Any unrealized loss is recorded in other current liabilities and other liabilities and any unrealized gain is recorded in other current assets and other assets.
As of June 30, 2008, approximately 9,816 gallons or 74% of the Company's budgeted 2008 remaining diesel fuel usage has been capped with the swap agreements in which the Company has agreed to pay a fixed price and receive a floating price per gallon of diesel fuel. The fixed prices for the notional quantity of 9,816 gallons range from $2.39 to $3.93 per gallon for the last six months of 2008. In addition, as of June 30, 2008, the Company has in place swap agreements with respect to 19,100 gallons, at fixed prices ranging from $2.74 to $3.89 per gallon, which mature in 2009 to 2011. At June 30, 2008, the fair value of these diesel fuel swap agreements is an asset of $22,086 which is recorded in prepaid expenses and other current assets and other assets in the amount of $13,863 and $8,223, respectively.
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The Company has also employed an options strategy – both purchasing and selling put options – to protect cash flows in the event diesel prices decline. As of June 30, 2008, the Company had purchased put options for 5,185 gallons at strike prices ranging from $2.20 to $3.25 per gallon for the last six months of 2008, and 2,646 gallons for the first six months of 2009 at a strike price of $3.50 per gallon. In the event that diesel prices decline below the strike price, the Company can exercise the put options and sell the 7,831 gallons at the strike price, therefore reducing the negative impact of any of the swap agreements that have settlement prices above market. As of June 30, 2008, the Company had sold put options for 2,646 gallons at a strike price of $3.00 per gallon. This was part of a put spread strategy that effectively provided protection for market prices between $3.50 and $3.00. The Company did not perceive a meaningful amount of price risk below the $3.00 strike. Additionally, the put spread strategy provides the ancillary benefit of partially offsetting the upfront cash premiums required on the purchased put options. At June 30, 2008, the fair value of all these diesel fuel put options is a net asset of $616 of which $963 is recorded in prepaid expenses and other current assets and $347 is recorded in accrued expenses and other current liabilities.
(10) Fair Value Measurements>
The Company adopted SFAS No. 157, Fair Value Measurements (“SFAS 157”) on January 1, 2008. This statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Additionally, on January 1, 2008, the Company elected the partial adoption of SFAS 157 under the provisions of FSP FAS 157-2, which amends SFAS 157 to allow an entity to delay the application of this statement until January 1, 2009 for certain non-financial assets and liabilities. The adoption of SFAS 157 did not have a material impact on our consolidated financial statements.
The Company adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an Amendment of FASB Statement No. 115 (“SFAS 159”), on January 1, 2008. This standard permits entities to choose to measure many financial instruments and certain other items at fair value. The adoption of SFAS 159 did not impact our consolidated financial statements, as the Company elected not to measure any additional financial assets or liabilities at fair value other than those which were recorded at fair value prior to adoption.
SFAS 157 clarifies that fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset and liability. As a basis for considering such assumptions, SFAS 157 establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1 measurement) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy defined by SFAS 157 are as follows:
The following table sets forth by level within the fair value hierarchy the company's financial assets that were accounted for at fair value on a recurring basis as of June 30, 2008. As required by SFAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The company's assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels.
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The following methods and assumptions were used to estimate the fair values of the assets and liabilities in the tables above.
Level 2 Fair Value Measurements
Forward Coal Purchases and Sales — The fair value of the forward coal purchases and sales contracts were estimated using discounted cash flow calculations based upon forward commodity price curves. The curves were obtained from independent pricing services reflecting broker market quotes.
Diesel Fuel Derivatives — Since the Company’s diesel fuel derivative instruments are not traded on a market exchange, the fair values are determined using valuation models which include assumptions about commodity prices based on those observed in the underlying markets.
Interest Rate Swaps — The fair value of the interest rate swaps were estimated using discounted cash flow calculations based upon forward interest-rate yield curves. The curves were obtained from independent pricing services reflecting broker market quotes.
(11) Postretirement Benefits Other Than Pensions
The following table details the components of the net periodic benefit cost for the Company’s retiree medical plan (the “Plan”):
The Company provides current and certain retired employees and their dependents postretirement medical benefits by accruing the costs of such benefits over the service lives of employees. Premiums are paid by the Company based on years of service, with the difference contributed by the employee, if any. Employer contributions for postretirement medical benefits paid for the three months ended June 30, 2008 and 2007 were $50 and $33, respectively, and for the six months ended June 30, 2008 and 2007 were $82 and $65, respectively. Employee contributions are insignificant and the Plan is unfunded.
