The US Coal Industry has been suffering recently due to the US economic slowdown, lower natural gas prices and the European economic crisis. However, the Coal Industry is expected to perform better in future because the shift from coal to gas in the US has slowed down, and has even started to move in the opposite direction. Rising US coal exports and the increasing contribution of coal in the power generation of Europe are other factors responsible for our optimism regarding the Coal Industry. Based on our belief that coal stocks would perform better going forward, Peabody Energy (BTU) is best placed to gain from the coal rebound. We are bullish on BTU as it has higher margins and ROE as compared to its competitors. Moreover, the company displayed robust financial performance in the recent third quarter despite the tough conditions for the industry.
BTU is one of the world's largest coal companies with annual sales of more than 250 million tons. The company delivered better financial results in the recent third quarter due to cost control measures and improved operational efficiency. BTU's stock is down almost 30% YTD. The stock has taken a dive but we believe that going forward the stock will show an upside as the market for coal improves.
Q3 Earnings Review
More than two quarter of the company's revenue is earned from its US mining operations while almost 40% is attributed to its mining operations in Australia. The US segment is the largest segment of the company and it displayed strong performance as revenues were up 1%, along with an 8% improvement in margins, driven mainly by cost control initiatives. The company's operations in Australia performed well as volume grew by 39%, mainly due to a 13% YOY decrease in prices. The shipments for the Australian segment reached the record level of 8.5 million tons, comprising 3.2 million and 3.5 million tons of thermal coal and metallurgical coal, respectively.
As coal prices in the US gained some strength alongside rising natural gas prices, BTU experienced an improvement in revenue per ton for its US operations from $21.99 in 3Q 2011 to $22.35 in 3Q 2012. This helped the company strengthen its gross margin per ton, which was up 8%.
Exposure To US Power Generation
The company has a significant exposure in the US power generation system as 12% of its total coal volume in fiscal year 2011 was sold to US electricity generators. This significant electricity generation exposure will be a key driver of the company's performance in the future as natural gas prices rise and power generators start burning more coal. The share of coal in power generation has increased by 9% from its share in the second quarter of the current year, to end up at 39% in 3Q 2012.
Growing Demand In The International Markets
Approximately 15% of the total volume of the company is sold outside the US. International markets play an important role in driving BTU's stock price. International coal markets have shown signs of improvement, and if the trend continues, it will benefit the company. As coal prices plunged in early 2012, European power producers found coal to be a cheaper substitute to natural gas and increased their coal driven electricity generation, maintaining higher US coal demand. Moreover, the coal contribution of India in electricity generation increased by 12% from January to September 2012. Increased demand in international markets will help strengthen coal prices and demand going forward.
The company has been improving its cost structure, which will help it expand its margins. The company anticipated almost $100 million in annual overhead savings, which will benefit the company in the coming years. These operational efficiencies will be achieved through elimination of contractors and workforce reduction. Moreover, the company offers better margins and return on equity as compared to its competitors. CONSOL Energy (CNX) has slightly better margins than BTU because CNX has both natural gas and coal exposure. The table below shows the comparison of BTU's margins and ROE with those of its competitors.
Arch Coal Inc. (ACI)
Alpha Natural Resources, Inc. (ANR)
Source: Yahoo finance and Nasdaq.com
The company currently offers a dividend yield of 1.4%, backed by its operating cash flow yield of more than 20% and free cash flow yield of 3%. Looking at the balance sheet of the company, debt seems to be on the higher side as compared to its competitors. BTU has a debt to equity of 105%. However, it has decent interest coverage of more than 7x.
The company's stock is currently trading near $25, with a 52 week range of $18.78 - $39.74. Due to the depressed environment of the coal industry, BTU has been trading at lower valuations. BTU has a trailing P/E of 10x and a forward P/E of 13.5x, based on its 2013 earnings. However, using the company's 5 years average P/E of 19x and analysts' estimates of $1.9 per share for 2013 earnings, we get a price target of $36, creating an upside potential of almost 40% for the company's stock.
5 years Average P/E of BTU
BTU - Estimated 2013 average EPS
Source: Qineqt's calculations
Using the bullish forecasts for 2013 EPS and BTU's 5 year average P/E of 19x, we get a price target of $49.
Downside: However, for a bearish scenario, we assume natural gas prices will not rise and natural gas would maintain its current share in electricity generation. Under these circumstances, the company's stock would continue trading to trade at its current P/E (TTM) of 11x. Using 2013 earnings' forecast of $1.9 and P/E of 11x, we get a price target of $20.