TMCnet News
ARMSTRONG ENERGY, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of financial condition and results of operations should be read in conjunction with our unaudited consolidated financial statements and related notes included in Item 1 of Part I of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and related notes included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (the SEC) on March 25, 2014. CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS Various statements contained in this quarterly report, including those that express a belief, expectation or intention, as well as those that are not statements of historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). These forward-looking statements may include projections and estimates concerning the timing and success of specific projects and our future production, revenues, income and capital spending. Our forward-looking statements are generally accompanied by words such as "estimate," "project," "predict," "believe," "expect," "anticipate," "potential," "plan," "goal" or other words that convey the uncertainty of future events or outcomes. The forward-looking statements in this quarterly report speak only as of the date of this quarterly report; we disclaim any obligation to update these statements unless required by law, and we caution you not to rely on them unduly. We have based these forward-looking statements on our current expectations and assumptions about future events. While our management considers these expectations and assumptions to be reasonable, they are inherently subject to significant business, economic, competitive, regulatory and other risks, contingencies and uncertainties, most of which are difficult to predict and many of which are beyond our control. These and other important factors may cause our actual results, performance or achievements to differ materially from any future results, performance or achievements expressed or implied by these forward-looking statements. These risks, contingencies and uncertainties include, but are not limited to, the following: • market demand for coal and electricity; • geologic conditions, weather and other inherent risks of coal mining that are beyond our control; • competition within our industry and with producers of competing energy sources; • excess production and production capacity; • our ability to acquire or develop coal reserves in an economically feasible manner; • inaccuracies in our estimates of our coal reserves; • availability and price of mining and other industrial supplies, including steel-based supplies, diesel fuel, rubber tires and explosives; • the continued weakness in global economic conditions or in any industry in which our customers operate, or sustained uncertainty in financial markets, which may cause conditions we cannot predict; • the disruption of rail, barge and other systems that deliver our coal; • coal users switching to other fuels in order to comply with various environmental standards; • volatility in the capital and credit markets; • availability of skilled employees and other workforce factors; • disruptions in the quantities of coal produced at our operations as a consequence of weather or equipment or mine failures; • our ability to collect payments from our customers; • defects in title or the loss of a leasehold interest; • railroad, barge, truck and other transportation performance and costs; • our ability to secure new coal supply arrangements or to renew existing coal supply arrangements; • our relationships with, and other conditions affecting, our customers; • the deferral of contracted shipments of coal by our customers; • our ability to service our outstanding indebtedness; • our ability to comply with the restrictions imposed by our revolving credit facility, the indenture governing our notes and other financing arrangements; • the availability and cost of surety bonds; • terrorist attacks, military action or war; • our ability to obtain and renew various permits, including permits authorizing the disposition of certain mining waste; • existing and future legislation and regulations affecting both our coal mining operations and our customers' coal usage, governmental policies and taxes, including those aimed at reducing emissions of elements such as mercury, sulfur dioxide, nitrogen oxides, or toxic gases, such as hydrogen chloride, particulate matter or greenhouse gases; • the accuracy of our estimates of reclamation and other mine closure obligations; • our customers' ability to meet existing or new regulatory requirements and associated costs, including disposal of coal combustion waste material; • our ability to attract and retain key management personnel; and • efforts to organize our workforce for representation under a collective bargaining agreement. 20 -------------------------------------------------------------------------------- Table of Contents When considering these forward-looking statements, you should keep in mind the cautionary statements in this document and in our other SEC filings, including the more detailed discussion of these factors and other factors that could affect our results included in "Risk Factors" in our Annual Report on Form 10-K filed with the SEC on March 25, 2014. Overview Armstrong Energy, Inc. (together with its subsidiaries, we or the Company) is a diversified producer of low chlorine, high sulfur thermal coal from the Illinois Basin, with both surface and underground mines. We market our coal primarily to proximate and investment grade electric utility companies as fuel for their steam-powered generators. Based on 2013 production, we are the fifth largest producer in the Illinois Basin and the