* Peabody spinoff had aimed to dominate Appalachia coal
* Five years later, Patriot files for Ch. 11 protection
* Recession, crippling $2 bln legacy liabilities cited
By Steve James
July 13 When Patriot Coal was spun off by Peabody Energy Corp five years ago, it aimed to become the dominant producer in the Appalachian coalfields, buying up small, struggling mining companies and increasing production to cater to growing demand from power companies and steelmakers.
For a while, Patriot was a darling of Wall Street, its stock rising from $15 at its IPO on Oct. 31, 2007, to an all-time high of $80.70 on June 18, 2008.
During the same period, the shares of Peabody, which had shifted its focus to lower-cost mines in Wyoming and lucrative, export-oriented mines in Australia, nearly doubled from $44.65 to $88.69.
Then the recession hit.
Patriot had only one profitable quarter since the spinoff, and on Monday it filed for Chapter 11 bankruptcy protection. It is continuing to operate, but has cut 1,000 of its 4,700 workforce, idled some of its 19 underground mines and lowered sales targets.
Patriot, like most of its peers, was rocked a year after its spinoff when the economy went into a slide, sending coal prices tumbling, along with demand from utilities and steelmakers.
But the downturn also prevented Patriot from achieving its stated goal of acquiring other assets and becoming the premier coal company in Appalachia.
As a smaller producer with lower revenue, Patriot had trouble obtaining adequate financing. In addition, it was saddled with legacy pension and health cost liabilities of around $2 billion -- almost twice that of Peabody, a company that produces 10 times as much coal.
"The coal industry is undergoing a major transformation and Patriot's existing capital structure prevents it from making the necessary adjustments to achieve long-term success," Chairman and CEO Irl Engelhardt said in a statement on the day of the Chapter 11 filing.
Peabody declined comment on Patriot's Chapter 11 filing.
Despite Patriot's bankruptcy, analysts do not expect a wave of similar action by publicly traded coal companies, although many smaller, independent mining companies are vulnerable, they say.
"Others hope to weather the storm, but for Patriot the storm hit hard," said Lucas Pipes, an analyst with Brean Murray, Carret & Co.
It was not supposed to turn out this way.
Peabody had such confidence in Patriot's prospects in 2007 that several high-level Peabody veterans joined the young company's management team, including Engelhardt, a former Peabody CEO with a sterling reputation in the industry.
Engelhardt was Patriot's chairman, and in May this year added the CEO post when he replaced Richard Whiting.
Patriot's growth strategy looked appealing at a time when the long-term outlook for coal was bright, according to the IPO filing. "With its strong presence in Appalachia, Patriot will be positioned to be a consolidator in that highly fragmented region," Peabody said in a letter to shareholders.
"It was a good idea at the time," said analyst Bill Burns, of Johnson Rice & Co in New Orleans, referring to the spinoff.
Patriot shareholders were given a rosy outlook by Peabody. "We believe strong coal markets will continue worldwide, as long as growth continues in the U.S., Asia and other industrialized economies that are increasing coal demand for electricity generation and steelmaking," it said in the filing.
But Peabody also warned that Patriot was assuming "significant" legacy liabilities with the assets it took over.
In its first year, strong coal prices and demand offset the higher costs of mining in the older coalfields of eastern Kentucky, West Virginia and Virginia. But the recession hit and coal demand fell, sending down prices along with Patriot's stock.
Patriot was able to acquire only one other asset -- a subsidiary of Arch Coal called Magnum.
Then this year, demand sharply dropped when the mild winter depressed electricity use and some power companies switched from coal as natural gas prices made it a more economical fuel.
Patriot responded by cutting its workforce and production, lowering its 2012 sales target to 25 million to 27 million tons -- down from the 31 million it sold last year. Revenue in the first quarter of this year declined 13 percent to $502 million.
With less revenue, the company struggled to pay pensions and healthcare to workers and retirees, while debt repayments on $200 million in convertible notes due next year loomed.
On May 8, Patriot posted a wider-than-expected quarterly loss, but at the same time announced it had signed a $625 million revolving credit facility and term loan.
Just a week later, Patriot warned that a major customer might default on a contract, setting off a stock drop that ended with the Chapter 11 filing and Patriot shares at just 61 cents.
The company did not reveal which customer defaulted, but in the Chapter 11 filing, Chief Financial Officer Mark Schroeder identified two -- Bridgehouse Commodities Trading Ltd and Keystone Industries -- and Patriot has sued both for breach of contract.
Florida-based Keystone did not respond to a Reuters request for comment. Bridgehouse, which is registered in the Isle of Man, could not immediately be reached.
Patriot suggested in its May 14 statement that the deals amounted to a total of about 1 million tons of steelmaking coal, or 20 percent of its 2012 sales target for that coal type.
In its Chapter 11 filing, St Louis-based Patriot said it has $3.57 billion in assets and $3.07 billion of liabilities. It has arranged for $802 million of financing to help it continue operating through reorganization.
"This outcome was not fully unexpected given the inability for Patriot to refinance debt immediately following the contract default," said analyst Curt Woodworth of Nomura.
He forecast Patriot's negative free cash flow will worsen, growing to $172 million in 2013 compared with $157 million this year.
Pipes said Peabody and Arch could be financially affected by Patriot's filing. A Peabody filing with the SEC lists potential liabilities of less than $150 million due to federal and state black lung occupational disease liabilities, which had been assumed by Patriot.
Arch listed potential obligations due to contracts acquired by Magnum as about $64 million.