Two of the Company’s subsidiaries are required to make contributions to the 1974 UMWA Pension Plan and Trust and/or the 1993 UMWA Benefit Plan. The contributions made to these plans for the three months ended June 30, 2008 and 2007 were $53 and $24, respectively, and for the six months ended June 30, 2008 and 2007 were $98 and $49, respectively.
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(12) Comprehensive Income
Total comprehensive income is as follows for the three months and six months ended June 30, 2008:
The following table summarizes the components of accumulated other comprehensive loss at June 30, 2008:
(13) Commitments and Contingencies
(a) Guarantees and Financial Instruments with Off-balance Sheet Risk
In the normal course of business, the Company is a party to certain guarantees and financial instruments with off-balance sheet risk, such as bank letters of credit and performance or surety bonds. No liabilities related to these arrangements are reflected in the Company's condensed consolidated balance sheets. Management does not expect any material losses to result from these guarantees or off-balance sheet financial instruments. The amount of bank letters of credit, not including letters of credit issued under our Credit Agreement, outstanding as of June 30, 2008 was $82,195. The amount of surety bonds outstanding at June 30, 2008 related to the Company's reclamation obligations is presented in Note 7 to the condensed consolidated financial statements. The Company has provided guarantees for equipment financing obtained by certain of its contract mining operators totaling approximately $651 as of June 30, 2008. The estimated fair value of these guarantees is not significant.
The Company is a party to a number of legal proceedings incident to our normal business activities. While we cannot predict the outcome of these proceedings, we do not believe that any liability arising from these matters individually or in the aggregate should have a material impact upon our consolidated cash flows, results of operations or financial condition.
In December 2004, prior to the Company's Nicewonder Acquisition in October 2005, the Affiliated Construction Trades Foundation brought an action against the West Virginia Department of Transportation, Division of Highways (“WVDOH”) and Nicewonder Contracting, Inc. ("NCI"), which became the Company's wholly-owned indirect subsidiary after the Nicewonder Acquisition, in the United States District Court in the Southern District of West Virginia. The plaintiff sought a declaration that the contract between NCI and the State of West Virginia related to NCI's road construction project was illegal as a violation of applicable West Virginia and federal competitive bidding and prevailing wage laws. The plaintiff also sought an injunction prohibiting performance of the contract but has not sought monetary damages.
On September 5, 2007, the Court ruled that WVDOH and the Federal Highway Administration (which is now a party to the suit) could not, under the circumstances of this case, enter into a contract not requiring the contractor to pay the prevailing wages as required by the Davis-Bacon Act. Although the Court has not yet decided what remedy it will impose, the Company expects a ruling in 2008. The Company anticipates that the most likely remedy is a directive that the contract be renegotiated for such payment. If that renegotiation occurs, WVDOH has committed to agree, and NCI has a contractual right to insist, that additional costs resulting from the order will be reimbursed by WVDOH and as such neither NCI nor the Company believe, at this time, that they have any monetary expense from this ruling. As of June 30, 2008, the Company had a $7,025 long-term receivable for the recovery of these costs from WVDOH and a long-term liability for the obligations under the ruling.
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(14) Segment Information
The Company extracts, processes and markets steam and metallurgical coal from surface and deep mines for sale to electric utilities, steel and coke producers, and industrial customers. The Company operates only in the United States with mines in the Central Appalachian and Northern Appalachian regions. The Company has one reportable segment: Coal Operations, which as of June 30, 2008, consisted of 32 underground mines and 26 surface mines located in Central Appalachia and Northern Appalachia. Coal Operations also includes the Company's coal sales function, which markets the Company's Appalachian coal to domestic and international customers. The All Other category includes the Company's equipment sales and repair operations, as well as other ancillary business activities, including terminal services, coal and environmental analysis services, and leasing of mineral rights. In addition, the All Other category includes the operations of the Company's road construction businesses and the lime processing business being developed by the Company. The Corporate and Eliminations category includes general corporate overhead and the elimination of intercompany transactions. The revenue elimination amount represents inter-segment revenues. The Company evaluates the performance of its segment based on EBITDA which the Company defines as net income plus interest expense, income tax expense, and depreciation, depletion and amortization, less interest income.