second largest in Western Kentucky. We were formed in 2006 to acquire and develop a large coal reserve holding. We commenced production in the second quarter of 2008 and currently operate seven mines, including four surface and three underground, and are seeking permits for three additional mines. We control approximately 571 million tons of proven and probable coal reserves. Our reserves and operations are located in the Western Kentucky counties of Ohio, Muhlenberg, McLean, Union and Webster. We also own and operate three coal processing plants, which support our mining operations. From our reserves, we mine coal from multiple seams that, in combination with our coal processing facilities, enhance our ability to meet customer requirements for blends of coal with different characteristics. The locations of our coal reserves and operations, adjacent to the Green River, together with our river dock coal handling and rail loadout facilities, allow us to optimize our coal blending and handling, and provide our customers with rail, barge and truck transportation options. We market our coal primarily to large utilities with coal-fired, base-load, scrubbed power plants under multi-year coal supply agreements. Our multi-year coal supply agreements usually have specific volume and pricing arrangements for each year of the agreement. These agreements allow customers to secure a supply for their future needs and provide us with greater predictability of sales volume and sales prices. At June 30, 2014, we had coal supply agreements with eight customers for terms ranging from one to six years. We are contractually committed to sell 9.8 million tons of coal in 2014 and 8.2 million tons of coal in 2015. The average price per committed ton for 2014 is $46.81 and the average price per committed ton for 2015 is $48.19. Our principal expenses related to the production of coal are labor and benefits, equipment, materials and supplies (explosives, diesel fuel and electricity), maintenance, royalties and excise taxes. Unlike some of our competitors, we employ a completely non-union workforce. Many of the benefits of our non-union workforce are related to higher productivity and are not necessarily reflected in our direct costs. In addition, while we typically do not pay our customers' transportation costs, they may be substantial and are often the determining factor in a coal consumer's contracting decision. Recent Developments Lewis Creek Underground Mine Our Lewis Creek underground mine, which produces coal from the West Kentucky #9 seam, has experienced significant operating inefficiencies since July 2013 due to the geological conditions of the portion of the reserve being mined. As a result of the ongoing mining difficulties, the decision was made at the end of the first quarter of 2014 not to continue advancing under the current mine plan, but rather to retreat and mine only in the eastern portion of the reserve, which is expected to be fully depleted in the first half of 2015. The mine plan was initially changed to abandon the existing portal to the Lewis Creek underground mine and relocate all of the equipment to our other mining operations. However, during the second quarter of 2014, we began obtaining drill samples and performed analysis of the West Kentucky #8 coal seam, which lies beneath the currently mined seam. We continue to analyze the information and are considering a further change to the mine plan to drive an additional slope deeper to the West Kentucky #8 seam. As a result, we have delayed the decision to abandon the portal at the Lewis Creek underground mine until we have completed our assessment on the feasibility of mining the lower seam, which is expected to be done in the third quarter of 2014. Coal Mine Dust Regulations On Oct. 19, 2010, the U.S. Mine Safety and Health Administration (MSHA) published a proposed rule regulating miners' exposure to respirable coal mine dust in all underground and surface coal mines. On April 23, 2014, MSHA issued a final rule with respect to the issue which, among other things, reduces the overall dust standard from 2.0 mg to 1.5 mg per cubic metre of air and cuts in half the standard from 1.0 to 0.5 for certain mine entries and miners with pneumoconiosis. The rule also requires mine operators to install devices to continuously monitor a mine's dust levels, and take immediate action when levels are too high. Some of the costs of complying with the new dust standards may be passed on to our customers, based on the terms of our long-term contracts. The new rule has a staggered implementation with some of the provisions requiring compliance by August 2014, while certain provisions, including continuous monitoring of coal mine dust concentrations and the overall reduction in the limit of respirable coal mine dust, will not be effective until 2016. We are reviewing the final rule and evaluating its potential effects on our financial condition and results of operations. 