Peabody Energy Carries Higher Expectations, But Solid Value

By Stephen D. Simpson, CFA | June 14, 2013 AAA

Having recently examined Arch Coal (NYSE:ACI) and Cloud Peak Energy (NYSE:CLD), it's time to examine the largest U.S. coal producer – Peabody Energy (NYSE:BTU). There is a lot to like about Peabody at first glance, as this company has attractive U.S. thermal coal exposure (with minimal Appalachian reserves) and heavily China-leveraged met coal exposure.

On the other hand, Peabody is arguably the most well-respected coal miner out there (and maybe one of the best-regarded natural resource companies overall) and investors and analysts consistently award the stock a higher multiple than its peers. Consequently, while Peabody may the highest-quality coal stock to own today, the upside in these shares to a thermal (and/or met) coal recovery doesn't seem as great as in its rivals.

SEE: A Primer On Coal

Familiar News On U.S. Thermal
As I mentioned with both Arch Coal and Cloud Peak, some investors and analysts have been getting more optimistic about U.S. thermal coal demand. Higher natural gas prices have led some utilities to utilize more coal-fired generation capacity and coal-fired generation is up about 11% over last year. At the same time, utilities are working down their inventories and that is often good for prices.

The question, though, is just how much pricing leverage is really out there. Peabody management has said that they believe utility inventories need to drop below 60 days for prices to really react. While some Western utilities are apparently now in the 60s, the last reported datum point from the EIA indicated that nationwide inventories were in the low 70s (or about 20% higher than the breakpoint).

It's also important to note that there will be gaps and lags between price action and improvement in the reported financials. Peabody already has about 60% or so of anticipated 2014 U.S. thermal production under contract, and at prices pretty similar to 2013 levels. Likewise, Cloud Peak has recently been contracting for 2014 deliveries at prices scarcely better than current costs. There is also the chance that idled capacity (20-30% of thermal capacity is believed to be idle) will come on line again as prices improve, though Peabody management maintains that a lot of this capacity needs maintenance and can't/won't come back quickly (which, incidentally, likely makes watching trends in Joy Global's (NYSE:JOY) reported aftermarket/parts revenue well worth watching).

SEE: The Industry Handbook Tutorial – The Utilities Industry

Met Coal Not Looking So Hot Right Now
It wasn't so long ago that seemingly insatiable demand for steel in China pushed met coal prices to very attractive levels, enticing companies like Peabody, Arch Coal, Teck (NYSE:TCK) and Walter (NYSE:WLT) to expand their met coal holdings. As is so often the case in cyclical commodities, the highs didn't last and now about 30% of the world's met coal supply is being produced at uneconomical prices (according to Peabody management).

Still, not all met coal assets are created equal. While Arch Coal took on a seemingly dangerous amount of debt to acquire high-cost underground Appalachian met coal assets that largely go to the European and U.S. steel markets, Peabody has built its met coal assets around China's steel industry with acquisitions and new greenfield projects in Australia, China, and Mongolia. Given that I think Chinese steel production is likely to outstrip European production (to say nothing of the fact that Peabody's mines could conceivably support demand in South Korea, Japan, and India as well as China), I like Peabody's assets more than Arch Coal's, even if global spot prices are pretty unattractive at present.

Plenty Of Noise Between Now And Then
It won't be a smooth ride for Peabody between here and the next coal boom. Peabody has pretty solid labor relations, but a quick look at the experience of companies in areas like South Africa and Indonesia shows that that sort of situation can change pretty quickly. Likewise, Peabody is a solid producer and capital allocator, but it could take some time for the per-ton margins to really improve.

I think it's worth mentioning that there's still a lot of uncertainty about Peabody's near-term financial performance, as the high/low spread on EBITDA estimates over the next 12 months is greater than one-third. That said, coal stocks generally trade more on coal prices than reported financial results. While it is extremely dangerous to say that prices can't get any worse, I have to think that, on balance, the odds favor improvements in thermal and met coal prices over the next few years.

SEE: Fueling Futures In The Energy Market

The Bottom Line
The problem for investors considering Peabody is that Peabody only gets cheap (relatively speaking) when things get very bad. Peabody doesn't have Arch Coal's liquidity or long-term Appalachia cost issues, nor Cloud Peak's pure exposure to U.S. thermal coal. Then again, investors and analysts seem to be more willing to look past 12-month EBITDA when valuing Peabody's shares.

On a 12-month EBITDA basis, Peabody should probably trade at around $19 to $20. That's higher than today's price, but maybe not enough to compensate investors for the risk and volatility that goes with global coal markets. On the other hand, long-term NPV analysis can produce a target near $30, which suggests meaningful undervaluation and pretty attractive relative valuation compared to Arch Coal and Cloud Peak. While it will probably take time for the coal markets to recover, Peabody offers a pretty interesting mix of quality-enhanced risk and long-term upside, even with the higher multiples that the stock usually gets from the market.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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