Operating segment results and capital expenditures for the three months ended June 30, 2008 and segment assets as of June 30, 2008 were as follows:
Operating segment results and capital expenditures for the six months ended June 30, 2008 and segment assets as of June 30, 2008 were as follows:
Operating segment results and capital expenditures for the three months ended June 30, 2007 and segment assets as of June 30, 2007 were as follows:
Operating segment results and capital expenditures for the six months ended June 30, 2007 and segment assets as of June 30, 2007 were as follows:
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Reconciliation of total segment EBITDA to net income:
The Company markets produced, processed, and purchased coal to customers in the United States and in international markets. Export revenues totaled $418,548 and $636,991 or approximately 58% and 52% of total coal and freight revenues for each of the three months and six months ended June 30, 2008, respectively. Export revenues totaled $153,404 and $299,869 or approximately 36% and 35% of total coal and freight revenues, respectively, for each of the three months and six months ended June 30, 2007.
(15) Equity Offering
On April 7, 2008, concurrent with the issuance of the $287,500 aggregate principal amount of 2.375% convertible notes due 2015 (See Note 6), the Company completed its public offering of 4,181,817 shares of common stock at a public offering price of $41.25 per share, including 545,454 shares granted to the underwriters to cover over allotments. The net proceeds from the common stock offering were $164,666 after commissions and expenses.
(16) Subsequent Events
On July 15, 2008, the Company entered into a definitive merger agreement pursuant to which, and subject to the terms and conditions thereof, Cleveland-Cliffs Inc. would acquire all outstanding shares of the Company in a stock and cash transaction. Under the terms of the agreement, for each share of the Company’s common stock, Company stockholders would receive 0.95 Cleveland-Cliffs Inc.’s common shares and $22.23 in cash.
The transaction is subject to shareholder approval as well as the satisfaction of customary closing conditions and regulatory approvals, including expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976. The transaction is expected to close by the end of 2008. The agreement contains customary break up fees if the transaction does not close.
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You should read the following discussion and analysis in conjunction with our financial statements and related notes included elsewhere in this report and our Annual Report on Form 10-K for the year ended December 31, 2007. Unless we have indicated otherwise, or the context otherwise requires, references in this report to “Alpha,” “the Company,” “we,” “us” and “our” or similar terms are to Alpha Natural Resources, Inc. and its consolidated subsidiaries.
Cautionary Note Regarding Forward Looking Statements
This report includes statements of our expectations, intentions, plans and beliefs that constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 and are intended to come within the safe harbor protection provided by those sections. These statements, which involve risks and uncertainties, relate to analyses and other information that are based on forecasts of future results and estimates of amounts not yet determinable and may also relate to our future prospects, developments and business strategies. We have used the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “project,” “should” and similar terms and phrases, including references to assumptions, in this report to identify forward-looking statements. These forward-looking statements are made based on expectations and beliefs concerning future events affecting us and are subject to uncertainties and factors relating to our operations and business environment, all of which are difficult to predict and many of which are beyond our control, that could cause our actual results to differ materially from those matters expressed in or implied by these forward-looking statements.
The following factors are among those that may cause actual results to differ materially from our forward-looking statements:
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When considering these forward-looking statements, you should keep in mind the cautionary statements in this report and the documents incorporated by reference. We do not undertake any responsibility to release publicly any revisions to these forward-looking statements to take into account events or circumstances that occur after the date of this report. Additionally, we do not undertake any responsibility to update you on the occurrence of any unanticipated events which may cause actual results to differ from those expressed or implied by the forward-looking statements contained in this report.