21-------------------------------------------------------------------------------- Table of Contents Results of Operations Non-GAAP Financial Information Adjusted EBITDA, as presented in this Quarterly Report on Form 10-Q, is a supplemental measure of our performance that is not required by, or presented in accordance with, accounting principles generally accepted in the United States ("GAAP"). It is not a measurement of our financial performance under GAAP and should not be considered as an alternative to net income (loss) or any other performance measures derived in accordance with GAAP or as an alternative to cash flows from operating activities as measures of our liquidity. We define "Adjusted EBITDA" as net income (loss) before deducting net interest expense, income taxes, depreciation, depletion and amortization, asset retirement obligation expense, non-cash production royalty for related party, loss on settlement of interest rate swap, loss on deferment of equity offering, gain on settlement of asset retirement obligations, non-cash stock compensation expense, non-cash charges related to non-recourse notes, gain on deconsolidation, and (gain) loss on extinguishment of debt. We caution investors that amounts presented in accordance with our definition of Adjusted EBITDA may not be comparable to similar measures disclosed by other issuers, because not all issuers and analysts calculate Adjusted EBITDA in the same manner. We present Adjusted EBITDA because we consider it an important supplemental measure of our performance and believe it is useful to an investor in evaluating our company. We also include a quantitative reconciliation of Adjusted EBITDA to the most directly comparable GAAP financial performance measure, which is net income (loss), in the sections that follow. Three Months Ended June 30, 2014 Compared to Three Months Ended June 30, 2013 Summary Three Months Ended June 30, Change 2014 2013 Amount Percentage (In thousands, except per ton amounts) Tons of coal sold 2,475 2,241 234 10.4 % Total revenue $ 116,287 $ 101,244 $ 15,043 14.9 % Average sales price per ton $ 46.98 $ 45.18 $ 1.80 4.0 % Cost of coal sales2 $ 95,166 $ 80,241 $ (14,925 ) (18.6 %) Average cost of sales per ton2 $ 38.45 $ 35.81 $ (2.64 ) (7.4 %) Net loss $ 4,138 $ 4,533 $ 395 8.7 % Adjusted EBITDA1 $ 16,443 $ 15,725 $ 718 4.6 % 1 Non-GAAP measure; please see definition above and reconciliation below. 2 Includes revenue-based production taxes and royalties; excludes depreciation, depletion, and amortization; asset retirement obligation expenses; and general and administrative costs. Revenue Our coal sales revenue for the three months ended June 30, 2014 increased by $15.0 million, or 14.9%, to $116.3 million, as compared to $101.2 million for the three months ended June 30, 2013. This increase is attributable to a favorable volume variance of approximately 0.2 million tons sold in the current year ($10.6 million) and a favorable price variance of $4.4 million year-over-year due to favorable customer mix and higher year-over-year contract prices. The completion of the Lewis Creek underground mine in July 2013 led to additional capacity experienced in the current year. Cost of Coal Sales Cost of coal sales increased 18.6% to $95.2 million in the three months ended June 30, 2014, from $80.2 million in the same period of 2013. On a per ton basis, our cost of coal sales increased during the three months ended June 30, 2014, compared to the same period of 2013, from $35.81 per ton to $38.45 per ton. This increase is due to lower productivity at the Parkway underground mine driven by poor geological conditions and production inefficiencies encountered at the Lewis Creek underground mine subsequent to the completion of the development of the mine, partially offset by favorable mining conditions at our Midway surface mine in the current year. 22-------------------------------------------------------------------------------- Table of Contents Production Royalties to Related Party Production royalties to related party increased $0.2 million to $2.2 million for the three months ended June 30, 2014, as compared to $2.0 million in the same period of 2013. The increase relates to production royalties earned by our affiliate, Thoroughbred Resources, L.P. (Thoroughbred), being higher as a result of an increase in sales originating from our Kronos mine (where the mineral reserves are leased directly from Thoroughbred) in the current quarter, as compared to the same period of 2013. Depreciation, Depletion and Amortization Depreciation, depletion, and amortization (DD&A) expenses increased by $0.8 million, or 8.5%, during the three months ended June 30, 2014 to $9.7 million, as compared to the same period of 2013. The increase is primarily due to an increase in depreciation of machinery and equipment as we expanded our operations with the completion of the development of the Lewis Creek underground mine in July 2013. In addition, depletion and amortization expenses were slightly higher as a result of the higher production in 2014, as compared to the prior year. Asset Retirement Obligation Expense Asset retirement obligation expense decreased by $0.1 million to $0.5 million in the three months ended June 30, 2014, as compared to the same period of 2013. The decrease is primarily attributable to changes in asset retirement cost estimates based on revisions to discount rates, reserve valuations and projected mine lives. General and Administrative Costs General and administrative (G&A) costs were $4.7 million for the three months ended June 30, 2014, which was $0.7 million, or 13.5%, lower than the three months ended June 30, 2013. On a per ton basis for the three months ended June 30, 2014, G&A expenses were $1.92, compared to $2.45 for the three months ended June 30, 2013. The decrease in the three months ended June 30, 2014, as compared to the same period of 2013, is due primarily to lower share-based compensation ($0.3 million) due to the forfeiture of a grant and the reversal of the associated expense and lower non-income related taxes ($0.4 million). Interest Expense, Net Interest expense, net is derived from the following components: Three Months Ended June 30, 2014 2013 (In thousands) 11.75% Senior Secured Notes due 2019 $ 5,875 $ 5,875 Senior Secured Credit Facility - - Long-term obligation to related party 1,837 2,773 Other, net 578 26 Total $ 8,290 $ 8,674 Interest expense, net was $8.3 million for the