Yes, that title seems counter-intuitive. Why buy a major U.S.-based producer of coal at a time when thermal coal prices are weak and the outlook for metallurgical coal is uncertain? Well, the reality is that it's only when coal markets look terrible, that Peabody Energy (NYSE:BTU) ever looks relatively cheap. While this leading energy company has more work to do in Australia than expected, today's prices represent a relatively good long-term entry point for patient and risk-tolerant investors.
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Blame it on the Wombats
Peabody's fourth quarter was not especially strong, and it's mostly the fault of the acquired operations of Ma carthur Coal in Australia. Honestly, few analysts or institutional investors really care about the revenue of a coal company like Peabody, but it was up 26% from last year, with an 8% increase in tons sold and better than 11% growth from the U.S.
What analysts do care about are metrics like EBITDA, shipment volumes and per-ton profits. Shipments were up about 8% as reported and a bit more than 6% on an "organic" basis. Although shipments from the West region were better than expected and Midwest shipments were OK, shipments in Australia were a fair bit weaker than expected. (For more on EBITDA, see EBITDA: Challenging The Calculation.)
At the same time, operating costs were problematic. The West was again pretty good this quarter, but costs were higher than expected in the Midwest and the operating costs in Australia were higher because of significant cost overruns at Macarthur, which were about twice the operating cost per ton of Australia as a whole. This took a real toll on operating EBTIDA, and although the reported growth was good, it was more than 10% shy of expectations.
2012 Will Be a Year of Retrenching
Peabody acknowledged its problems with Macarthur on the call, and at least some of the problems seem attributable to former management not really running operations at peak efficiency. That's not altogether surprising, given that Australian coal companies have been under a lot of pressure to increase production, with costs being a secondary concern, to meet surging Asian demand.
The problems in Australia are fixable; they'll just take some time and money to do so. Consequently, profit expectations in Australia need to be a little lower for 2012, but these adjustments will pay off with better profitability down the line.
A Chill in Thermal Coal
Peabody supplies about 10% of the coal burned by U.S. utilities and the state of the thermal coal market is a significant issue for coal stocks these days. Natural gas prices have fallen so low that they're actually starting to crimp demand for Powder River Basin coal; this is definitely a bad thing for a PRB pure-play like Cloud Peak (NYSE:CLD). How bad are things? Prices are getting close to the cash cost of production and that doesn't happen very often.
Unfortunately, it's hard to say that things will get rapidly better. At current prices, PRB coal is still about one-quarter more expensive than natural gas and coal from Appalachia is about 70% more expensive. Although it's true that there's a limit to how much utilities can substitute gas for coal, Peabody management thinks upwards of 80 million tons could be in play in 2012, depending upon prices. For companies with more exposure to thermal coal, names like Cloud Peak, Arch Coal (NYSE:ACI) and Penn Virginia (NYSE:PVR), that's definitely a concern heading into the year.
The Bottom Line
Peabody does have a metallurgical coal "kicker," but the uncertain economic outlook in Europe and China may keep a lid on met coal pricing and take some steam out of Peabody, Walter (NYSE:WLT) and Alpha Natural (NYSE:ANR). Still, the longer-term outlook is fairly positive.
Based on past EV/EBITDA experience, Peabody shares ought to be trading somewhere in the mid-to-high $40s. That suggests 25% or so undervaluation; maybe not the greatest discount out there among commodities, but more than investors often get with a company of Peabody's quality. By all means, consider other commodity plays like copper and steel, but also consider buying Peabody at these levels, as a play on eventual price recoveries. (For related reading, see Relative Valuation Of Stocks Can Be A Trap.)
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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.