Small Market Deal of the Year –

Last year, a sale-leaseback maneuver by Questor Management gave the firm and its platform, PinnOak Resources, the chance to turn around two struggling coal mines with tons of potential at a very low price.

In July, Questor-backed PinnOak acquired the mines from U.S. Steel, getting $300 million worth of assets for $67 million in equity. The very next week, the firm turned around and sold the mines in a sale/leaseback deal for $58 million. Now, it leases the assets from the new owner, Houston-based Natural Resource Partners, operating the mines and collecting returns minus a six percent royalty payment to the owner.

“In the end, we had $9 million in a deal that made $7 million in EBITDA in the first two months,” says Michael Madden, a principal at Questor who was involved in the transaction.

The sale/leaseback move is a financing strategy that has come into fashion in the last few years for buyout pros. They sell a piece of real estate from a portfolio company to a third party, freeing up capital for an acquisition, recapitalization, or even just to restructure the balance sheets. The company then leases the property back from the investor. In this case, it left Questor with very little capital invested in a deal that could prove to be quite lucrative.

After losing $5 million to $10 million per year in EBITDA under U.S. Steel, Madden expects the coal mines to have operational cash flows of $30 million for the next few years, resulting from a turnaround orchestrated by coal industry veteran Benjamin Statler. Statler’s leadership, coupled with Questor’s sale/leaseback strategy, makes this small-market deal a standout in 2003.

Statler’s Success

In 1999, Statler, now the president and chairman of PinnOak, retired as senior vice president of mining at CONSOL Inc., where he specialized in turning around underperforming mines, and scoured the market for new opportunities. Three years later he approached Questor, looking for capital he could use to acquire U.S. Steel’s coal mining assets-specifically Pinnacle Mining, located at Pineville, W. Va., and Oak Grove Resources, located near Birmingham, Ala.

“With our background the in energy and natural resources markets, we had been looking for deals in this space but hadn’t found anything we liked,” says Madden. “Then Ben came to us, and we found the opportunity to partner with him to be very compelling.” Madden said he was also attracted by the prospect of buying $300 million worth of assets for $58 million, plus some working capital.

Together, they formed PinnOak and spent nine months in due diligence and negotiating with U.S. Steel before the transaction was finally completed in July with a term loan and revolver provided by Foothill Capital Corp. (At press time, that facility had not been drawn down.) Shortly thereafter workforce reductions were announced, and PinnOak cut staffing costs at the mines by 40% through layoffs.

“The employee cost-base at the mines was much too high,” says Madden. “A steel company operating a coal mining operation is not a good combination. They were not operating the mines correctly.”

According to Madden, the mines also suffered from shoddy sales and marketing departments. PinnOak restructured the organizations, and within weeks, the mines operated with positive cash flow. “That’s one hell of a turnaround that Ben and his guys accomplished,” he adds.

The majority of PinnOak’s coal is sold to domestic and foreign steel producers. U.S. Steel is its biggest customer, buying roughly a quarter. In 2002, the two mines produced a combined 5.5 million tons of metallurgical coal-a type of coal that is limited in supply and vital to the steel production process. Madden says the mines should be producing 7.5 to 8 million tons annually.

“Through these mines, we control 40% of this type of coal in the country,” he says. “We are going to do well even if the integrated steel business in the country declines.”

Pushing Past The Problems

Despite Questor’s optimism, the forces of nature have wreaked havoc at the Pinnacle Mine in the last few months, showing the uncertainty that exists in the industry. A methane explosion in the mine that the firm blames on a Labor Day lightening strike has halted operations. Federal and state regulators have barred PinnOak from entering the mine, and the company does not expect to reopen production again for several months.

However, Questor doesn’t expect to lose financially. “The mine is shut down due to forces that are beyond our control, but luckily, our investment is insured for these kinds of unexpected work stoppages,” says Robert Denious, a managing director with Questor. “Financially, this will not affect our investment.”

Madden foresees several potential exit scenarios for Questor in the long term with respect to PinnOak. He says it’s possible that the firm will hold on to the investment for the long term, possibly recapitalizing it, and collect dividends every year. Otherwise, Pinnoak could be built into a company that is big enough to access the public markets or be sold to a strategic player in the public market.