three months ended June 30, 2014, as compared to $8.7 million for the three months ended June 30, 2013. The decrease is principally attributable to a decrease in the effective interest rate on the long-term obligation to related party due to revisions in the mine plan at December 31, 2013, partially offset by the increase in the principal balance of the long-term obligation to related party from the closing of the reserve transfer to Thoroughbred in April 2013, which increased the principal balance on the obligation by $4.9 million, and a lesser amount of capitalized interest in the current quarter due to a decline in capital expenditures year over year. Net Loss Net loss for the three months ended June 30, 2014 was $4.1 million, as compared to $4.5 million for the same period of 2013. The decrease in net loss is largely due to the improved gross margin resulting from the favorable volume variance and the reduction in G&A costs and interest expense year-over-year. 23-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA The following table reconciles Adjusted EBITDA to net loss, the most directly comparable GAAP measure: Three Months Ended June 30, 2014 2013 (In thousands) Net loss $ (4,138 ) $ (4,533 ) Income tax provision - - Depreciation, depletion, and amortization 9,731 8,969 Asset retirement obligation expense 500 592 Non-cash production royalty to related party 2,240 1,967 Interest expense, net 8,290 8,659 Non-cash stock compensation expense (180 ) 71 Adjusted EBITDA $ 16,443 $ 15,725 Our Adjusted EBITDA for the three months ended June 30, 2014 was $16.4 million, as compared to $15.7 million for the three months ended June 30, 2013. The increase in Adjusted EBITDA resulted primarily from improved gross margin as a result of selling 0.2 million tons more in the three months ended June 30, 2014, as compared to the same period of 2013, as well as lower G&A costs, exclusive of stock compensation expense, experienced in the current quarter. Six Months Ended June 30, 2014 Compared to Six Months Ended June 30, 2013 Summary Six Months Ended June 30, Change 2014 2013 Amount Percentage (In thousands, except per ton amounts) Tons of coal sold 4,832 4,454 378 8.5 % Total revenue $ 227,153 $ 202,466 $ 24,687 12.2 % Average sales price per ton $ 47.01 $ 45.45 $ 1.56 3.4 % Cost of coal sales2 $ 185,285 $ 162,265 $ (23,020 ) (14.2 %) Average cost of sales per ton2 $ 38.35 $ 36.43 $ (1.92 ) (5.3 %) Net loss $ 9,438 $ 11,029 $ (1,591 ) (14.4 %) Adjusted EBITDA1 $ 32,189 $ 29,330 $ 2,859 9.7 % 1 Non-GAAP measure; please see definition above and reconciliation below. 2 Includes revenue-based production taxes and royalties; excludes depreciation, depletion, and amortization; asset retirement obligation expenses; and general and administrative costs. Revenue Our coal sales revenue for the six months ended June 30, 2014 increased by $24.7 million, or 12.2%, to $227.2 million, as compared to $202.5 million for the six months ended June 30, 2013. This increase is attributable to a favorable volume variance of approximately 0.4 million tons sold in the current year ($17.8 million) and a favorable price variance of $6.9 million year-over-year due to favorable customer mix and higher year-over-year contract prices. The completion of the Lewis Creek underground mine in July 2013 led to additional capacity experienced in the current year. Cost of Coal Sales Cost of coal sales increased 14.2% to $185.3 million in the six months ended June 30, 2014, from $162.3 million in the same period of 2013. On a per ton basis, our cost of coal sales increased during the six months ended June 30, 2014, compared to the same period of 2013, from $36.43 per ton to $38.35 per ton. This increase is due to lower productivity at the Parkway underground mine driven by poor geological conditions and production inefficiencies encountered at the Lewis Creek underground mine subsequent to the completion of the development of the mine, partially offset by favorable mining conditions at our Midway surface mine in the current year. 24-------------------------------------------------------------------------------- Table of Contents Production Royalties to Related Party Production royalties to related party increased $0.3 million to $4.3 million for the six months ended June 30, 2014, as compared to $4.0 million in the same period of 2013. The increase relates to production royalties earned by our affiliate, Thoroughbred, being higher as a result of an increase in sales originating from our Kronos mine in the current year, as compared to the same period of 2013. Depreciation, Depletion and Amortization DD&A expenses increased by $2.2 million, or 12.2%, during the six months ended June 30, 2014 to $19.9 million, as compared to the same period of 2013. The increase is primarily due to an increase in depreciation of machinery and equipment as we expanded our operations with the completion of the development of the Lewis Creek underground mine in July 2013. In addition, depletion and amortization expenses were higher as a result of the higher production in 2014, as compared to the prior year. Asset Retirement Obligation Expense Asset retirement obligation expense decreased by $0.2 million to $1.0 million in the six months ended June 30, 2014, as compared to the same period of 2013. The decrease is primarily attributable to changes in asset retirement cost estimates based on revisions to discount rates, reserve valuations and projected mine lives. General and Administrative Costs G&A costs were $10.0 million for the six months ended June 30, 2014, which was $1.3 million, or 11.7%, lower than the six months ended June 30, 2013. On a per ton basis for the six months ended June 30, 2014, G&A