We produce, process and sell steam and metallurgical (met) coal from eight regional business units, which, as of June 30, 2008, were supported by 32 active underground mines, 26 active surface mines and 11 preparation plants located throughout Virginia, West Virginia, Kentucky, and Pennsylvania, as well as a road construction business in West Virginia and Virginia that recovers coal. We also sell coal produced by others, the majority of which we process and/or blend with coal produced from our mines prior to resale, providing us with a higher overall margin for the blended product than if we had sold the coals separately. For the three months and six month ended June 30, 2008, sales of steam coal were 4.4 and 8.3 million tons, respectively, and accounted for approximately 56% and 57%, respectively, of our coal sales volume. For the three and six months ended June 30, 2008, sales of metallurgical coal, which generally sells at a premium over steam coal, were 3.4 and 6.3 million tons, respectively, and accounted for approximately 44% and 43%, respectively, of our sales volume. Our sales of steam coal were made to large utilities and industrial customers in the Eastern region of the United States, and our sales of metallurgical coal were made to steel companies in the Northeastern and Midwestern regions of the United States and in several countries in Europe, South America, Africa and Asia. Approximately 52% of our coal sales and freight revenue in the first six months of 2008 was derived from sales made outside the United States, primarily in Turkey, Brazil, Egypt, Hungary, Canada, and Russia.
We also own 94% of Gallatin Materials, LLC (“Gallatin”), a lime manufacturing business in Verona, Kentucky. Gallatin completed the construction of the first of possibly two rotary pre-heater lime kilns in the first quarter, which produces lime for sale to steel producers for use as flux in electric arc and basic oxygen furnaces and municipalities for use in their water treatment facilities. We also expect future sales to coal burning utilities as a scrubbing agent for removing sulfur dioxide from flue gas. The minority owners were granted restricted membership interests in Gallatin, which vest based on performance criteria over a period of approximately three years from the closing date and which, if earned in their entirety, would reduce our ownership to 77.5%.
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In addition, we generate other revenues from equipment and parts sales, equipment repair, road construction, rentals, royalties, commissions, coal handling, terminal and processing fees, and coal and environmental analysis fees. We also record revenue for freight and handling charges incurred in delivering coal to our customers, which we treat as being reimbursed by our customers. However, these freight and handling revenues are offset by equivalent freight and handling costs and do not contribute to our profitability.
Our primary expenses are for wages and benefits, supply costs, repair and maintenance expenditures, cost of purchased coal, royalties, freight and handling costs, and taxes incurred in selling our coal. Historically, our cost of coal sales per ton is lower for sales of our produced and processed coal than for sales of purchased coal that we do not process prior to resale.
We have one reportable segment, Coal Operations, which includes all of our revenues and costs from coal production and sales, freight and handling, rentals, commissions, coal handling and processing operations and coal recovery incidental to our road construction operations. These revenues and costs included in our Coal Operations segment are reported by us in our coal revenues and cost of coal sales, except for the revenues and costs from rentals, commissions, and coal handling and processing operations, which we report in our other revenues and cost of other revenues, respectively.
In March 2008, we sold our equity interest in Fox River Dock Company, Inc., a coal terminal, which we acquired with the acquisition of Coastal Coal Company, LLC on March 11, 2003, to the majority holder of Fox River for $1.5 million in cash. We recognized a gain of $0.4 million from this transaction.
In March 2008, we and our subsidiary, ANR LLC, entered into two amendments to our senior secured credit facility. One of these amendments increased the amount available under the revolving credit portion of the facility from $275.0 million to $375.0 million. The other amendment, among other things, removed Alpha Natural Resources, Inc. from the application of most of the restrictive covenants and added exceptions to certain other covenants relating to payment of dividends and distributions.
On April 7, 2008, we completed concurrent public offerings of 4,181,817 shares of common stock at $41.25 per share and $287.5 million aggregate principal amount of 2.375% convertible senior notes due 2015. The aggregate net proceeds from the common stock offering and the notes offering were $443.3 million after commissions and expenses. We used the net proceeds from the offerings in part to repurchase $175.0 million aggregate principal amount of the 10% senior notes due 2012, co-issued by ANR LLC and Alpha Natural Resources Capital Corp. As a result, in the second quarter of 2008, we recorded a loss relating to the early extinguishment of debt of $14.7 million, consisting of $10.7 million in tender offer consideration and $4.0 million in write-off of unamortized deferred debt issuance costs.
On April 30, 2008, our subsidiary, Alpha Terminal Company, LLC, increased its equity ownership position in Dominion Terminal Associates (“DTA”) from 32.5% to 40.6% by making an additional investment of $2.8 million. DTA is a 20 million-ton annual capacity coal export terminal located in Newport News, Virginia. The terminal, constructed in 1982, provides the advantages of unloading/transloading equipment with ground storage capability, providing producers with the ability to custom blend export products without disrupting mining operations. This transaction maintains our largest ownership stake in the facility, effectively increasing our coal export and terminaling capacity from approximately 6.5 million tons to approximately 8.0 millions tons annually.
