Peabody Is The Best Of A Mangy Breed

By Stephen D. Simpson, CFA | October 23, 2012 AAA

As investors have come back around to the idea that maybe coal isn't forever doomed, shares of leading coal company Peabody Energy (NYSE:BTU) have rebounded over the past quarter. Better still, Peabody delivered the sort of quarter that ought to remind investors that it is indeed a high-quality operator in the sector. Although Peabody's recent stock market action has taken away a fair bit of the easy money, long-term investors could still have reason to own this name, albeit with some above-average risks.

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Good Performance Shines Through
Peabody's earnings may give some hope to those who believe that the coal industry has passed through the worst of this latest cyclical trough. At a minimum, management did demonstrate that it can execute on cost control.

Revenue rose 1% from last year and about 3% from the prior quarter as core coal mining results (up 9% from last year) were surprisingly strong. Volumes sold increased 4% from last year (excluding trading) and 14% from the prior quarter, led by very strong results in the Western region. While pricing was not so strong, the declines in the United States were in the low single digits and U.S. pricing actually improved a bit from last year.

Peabody matched the good production numbers with good cost control. Production costs (measured per ton) dropped 1% in the Midwest region on a sequential comparison, and 10% and 3% in the West and Australia, respectively. That latter number is particularly noteworthy given the recent angst from other miners such as BHP Billiton (NYSE:BHP) over rising costs in Australia.

Reported operating income still dropped about 31% from last year, with EBITDA down about 9%, but these results were nevertheless better than expected.

SEE: How To Decode A Company's Earnings Reports

It's Still Tough Out There
Although Peabody's results were decent, investors shouldn't allow themselves to get complacent about the state of the coal market.

For starters, railroad earnings haven't included a lot of good news for the sector. CSX (NYSE:CSX) continues to expect weak volumes and uncertain (but probably negative) export volumes, while Kansas City Southern (NYSE:KSU) believes more than a quarter of its coal volume could be at risk to substitution. Likewise, Union Pacific (NYSE:UNP) is seeing double-digit declines in carload volume, while hoping to offset some of the damage with higher rates.

It certainly doesn't help matters that the breakeven price analyses still don't favor coal. Natural gas prices have risen some, but they need to be in the $4 range for coal to really become competitive again. Though it's true that a Republican victory in November could lead to a rollback of some of the environmental and labor regulations that have made coal less competitive, such a victory would also probably mean less restrictions on fraccing and pipeline construction, which would be good for gas.

And don't forget steel. Met coal (used in the steelmaking process) was supposed to be the ace in the hole for many miners such as Peabody, CONSOL (NYSE:CNX) and Arch Coal (NYSE:ACI), but major steelmakers have increasingly looked to supply their own met coal needs and the smaller steelmakers are the ones seeing the most pressure from the current steel industry malaise.

SEE: A Primer On Coal

A Good Operator Through Thick and Thin
While the coal market still isn't in calm waters, Peabody still looks like a good choice for investors looking to play a rebound. For starters, Peabody has positioned itself in the right places - Illinois Basin coal, Powder River Basin and Australia. This gives the company exposure to (relatively) cleaner coal that can be mined less expensively, as well as better exposure to the growing Indian and Chinese markets. What's more, less exposure to Appalachian coal means less exposure to legacy pension costs, less vulnerability to worker safety regulations and less underground mining.

The Bottom Line
Coal stocks typically trade around eight times forward EBITDA estimates, and Peabody has often garnered a premium for the perception that it is a better-than-average operator. Of course, the danger in making decisions on the basis of multiples such as EV/EBITDA is that the EBTIDA estimates can change significantly - estimates for Peabody dropped about 15% in just the last six or seven weeks.

Using the current sell-side estimates and that eight times multiple, Peabody looks slightly undervalued with a fair value target in the mid-$30s. Although it's probably true that analysts will underestimate the scope of a coal recovery (if/when one comes), it's also true that the coal market may never be what it once was if regulations convince utilities to turn from coal to gas for the long term. Consequently, while it seems that Peabody is probably undervalued today, there are definitely some risks to near-term performance and financials.

SEE: Value Investing Using The Enterprise Multiple

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

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