expenses were $2.07, as compared to $2.54 for the six months ended June 30, 2013. The decrease in the six months ended June 30, 2014, as compared to the same period of 2013, is due primarily to lower non-income related taxes ($0.6 million), lower legal and other professional fees ($0.3 million) and lower share-based compensation ($0.4 million) from the decline in unvested shares and the forfeiture of a grant and the reversal of the associated expense during the second quarter of 2014. Interest Expense, Net Interest expense, net is derived from the following components: Six Months Ended June 30, 2014 2013 (In thousands) 11.75% Senior Secured Notes due 2019 $ 11,750 $ 11,750 Senior Secured Credit Facility - - Long-term obligation to related party 3,664 5,370 Other, net 1,120 92 Total $ 16,534 $ 17,212 Interest expense, net was $16.5 million for the six months ended June 30, 2014, as compared to $17.2 million for the six months ended June 30, 2013. The decrease is principally attributable to a decrease in the effective interest rate on the long-term obligation to related party due to revisions in the mine plan at December 31, 2013, partially offset by the increase in the principal balance of the long-term obligation to related party from the closing of the reserve transfer to Thoroughbred in April 2013, which increased the principal balance on the obligation by $4.9 million, and a lesser amount of capitalized interest in the current year due to a decline in capital expenditures year over year. Net Loss Net loss for the six months ended June 30, 2014 was $9.4 million, as compared to $11.0 million for the same period of 2013. The decrease in net loss is largely due to the improved gross margin resulting from the favorable volume variance and the reduction in G&A costs and interest expense year-over-year. 25-------------------------------------------------------------------------------- Table of Contents Adjusted EBITDA The following table reconciles Adjusted EBITDA to net loss, the most directly comparable GAAP measure: Six Months Ended June 30, 2014 2013 (In thousands) Net loss $ (9,438 ) $ (11,029 ) Income tax provision - - Depreciation, depletion, and amortization 19,938 17,765 Asset retirement obligation expense 1,008 1,165 Non-cash production royalty to related party 4,264 4,017 Interest expense, net 16,534 17,212 Non-cash stock compensation expense (117 ) 290 Gain on settlement of asset retirement obligation - (90 ) Adjusted EBITDA $ 32,189 $ 29,330 Our Adjusted EBITDA for the six months ended June 30, 2014 was $32.2 million, as compared to $29.3 million for the six months ended June 30, 2013. The increase resulted primarily from improved gross margin as a result of selling 0.4 million tons more in the six months ended June 30, 2014, as compared to the same period of 2013, as well as lower G&A costs, exclusive of stock compensation expense, experienced in the current year. Liquidity and Capital Resources Liquidity Our business is capital intensive and requires substantial capital expenditures for purchasing, upgrading and maintaining equipment used in mining our reserves, as well as complying with applicable environmental laws and regulations. Our principal liquidity requirements are to finance current operations, fund capital expenditures, including acquisitions from time to time, and to service our debt. Our primary sources of liquidity to meet these needs have been cash generated by our operations, borrowings under our credit facility and contributions from our equity holders. On December 21, 2012, we completed a $200.0 million Notes offering and received proceeds of $193.1 million, as the Notes were issued at an original issue discount of 96.567%. Interest on the Notes is due semiannually on June 15 and December 15 of each year, with the first payment made on June 15, 2013. In connection with the offering, we prepaid and terminated our then existing senior secured credit facility and recognized a loss on extinguishment of debt of $4.0 million associated with the write-off of a portion of the unamortized deferred financing fees incurred on the senior secured credit facility. In addition, we entered into a new asset based revolving credit facility, which provides for revolving borrowings of up to $50.0 million (the 2012 Credit Facility). We believe our existing cash balances, cash generated from operations and capacity under the 2012 Credit Facility will be sufficient to meet working capital requirements, anticipated capital expenditures and debt service requirements. We manage our exposure to changing commodity prices for our long-term coal contract portfolio through the use of multi-year coal supply agreements. We generally enter into fixed price, fixed volume supply contracts with terms greater than one year with customers with whom we have historically had limited collection issues. Our ability to satisfy debt service obligations, to fund planned capital expenditures, and to make acquisitions, will depend upon our future operating performance, which will be affected by prevailing economic conditions in the coal industry and financial, business and other factors, some of which are beyond our control. The principal indicators of our liquidity are our cash on hand and availability under the 2012 Credit Facility. As of June 30, 2014, our available liquidity was $82.8 million, comprised of cash on hand of $62.6 million and $20.2 million available under the 2012 Credit Facility. 