Warm winter weather and low natural gas prices have gutted the coal market in the United States. Utilities like American Electric Power (NYSE:AEP) are switching over as much production to natural gas as they can, while railroads from Union Pacific (NYSE:UNP) to CSX (NYSE:CSX) are reporting sharp drops in coal carloads. That is leading coal producers like Peabody Energy (NYSE:BTU) and Cloud Peak Energy (NYSE:CLD) to cut production, and leading investors to fret about the near-term outlook for EBTIDA.
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Cloud Peak on Target, but Nobody Cares
Cloud Peak actually did more or less as the Street expected for the March quarter. Revenue rose about 5% from the year-ago period, but fell about 9% from the fourth quarter. Sales volume dropped 11% sequentially, neutralizing the benefit of a modest (4%) increase in price realization.
Unfortunately, while volumes and price are under pressure, costs are not likewise constrained. The average cost per ton increased about 9% from the fourth quarter, leading the company to report a 9% sequential decline in operating income, a nearly 10% decline in cash operating margin per ton and an 8% decline in EBTIDA.
For a better understanding about the commodity of natural gas, read A Natural Gas Primer.
It's Not 2012 That's the Biggest Problem
Cloud Peak has quite a large percentage (more than 90%) of its anticipated 2012 production under contract, and under contract at prices that are pretty attractive relative to spot rates. Unfortunately, utility customers are already requesting deferrals as their coal stockpiles continue to increase. Though Cloud Peak is not always contractually bound to grant deferrals, cramming its customers with coal they don't want is not exactly a good long-term strategic move. Consequently, there's still revenue risk for 2012 even with that high level of contract coverage.
The outlook for 2013 and 2014 is the more worrisome bit. About 40% of expected 2013 coal production in uncontracted, and that figure jumps to about 60% of 2014. While Cloud Peak saw over $13 a ton in realized prices for the first quarter, the current spot price for Powder River Basin coal is below $9 a ton.
This puts Cloud Peak in a pretty tough spot. It's not as though there's likely to be enough demand out there for Cloud Peak to just ramp up production to cover the difference (volume versus price), even if it were economical to do so. Consequently, management has to either take a risk and hope that prices improve exiting 2012 or sign contracts that all but guarantee poor year-on-year EBITDA in 2013.
SEE: Pencil In Profits In Any Market With A Calendar Spread
Coal Should Rebound, but Nobody Knows When or How Far
Coal bulls will point to the large percentage of power in the United States that is still generated by coal, the growing overseas demand for coal and the relative benefits of PRB coal as an argument for keeping the faith. While those points are all true to a point, that "point" can be a rather sharp one.
It is true that coal is still the primary source of electricity in the U.S., but utilities are scrambling to switch over as much capacity to natural gas as they can. Not only is gas cheaper (for now, at least), but there seems to be a high level of confidence about future supply and the environmental burdens are lower.
As for overseas demand, it is true that countries like China and India are demanding more and more thermal coal. That doesn't necessarily help Cloud Peak, though. For starters, China would rather buy from mines in Australia (like those controlled by Peabody) and save the shipping. That's even more relevant when factoring in the lower BTU content of the Powder River Basin coal - importers have to pay more in shipping for the same thermal bang.
It's also true that the Powder River Basin coal has certain intrinsic advantages. Cloud Peak is responsible for about 10% of the country's coal production and is dedicated solely to PRB coal ((though Peabody and Arch Coal (NYSE:ACI) are actually larger PRB producers)). And PRB coal does have advantages like lower pollutant content and less risky (and costly) mining. Unfortunately, that just doesn't matter much when utilities are full and want no more.
To make sure your portfolio of investments isn't too risky, read How Risky Is Your Portfolio?
The Bottom Line
As investors have seen in stocks like Alcoa (NYSE:AA) and Freeport-McMoRan (NYSE:FCX), the historical average for EBITDA multiples mean very little when the market has soured on the commodity in question. So while the fact that Cloud Peak trades at less than 3.5 times 2012 EBITDA estimates would make it quite cheap by historical standards, Wall Street is unlikely to get excited about the name so long as there are expectations that 2013 and 2014 EBITDA could be lower still.
A patient, long-term investor can definitely think about building a position in coal stocks today; it's difficult to see how prices could stay this low on an indefinite basis. That said, nobody should buy Cloud Peak today if they can't stomach the thought of seeing a $10 price on the stock before the rebound. Although I don't necessarily believe that's where the stock is going, I've seen too many bear cycles in commodities to not recognize that that possibility is still on the table.
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