On May 1, 2008, we granted each of our employees except our executive officers 25 shares of our stock with a 90-day holding period to reward them for their past service and role in the Company’s financial success. As a result, in the second quarter of 2008, the Company recorded a charge of $7.2 million, which consists of $4.5 million in share-based compensation expense and $2.7 million as a cash bonus on behalf of the employees to cover the required tax withholding associated with the stock grant.
On July 1, 2008, our $287.5 million aggregate principal amount of 2.375% convertible senior notes due 2015 became convertible at the option of the holders and will remain convertible through September 30, 2008, the last trading day of the current fiscal quarter. The notes became convertible because the Company’s common stock exceeded the conversion threshold price of $71.06 per share (130% of the applicable conversion price of $54.66 per share) for at least twenty trading days within the thirty consecutive trading days ending June 30, 2008. As a result of the notes becoming convertible, in the second quarter of 2008, the Company is required to fully amortize the deferred debt issuance costs in the amount of $8.9 million incurred with the issuance of the notes. As of July 31, 2008, no holders have converted their notes.
On July 15, 2008, the Company entered into a definitive merger agreement pursuant to which, and subject to the terms and conditions thereof, Cleveland-Cliffs Inc. would acquire all outstanding shares of the Company in a cash and stock transaction. Under the terms of the agreement, for each share of the Company’s common stock, Company stockholders would receive 0.95 Cleveland-Cliffs Inc.’s common shares and $22.23 in cash.
Coal Pricing Trends, Uncertainties and Outlook
Coal supply continues to tighten around the world as demand continues to increase. While traditional coal exporting nations such as Australia, Poland, Indonesia and South Africa have been subject to supply disruptions or voluntary cutbacks, U.S. exports of both thermal and metallurgical coal have shown sustained strength. With world steel output climbing, prices for metallurgical coal have risen quickly as has international demand.
Rising natural gas prices and the U.S. dollar’s weakness are adding fuel to thermal coal demand both domestically and overseas, while high steel prices have mills searching the world for reliable supplies of metallurgical coal. U.S. steel mills, in particular, are striving to maintain inventories at service centers at a time of increased production to avoid record high steel prices. In this environment, Alpha continues its strategy of gradually layering in sales commitments at favorable prices.
As of July 23, 2008, we had committed 98% of planned thermal coal production for 2008 while leaving approximately 13% of planned production uncommitted for 2009 and 62% for 2010. We are in active discussions with a number of U.S. utilities for supply in 2009 and beyond.
With steel prices rising at the end of 2007, and the domestic steel industry expecting a strong rebound this year after a dramatic draw down of service center inventories, demand for metallurgical coal has remained very strong. Global supplies of hard coking coals for making steel have tightened considerably due to production and logistical issues in Eastern Europe and Australia.
As the largest exporter of metallurgical coal out of the U.S., we have experienced a surge of 778,000 tons in second-quarter exports, year-over-year, which boosted total met coal sales to 44% of the company’s total sales volumes for the quarter. Due to the fact that pricing resets at the end of the first quarter of every year for the majority of our contracted metallurgical business, we achieved a proportionally higher level of revenues in the second quarter than in the first, and we expect to continue to achieve proportionally higher revenues in the third and fourth quarters than in the first quarter as the higher-priced export contracts continue to phase in. As of July 23, 2008, we had approximately 0.4 million tons of planned metallurgical production remaining to be contracted for 2008. Uncommitted and unpriced production stands at approximately 10.1 million tons, approximately78% of our planned production, for 2009 and approximately 11.4 million tons, approximately 89% of our planned production, for 2010.
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While our outlook on coal pricing remains positive, future coal prices are subject to factors beyond our control and we cannot predict whether or for how long this current coal pricing environment will continue. As of July 23, 2008, 97% of our planned 2008 production was committed and priced and 3% was uncommitted and unpriced, with approximately 0.4 million tons uncommitted. Committed steam coal prices for 2008 average $50.12 per ton and met coal prices average $110.85 per ton. Approximately 57% of our planned production in 2009 is committed.