26-------------------------------------------------------------------------------- Table of Contents Cash Flows The following table reflects cash flows for the applicable periods: Six Months Ended June 31, 2014 2013 (In thousands) Net cash provided by (used in): Operating activities $ 23,132 $ 29,290 Investing activities $ (6,838 ) $ (40,617 ) Financing activities $ (5,337 ) $ (4,099 ) Six Months Ended June 30, 2014 Compared to six Months Ended June 30, 2013 Net cash provided by operating activities was $23.1 million for the six months ended June 30, 2014, a decrease of $6.2 million from net cash provided by operating activities of $29.3 million for the same period of 2013. We experienced an increase in operating income in the first six months of 2014 due to higher gross margin driven by an increase in shipments and favorable price variance, as well as lower G&A expenses due to a decline in non-income related taxes, legal and other professional fees, and share based compensation. The higher production levels and completion of the Lewis Creek underground mine also increased depreciation, depletion, and amortization by $2.2 million in the first six months of 2014, as compared to the same period of 2013. Positively impacting cash flows from operations for the six months ended June 30, 2014 was an increase in accounts payable and accrued liabilities of $5.1 million and net related party liabilities of $7.1 million due to the deferment of amounts owed to our affiliate, Thoroughbred, including interest and royalties earned on leased reserves. Negatively impacting operating cash flows was an increase in other non-current assets during the six months ended June 30, 2014 due to an increase in collateral posted against outstanding surety bonds, which are used to secure the performance of our reclamation obligations, as well as an increase in accounts receivable related to the increase in revenue and the timing of cash receipts. Positively impacting cash flows from operations for the six months ending June 30, 2013 was an increase in accounts payable and accrued liabilities of $16.5 million due to the timing of payments as well as increased capital expenditures associated with the development of the Lewis Creek underground mine, which was completed in the first half of 2013, and an increase in related party payables due to an increase in royalties earned by Thoroughbred. Negatively impacting operating cash flows was an increase in inventory experienced during the six months ended June 30, 2013 due to an increase in coal inventory on hand, as well as an increase in materials and supplies inventory resulting from the development of the Lewis Creek underground mine. Net cash used in investing activities decreased $33.8 million to $6.8 million for the six months ended June 30, 2014, compared to $40.6 million for the same period of 2013. The current year investment is primarily attributable to capital expenditures associated with maintaining our existing fixed assets, whereas the prior year investment is largely attributable to capital expenditures on equipment and mine development for the completion of the Lewis Creek underground mine. In addition, negatively impacting cash flows in the six months ending June 30, 2013 is the short-term note of $17.5 million to Thoroughbred. The proceeds from the note, which was repaid in July 2013, were used by Thoroughbred as a partial down-payment to acquire additional reserves that were leased to us in February 2014. Net cash used in financing activities was $5.3 million for the six months ended June 30, 2014, compared to net cash used in financing activities of $4.1 million for the six months ended June 30, 2013. The current year and prior year activity relates primarily to scheduled capital lease and other long-term debt payments. Contractual Obligations Our contractual obligations have not changed materially from the disclosures in our Annual Report on Form 10-K filed with the SEC on March 25, 2014. Capital Expenditures Our mining operations require investments to expand, upgrade or enhance existing operations and to comply with environmental regulations. Our anticipated total capital expenditures for 2014 are estimated in a range of $36.0 million to $38.0 million, of which approximately 50% represents machinery, equipment, and land purchases and approximately 50% represents mine development related expenditures. Management anticipates funding 2014 capital requirements with current cash balances and cash flows provided by operations. We will continue to have significant capital requirements over the long-term, which may require us to incur debt or seek additional equity capital. The availability and cost of additional capital will depend upon prevailing market conditions and several other factors over which we have limited control, as well as our financial condition and results of operations. 27-------------------------------------------------------------------------------- Table of Contents Mine Development Costs Mine development costs are capitalized until production commences, other than production incidental to the mine development process, and are amortized on a units-of-production method based on the estimated proven and probable reserves. Mine development costs represent costs incurred in establishing access to mineral reserves and include costs associated with sinking or driving shafts and underground drifts, removing overburden to access reserves in a new pit, permanent excavations, roads and tunnels. The end of the development phase and the beginning of the production phase takes place when construction of the mine for economic extraction is substantially complete. Our estimate of when construction of the mine for economic extraction is substantially complete is based upon a number of assumptions, such as expectations regarding the economic recoverability of reserves, the type of mine under development, and the completion of certain mine requirements, such