Uncovering Value In Coal (BTU, ACI, ANR)

By Dean Lundell | September 11, 2007 AAA

If you want to build an electric utility, you basically have four choices:

A) Hydroelectric - if there are no rivers or dams nearby you have a problem.
B) Nuclear Plants - not in my back yard.
C) Natural Gas - clean, but very expensive.
D) Coal - cleanable emissions, plenty of supply, and it is relatively cheap.

Not much of a contest is it? Continue reading as we look at three coal companies of vastly different size and then dissect them from an investor's point of view.

World Leader for a Reason
Peabody Energy Corporation (NYSE:BTU) with a market capitalization of about $11.4 billion mined 20% of the coal in the United States last year. This amounted to just more than $5.3 billion in revenue, with roughly three-quarters of it coming from the Powder River Basin (PRB) in Montana and Wyoming. Peabody has scale advantages in the PRB - advantages the other four companies competing in the area can't match .

Peabody Energy is also geographically diverse, which works to its advantage. It has the PRB in the West, Appalachia in the East. It also has operations in the Southwest, Midwest and even in Australia and Venezuela. Peabody is the world's largest private-sector coal company by any measure. And it has vast undeveloped assets, so it can literally pick and choose where it decides to break ground.

The risks include those of any coal company. There is commodity price exposure on both sides, and the usual set of environmental, regulatory and safety issues. Financial results are quite good for a company of this size, with revenue growth averaging almost 23% over the last three years, growth in earnings posting more than 127% for the same period and a return on equity of almost 20%.

Looking West
Arch Coal (NYSE: ACI) is the second largest coal producer in the United States, providing 6% of the coal needed to generate electricity. With a market capitalization of over $4.3 billion, Arch Coal generates almost $1.8 billion in sales. The company has sold off much of its eastern assets in the United States to focus on coal deposits in the West, particularly the PRB, where it is the No. 2 firm in operation. The coal from PRB has two conflicting attributes - it contains less sulfur, which makes it cleaner burning, but it also contains more moisture and therefore less energy than other coal.

Going forward, Arch Coal has two major issues to deal with. It is increasingly focusing on its western assets and selling off its central Appalachian properties and the really good news is that many of its older legacy contracts with low prices are coming due to be re-priced at considerably higher prices. From a risk standpoint, ACI has all the standard coal producing risks.

Arch Coal's financial statements reflect the sale of its Appalachian properties, but there is some insight to be gained from them. If you look at its earnings growth, it averaged 166.6% over the last three years and 928.6% last year. The revenue growth rate is far more telling, averaging 20.3% over the last three years and -0.3% last year. ACI operates at a gross margin of 21.3% and a net margin of 8.2% and its return on equity is 13.8%.

Steel Specialist
Alpha Natural Resources (NYSE:ANR) is the smallest of our trio, with a market cap of $1.2 billion and sales of not quite $1.8 billion. The company enjoys a special attribute - one-third of the coal it mines is metallurgical coal, which is a necessary ingredient in the production of steel. This gave it entry into overseas markets such as China and India. Metallurgical coal also sells at a premium to non-metallurgical coal. Alpha Natural Resources has a choice. It can clean up its coal for steel making, or it can be sold to a utility as it is. The company lets price dictate which option it chooses.

Most of its mining comes from Appalachia so it enjoys a transportation cost advantage of its low-sulfur coal to its utility customers. Another advantage is that it also has a nearly union-free work force. On the minus side, Appalachian coal is among the most expensive types to extract and the company has a low reserve position of about 20 years.

Alpha Natural Resources has only been public since early 2005, so its numbers are somewhat thin with the limited history. Its revenue has seen an average growth rate of 34.1% over the last three years, but declined to 17.4% last year. The company sees a net margin of 5.1% from a gross margin of 16.3% but posts an admirable 24.9% return on equity.

In the coal mining business the plain, simple truth is that size matters. The bigger you are, the more economies of scale you enjoy which ultimately translates into higher share prices. Aside from the volatility along the way, over the last three years Alpha Natural Resources has returned zero, Arch Coal has risen about 100% and Peabody has appreciated an impressive 250%.

Of course, there are energy alternatives to coal, hydroelectric, nuclear and natural gas. To learn more, check out Clean Or Green Technology Investing.

Looking to cook up a market-stomping stock portfolio? Check out our FREE report "7 Ingredients to Market Beating Stocks" and get started right now!

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