Multiple sell-side analysts keep talking about the thermal coal recovery, but Wall Street seems to be responding with “that's okay, after you...”. On a six-month, year-to-date, and three-month basis, the shares of most of the major U.S. coal producers are in the red, with the met-coal miners like Peabody (NYSE:BTU), Arch Coal (NYSE:ACI), and Alpha Natural (NYSE:ANR) under-performing the thermal-focused Cloud Peak Energy (NYSE:CLD).
It's true that natural gas prices have risen of late, making coal more cost-competitive. It's also true that coal inventories have been worked down at utilities and that miners have been relatively responsible in idling marginal mines.
It's still not abundantly clear that Cloud Peak Energy offers a great opportunity today. While this is a very well-run miner with solid assets, the counter-intuitive reality is that it's offer the lesser operators that see the biggest stock price improvements early in a recovery. It's also not certain that this “recovery” has legs or will show up in the numbers anytime soon, as there is ample capacity, prices are still weak, and margins are very thin. While I think Cloud Peak is on balance a good play on an eventual thermal coal recovery, investors are going to need patience for this stock to work.
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Q1 Results Highlight The Challenges
Analysts have gotten incrementally more bullish on domestic thermal coal companies, largely as utility inventories have started declining (although days of consumption in inventory were still 25% above long-term averages as of March). At the same time, natural gas prices have been moving up, leading to a much more compelling cost-benefit tradeoff for coal (particularly Powder River Basin (PRB) coal).
But there's a big difference between lagging data on utility inventories and current financial results, and Cloud Peak's first quarter earnings reflect some of this. Tons sold declined 7% from the year-ago period (and 12% from the prior quarter), and realized prices also declined about 2%. Making matters worse, the average cost per ton rose 6%, leading to a 23% decline in cash operating margins per ton and a 36% decline in adjusted EBITDA (missing the average estimate by a quarter).
In some respects it's even worse than those numbers might suggest. Coal exports aren't a large part of Cloud Peak's business on a raw tonnage basis (around 5% or so last year), but they contributed about 20% of 2012 EBITDA. Right now, though, international prices are down about 25% and exporting PRB coal is basically a losing proposition.
SEE: A Clear Look At EBITDA
If Things Are Getting Better, Why Is Cloud Peak Selling Cheap?
There were some curious developments reported with those earnings with respect to contracted coal sales. It looks like Cloud Peak agreed to sell another 4 million tons of 2013 coal production for less than $10 a ton, even though the quarter's cost per ton was above $10. Likewise, the company contracted for 6 million tons at a price that is more or less a breakeven proposition at current prices.
Now maybe Cloud Peak management has insight and a pathway to lower costs as the year progresses. Even so, I find it interesting that other coal companies like Arch Coal and Peabody have confirmed more interest from utilities in contracting for 2014 coal, but at prices that aren't encouraging them (the coal miners, that is) to sign on the dotted line just yet.
It's also worth noting that as much as 20-30% excess capacity in thermal coal could be idled at present and brought back into production if or when those contract prices start moving up. All told, then, it looks like it might be hard for PRB prices to go substantially higher in the near-term. While $4 natural gas would normally imply prices of about $20/ton, Cloud Peak contracted for less than half of that, so it's hard to say that the markets are close to healthy just yet.
Good Company, Good Costs, And Good Assets
There's a lot to like about Cloud Peak. Although the company did not significantly grow its reserves from 2012 to 2013, the company's 1.3 billion tons of reserves offers a reserve life of about 14 years and the company has the Youngs Creek and Crow projects to look forward to in the coming years. What's more, Cloud Peak's coal assets are above average in terms of heat content (BTU per lb), and at over 9,300 BTU/lb, the company's Spring Creek coal is more attractive for export.
It's also well worth noting that Cloud Peak doesn't do underground mining, allowing for much lower costs, and management hasn't made any ill-timed expensive deals (like Arch Coal's foray into met coal at almost exactly the wrong time). Last and not least, Cloud Peak is well-connected, with lines from Union Pacific (NYSE:UNP) and Berkshire Hathaway's (NYSE:BRK.A, BRK.B) BNSF servicing its fields and good positioning relative to export terminals in Canada.
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The Bottom Line
Unlike Arch Coal, you can value Cloud Peak on 2013/14 EBITDA and generate a reasonable fair value estimate. Using the average estimate for the next 12 months and a 6.5x multiple generates a fair value of about $21.50, or almost 20% more than today's price. Cloud Peak doesn't look as compelling as Arch Coal on a price-to-book (P/B) or tangible book (PTBV) basis, though, largely due to the fact that Cloud Peak's balance sheet is in much better shape today.
If met coal suddenly rebounds and thermal coal stagnates, Cloud Peak will underperform and Arch Coal (as well, most likely, as Peabody) will outperform. On the other hand, a big recovery in thermal should be good for Cloud Peak, though for the reasons explained above it may take a while to see the improvements in the financials. Although Arch Coal will likely show better stock price performance if investors buy into the rally thesis, Cloud Peak is probably the safer choice today and a worthwhile, albeit very risky, stock to consider for investors will to buy into the thermal recovery story in the early days.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.