as ventilation. Coal extracted during the development phase is incidental to the mine's production capacity and is not considered to shift the mine into the production phase. We began development of a new underground mine in the second quarter of 2014 at our Parkway mine complex to extract coal from the West Kentucky #8 seam, which is anticipated to be completed in the first half of 2015. Off-Balance Sheet Arrangements In the normal course of business, we are a party to certain off-balance sheet arrangements. These arrangements include guarantees and financial instruments with off-balance sheet risk, such as surety bonds and performance bonds. No liabilities related to these arrangements are reflected in our consolidated balance sheet, and we do not expect any material adverse effects on our financial condition, results of operations or cash flows to result from these off-balance sheet arrangements. Federal and state laws require us to secure certain long-term obligations such as mine closure and reclamation costs and other obligations. We typically secure these obligations by using surety bonds, an off-balance sheet instrument. The use of surety bonds is less expensive for us than the alternative of posting a 100% cash bond. To the extent that surety bonds become unavailable, we would seek to secure our reclamation obligations with letters of credit, cash deposits or other suitable forms of collateral. We also post performance bonds to secure our performance of various contractual obligations. As of June 30, 2014, we had approximately $35.7 million in surety bonds outstanding to secure the performance of our reclamation obligations, which were supported by approximately $6.0 million of cash posted as collateral. Related Party Transactions Merger of Related Parties On February 1, 2014, Armstrong Resource Partners, L.P. merged with and into Thoroughbred Resources, LLC, with Armstrong Resource Partners, L.P. as the surviving entity (the Merger). Effective with the Merger, Armstrong Resource Partners, L.P. changed its name to Thoroughbred. Our wholly-owned subsidiary, Elk Creek GP, LLC (ECGP), remained the general partner of the surviving entity, under the terms of the amended and restated limited partnership agreement, which is substantially the same as the limited partnership agreement in effect immediately prior to the Merger. As a result of the Merger, ECGP's equity interest in the combined company was reduced to approximately 0.2%. In January 2014, our investment in Ram Terminals, LLC (RAM), an entity majority owned by Yorktown, was converted into an equal ownership percentage of Terminal Holdings, LLC, a holding company which is the sole member of both RAM and MG Midstreaming, LLC. Subsequent to the Merger, but also on February 1, 2014, Terminal Holdings, LLC merged with and into a merger subsidiary of Thoroughbred created for the purpose of the transaction, with Terminal Holdings, LLC as the surviving entity. Terminal Holdings, LLC was owned by us and Yorktown in the same percentage as their prior interests in RAM, and by virtue of the merger, our equity interest, was converted into an equal number of common units representing limited partnership interests in Thoroughbred. Because of our ownership interest in Thoroughbred through ECGP, the newly converted interest, which equaled 0.9%, will be accounted for under the equity method. Sale of Coal Reserves We have executed the sale of an undivided interest in certain land and mineral reserves to Thoroughbred, through a series of transactions beginning in February 2011. Subsequently, we entered into lease agreements with Thoroughbred pursuant to which Thoroughbred granted us leases to its undivided interests in the mining properties acquired and licenses to mine and sell coal from those properties in exchange for a production royalty. Due to our continuing involvement in the land and mineral reserves transferred, these transactions have been accounted for as financing arrangements. A long-term obligation has been established that is being amortized over the anticipated life of the mineral reserves. In addition, effective February 2011, we and Thoroughbred entered into a Royalty Deferment and Option Agreement whereby we have been granted an option to defer payment of any royalties earned by Thoroughbred on coal mined from these properties. Compensation for the aforementioned transactions has consisted of a combination of cash payments and the forgiveness of amounts owed by us, which primarily consisted of deferred royalties. 28-------------------------------------------------------------------------------- Table of Contents On April 1, 2013, we sold an additional 2.59% undivided interest in certain land and mineral reserves to Thoroughbred. The percentage interest in the land and mineral reserves sold was based on a fair value determined by a third-party specialist. In exchange for the undivided interest in the land and mineral reserves, Thoroughbred forgave amounts owed by us totaling $4.9 million. This transaction increased Thoroughbred's undivided interest in certain of our land and mineral reserves in Muhlenberg and Ohio Counties to 53.4%. In addition, the transferred mineral reserves were leased back to us on terms similar to those applicable to the previous transfers. As we will have a continuing involvement in the reserves, the transaction is accounted for as a financing arrangement and an additional long-term obligation to Thoroughbred of $4.9 million was recognized in the second quarter of 2013. As a result of the additional asset transfer in April 2013, the effective interest rate on the long-term obligation to related party was adjusted to 10.65%. Based on the current mine