CTRA is a company that mines and processes coal before selling it to powerplants and steel producers. 2020 has brought some unexpected challenges for all energy producing companies, as demand has fallen sharply. According to the U.S. Energy Information Association, demand for coal is down 37% from last year. But CTRA is not merely struggling with the fallout of the pandemic, there recent disclosures have raised a bevy of red flags related to their accounting and internal controls.
Repetitive SEC Comment Letters Raise a Red Flag
Our friend and occasional guest contributor, Olga Usvyatsky CPA , drew our attention to CTRA’s recent SEC Comment Letters. These letters concern Item 101(c)(1)(vii) of Regulation S-K, which requires a company to disclose the names of any customers that account for more than 10% of revenue, if the loss of that customer would have a materially adverse effect on the company.
CTRA does not disclose the list of its customers, even though one of their clients accounted for 16.7% of revenue, and their top ten consumers account for 60%. When the SEC first asked about this issue in June of 2019, CTRA explained that the market for coal was highly liquid, and therefore the loss of any one customer would not be material because they would easily be replaced. Markets tend to be liquid when demand consistently outpaces supply.
CTRA does not explain in their comment letter why the market for coal is highly liquid, but we will take them at their word that this is usually the case, even with a limited consumer base. Thereafter CTRA included their dependence on a few large customers in their risk factor section, although they continued to omit the names of its customers.
Remarkably, in May 2020 the SEC asked the exact same question they had asked in June of 2019. The most reasonable explanation for this repetition is that the SEC staff members believe the impact of the coronavirus out to have changed CTRA’s response. Yet CTRA gave this response:
Given the fluid nature of the commodity market for coal products sold by the Company, we do not think a loss of any such customer would have a material adverse effect on the long-term financial results or prospects of our business.
The Company respectfully advises the Staff that in a customary business environment the coal market exhibits high levels of liquidity given the nature of the commodity. Our sales force is experienced in moving coal sales volumes from one account to another as required by market conditions, either with established customers or new customers.(emphasis added)
Two parts of this statement are problematic, so we will take each in turn. The first problem is that the regulation asks for the names of customers if their loss would be material. It does not qualify this requirement by stating that the loss must be material in the “long-term.” Here CTRA qualifies their statement by saying the loss of any one customer would not be material “on the long-term financial results.” But what about the impact right now?
Even in a relatively illiquid market the loss of an important customer might not have a material effect in the “long-term.” Could CTRA replace a lost customer within a day? A week? A month? A quarter? A year? A decade? In the “long-term” it is possible that coal power plants will be replaced with fusion power plants. Lots of things can happen if you stretch out your time horizon.
The second problem is that amid this coronavirus we are not in a “customary business environment.” As stated earlier, demand has fallen over 37% from last year. Cratering demand means that the market is losing its liquidity. We know that the price of coal is falling because of excess supply, making it more difficult for CTRA to resell their coal on similar terms if one of their big customers scales back use or ceases operations.
We also know that CTRA expects this collapse in price to continue for some time in the future. In their latest quarterly report, CTRA wrote off $33 million dollars in mines which are not viable at the current price point, and their estimates for the future do not show them recovering:
[D]ue to declines in metallurgical and thermal coal pricing which reduced forecasted margins at certain locations to amounts below those required for full recoverability, the Company determined that indicators of impairment were present for four long-lived asset groups…
Just when will things go back to a “customary business environment?” Hopefully, it will in the “long-term.” As for the SEC, they seem satisfied with CTRA’s response since they completed their review.
CTRA’s Parts Ways with KPMG over Internal Control Issues
In May, CTRA dismissed their auditor KPMG and replaced them with RSM US LLP. KPMG had given the company an adverse opinion in their annual report for 2019. KPMG highlighted material weaknesses in the risk assessment process was ineffective and their staff was not properly trained in certain control procedures. As a result, there are substantial questions concerning the company’s valuations of its coal inventory, as well as what it reported about its procurement process.
This lack of proper internal controls greatly increases the risk that the financial statements could be restated due to error or fraud. It also opens the company to potential litigation if the financial statements turn out to be false. Perhaps the best protection that CTRA currently has against litigation is the fact that their share price has already hit rock bottom.
The coronavirus has hit all energy companies hard, and hopefully the impacts of this virus will be relatively short lived. This may be a great time to buy energy companies if you believe demand will recover over time, and the stock prices will follow. However, investors should be aware of potential accounting issues that can hinder a company’s stock price. With its auditor changes and internal control issues, CTRA is facing far more challenges on its road to recovery than just recovering from the impact of the coronavirus.