At June 30, 2008, we had unrealized gains (losses) on open purchase and sale contracts that meet the definition of a derivative under SFAS 133 in the amount of $69.3 million and ($58.5 million), respectively. These assets are recorded in prepaid expenses and other current assets and $45.0 million of the liabilities are recorded in accrued expenses and other current liabilities and the remaining $13.5 million of liabilities are recorded in other liabilities on our balance sheet, with periodic changes in fair value recorded to the income statement. Since we intend to take delivery or provide delivery of coal under these contracts, the unrealized gains and losses recorded as of June 30, 2008 will reverse into the income statement in future periods. The reversal of the net unrealized gains related to these contracts will result in higher costs of sales in future periods when we ultimately take delivery of the coal under these contracts and sell it to our customers. In addition, as of June 30, 2008, we had an unrealized gain on diesel swap agreements and put options that met the definition of a derivative under SFAS 133 that are marked to market in the amount of $22.1 million and $0.6 million, respectively. Due to market price fluctuations, we could experience significant earnings volatility related to coal contracts, diesel swap agreements, and diesel put options that are classified as derivatives.
We own a 24.5% interest in Excelven Pty Ltd., a coal mine development project located in Venezuela accounted for under the equity method. The project, currently in the developmental stage, is challenged by political risk. In particular, the Venezuelan government has expressed an interest in increasing government ownership in Venezuelan natural resources. Any future deterioration in the political environment in Venezuela or the government’s denial of the Affectation of Resources permit could lead to a potential impairment adjustment. In addition, such political and economic uncertainties could also lead to events such as civil unrest, work stoppages or the nationalization or other expropriation of private enterprises by the Venezuelan government, which could result in a loss of all or a portion of our investment in Excelven, which is approximately $4.6 million as of June 30, 2008.
For additional information regarding some of the risks and uncertainties that affect our business, see Item 2 of this report, and Item 1A “Risk Factors,” in our Annual Report on Form 10-K.
Reconciliation of Non-GAAP Measures
EBITDA is defined as net income plus interest expense, income tax expense, and depreciation, depletion and amortization, less interest income. EBITDA is a non-GAAP measure used by management to measure operating performance, and management also believes it is a useful indicator of our ability to meet debt service and capital expenditure requirements. Because EBITDA is not calculated identically by all companies, our calculation may not be comparable to similarly titled measures of other companies.
The following unaudited table reconciles EBITDA to net income, the most directly comparable GAAP measure.
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Results of Operations
Three Months Ended June 30, 2008 Compared to the Three Months Ended June 30, 2007
For the three months ended June 30, 2008, we recorded revenues of $732.2 million compared to $435.3 million for the three months ended June 30, 2007, an increase of $296.9 million. Net income increased from $4.7 million ($0.07 per diluted share) in the second quarter of 2007 to $74.3 million ($1.04 per diluted share) for the second quarter of 2008. EBITDA, as reconciled to our net income in the table under “Reconciliation of Non-GAAP Measures” above, was $141.8 million and $53.7 million in the second quarter of 2008 and 2007, respectively.
Our results for the second quarter of 2008 include a benefit of $17.9 million ($0.25 per diluted share) from reversing a portion of our existing valuation allowance for deferred tax assets, of which $11.2 million ($0.16 per diluted share) was recognized as a discrete item with the effect of reducing income tax expense, charges in the amount of $14.7 million ($11.3 million net of tax or $0.16 per diluted share) for a loss on early extinguishment of debt, $8.9 million ($6.9 million net of tax or $0.10 per diluted share) of interest expense from the full amortization of debt issuance costs related to the 2.375% convertible senior notes due 2015 which became convertible on July 1, 2008, $15.6 million ($12.0 million net of tax or $0.17 per diluted share) related to our employee appreciation and retention program and other incentive plans, and $6.5 million in unrealized gains related to changes in the fair value of derivative contracts ($5.0 million net of tax or $0.07 per diluted share).
We sold 7.8 million tons of coal during the second quarter of 2008, 0.9 million more than the comparable period in 2007. Coal margin, which we define as coal revenues less cost of coal sales, divided by coal revenues, increased from 16.8% in the second quarter of 2007 to 26.8% in the second quarter of 2008. Coal margin per ton was $21.85 in the second quarter of 2008, a 130% increase from the second quarter of 2007. Coal margin per ton is calculated as coal sales realization (sales price) per ton less cost of coal sales per ton.