plan, the effective interest rate of the obligation was reduced to 7.0% beginning January 1, 2014. As of June 30, 2014 and December 31, 2013, the outstanding long-term obligation to related party totaled $105.2 million and $106.3 million, respectively. Interest expense recognized for the three months ended June 30, 2014 and 2013 associated with the long-term obligation to related party was $1.8 million and $2.8 million, respectively and $3.7 million and $5.4 million for the six months ended June 30, 2014 and 2013, respectively. Lease of Coal Reserves In February 2011, Thoroughbred entered into a lease and sublease agreement with us relating to its Elk Creek reserves and granted us a license to mine coal on those properties. The terms of this agreement mirror those of the lease agreements associated with the jointly owned reserves. Total production royalties owed from mining of the Elk Creek reserves, where our Kronos mine resides, for the three months ended June 30, 2014 and 2013 totaled $2,240 and $1,967, respectively, and for the six months ended June 30, 2014 and 2013 $4,264 and $4,017, respectively. Short-term Note Receivable On June 28, 2013, Thoroughbred acquired approximately 175 million tons of fee-owned coal reserves and approximately 23 million tons of leased coal reserves from a third party. The acquired coal reserves are located in Muhlenberg and McLean Counties of Kentucky, contiguous to our reserves. In February 2014, we entered into a lease of these reserves from Thoroughbred in exchange for a production royalty. In connection with Thoroughbred's acquisition of these coal reserves, we loaned Thoroughbred $17.5 million, which was repaid in July 2013. The proceeds of the loan, which was evidenced by a promissory note, were used by Thoroughbred to make a portion of the down payment for the purchase of the coal reserves. Administrative Services Agreements Effective as of January 1, 2011, we entered into an Administrative Services Agreement with Thoroughbred and its general partner, ECGP, pursuant to which we agreed to provide Thoroughbred with general administrative and management services, including, but not limited to, human resources, information technology, financial and accounting services and legal services. As consideration for the use of our employees and services, and for certain shared fixed costs, Thoroughbred paid us $0.3 million and $0.2 million for the three months ended June 30, 2014 and 2013, respectively and $0.5 million and $0.4 million for the six months ended June 30, 2014 and 2013, respectively. Prior to the Merger, we had separate administrative services agreements with Thoroughbred Resources, LLC and RAM. For the three and six months ended June 30, 2013, we were paid $36 and $72, respectively, for the associated services rendered to Thoroughbred Resources, LLC and RAM. Other In 2006 and 2007, we entered into overriding royalty agreements with a current and a former executive employee to compensate each of them $0.05/ton of coal mined and sold from properties owned by certain of our subsidiaries. The agreements remain in effect for the later of 20 years from the date of the agreement or until all salable coal has been extracted. Both royalty agreements transfer with the property regardless of ownership or lease status. The royalties are payable the month following the sale of coal mined from the specified properties. We account for these royalty arrangements as expense in the period in which the coal is sold. Associated royalty expense recorded in the three months ended June 30, 2014 and 2013 was $0.2 million and $0.2 million, respectively, and $0.4 and $0.5 in the six months ended June 30, 2014 and 2013, respectively. 29 -------------------------------------------------------------------------------- Table of Contents Please read "Item 13-Certain Relationships and Related Party Transactions, and Director Independence" in our Annual Report on Form 10-K filed with the SEC on March 25, 2014 for additional information concerning related party transactions. Critical Accounting Policies and Estimates Our preparation of financial statements in conformity with GAAP requires that we make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We base our judgments, estimates and assumptions on historical information and other known factors that we deem relevant. Estimates are inherently subjective as significant management judgment is required regarding the assumptions utilized to calculate accounting estimates. The most significant areas requiring the use of management estimates and assumptions relate to units-of-production amortization calculations, asset retirement obligations, useful lives for depreciation of fixed assets, and the accounting for the long-term obligation to related party. For a full discussion of our accounting estimates and assumptions that we have identified as critical in the preparation of our condensed consolidated financial statements, refer to our Annual Report on Form 10-K filed with the SEC on March 25, 2014. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (FASB) issued a comprehensive revenue recognition standard that will supersede nearly all existing revenue recognition guidance under GAAP. The standard requires revenue to be recognized when promised goods or services are transferred to a customer in an amount that reflects the consideration expected in exchange for those goods or services. The new standard is effective for us on January 1, 2017. The standard permits the use of either the full retrospective or modified retrospective transition method and early adoption is not permitted. We are currently evaluating the impact of this new pronouncement on our financial statements. |