Introduction: current and future conditions of the coal industry
The coal industry has been under intense pressure for several key cyclical and possibly structural reasons. The U.S. Energy Information Administration's 2013 energy outlook predicts a decline in Appalachian mining, but an increase in PDR and Midwestern coal regions much through 2015 and slow growth as an industry through 2030. The forecast just highlights possible future scenarios for the coal industry. Structurally, U.S. coal has to become cleaner with the proper development of carbon capture technology. Furthermore, the pace of development should not be endangered by short term worries of pollution or climate change. Solar power, renewable energy, and carbon capture will become advanced and economical enough with appropriate investments and infrastructure improvements. It is more essential to research individual companies in the coal industry with the most ample management focused on shareholder value creation by fully understanding the risks of a cyclical business and maintaining capital and financial discipline to withstand elongated market downturns.
Where is the value in coal?
For much of 2013 it has become apparent that major U.S. coal corporations spent billions on acquisitions that have destroyed shareholder value through additional capital requirements or selling shares diluting shareholder's value significantly. The market downturn for coal has increased the probability of liquidity issues due to extreme leverage, high interest payments, and unprofitable mines. With such difficult conditions it would prove wise to invest in the company that shows examples of shareholder friendliness and capability to have a business that can grow with invested capital at a decent rate rather than destroy and deteriorate future earnings. The risk reward scenario with the coal industry must take in account not only the cyclical nature of commodities, but also the return on retained earnings individual companies can achieve.
The two main uses of coal are thermal for electric generation and metallurgical used in the steel making process. In brief the major risk facing thermal coal is low and abundant natural gas in the U.S., abundant thermal coal in China, and increasing EPA and related climate change legislation costs. An extensive detail of these challenges can be found with the EIA Annual 2013 Energy Outlook. The metallurgical coal market is currently oversupplied due to the cease of disruptions in Australian mines, increased supply of coal from Mongolia directly to China, and production being continued at a loss due to high rail and port contract payments for several large mining corporations in Australia. Australian mines can produce significantly more coal at a lower cash cost per ton basis than U.S. and Canadian mines and sales are benefited in part due to the weakening of the Australian dollar vs. the U.S. dollar. Overall, the supply and demand graph is lopsided supporting low priced met coal across the globe. Certainly the met coal market will rebalance with the fact no new investments or capacity increases are planned through 2015-2016 in which demand should benefit from growth across Asia and Europe exciting a double recession. Natural gas is a hot topic and I would be extremely cautious trying to predict future price ranges due in part of the speculative nature of commodity markets.
With that said, Peabody Energy (BTU), Alliance Resource Partners, L.P. (ARLP), and Cloud Peak Energy (CLD) are the major pure coal miners that reflect decent management and financial disciple to offer higher returns to investors than Walter Energy (WLT), Alpha Natural Resources (ANR), and Arch Coal (ACI). I strongly recommend an investor research thoroughly these six companies along with Cliff Natural Resources (CLF), BHP Billiton (BHP), and any publicly sold business involved with mining and related industries for a complete understanding of the market. This is my humble opinion and I may be wrong; however, I will demonstrate below some major concerns and potential reasons to avoid certain companies in the industry and focus on those companies that can create value through an extended downturn.
At today's market price, is Peabody Energy a good value?
Peabody Energy compared to Arch Coal, Alpha Natural Resources, and Walter Energy looks like a gold medal. Peabody Energy will one day take advantage of its asset locations in both the U.S. Powder River Basin for cost competitive U.S. fuel and Australian mining complexes for metallurgical coal. I believe Peabody Energy is financially secure enough to withstand continued market conditions for several years and is keenly aware of its capital use. One could argue that its MacArthur coal transaction was a bad one since the return on assets is not as great as originally estimated since the coal market downturn. Although a huge increase in leverage, the company did not issue shares and dilute shareholder's ownership. Comparatively to other mining assets, it is not in bad shape. For instance, domestic coal miners Arch Coal, Alpha Natural Resources, and Walter Energy acquired assets in 2011 and consequently idled and closed several mines directly related to their respective acquisitions. These idled and closed mines have required millions of dollars of capital and unnecessary expenses. I find three important aspects to consider in greater detail: One is Peabody's past and current owner's earnings vs. peers, second is the current business conditions, and finally, the ability of management to invest shareholder's capital profitable with a decent return.
I calculated and interpreted owner earnings by using adjusted net income excluding asset impairments + depreciation - capital expenditures required to maintain mines and production at current levels.
Disclosure: These numbers also have author's own adjustments including subtracting share compensation and western lease payments. It is recommended to look at their own respective 10-K and recent 10-Q for updated and more accurate information
The basis for these calculations are to show that during the boom cycle, only Peabody and Walter Energy were able to generate a significant amount of owner's earnings to re-invest in the business and create value for shareholders. The difference between Walter Energy and Peabody is that when metallurgical coal prices fell to current levels, high cost Canadian and West Virginian mines had to be closed and idled in order to eliminate losses. Whereas, Peabody Energy has kept all of their Australian mines since the acquisition in production making a profit, but significantly lower than previous years.
The first 6 months of 2013 reported earnings, without any adjustments are below including total long term debt and market capitalization as of Monday August 19, 2013. Due to low capital expenditures, the companies' cash from operations is higher than earnings depict. If market conditions do not improve, then I would expect high interest payments and geographic mining difficulties at the mines to cause even more financial stress for all companies that may require additional liquidity through stock sales or debt offerings.
2013 6 months earnings:(000s)
Alpha Natural Res
Source: from all four respective 10-Q forms filled with the SEC for the 2nd quarter
Of these four companies, Peabody Energy would likely benefit due to its metallurgical coal exposure from its Australian mines, weak Australian dollar, and close proximity to the Asian markets. With Peabody able to cut costs and keep production at current levels, along with other miners in the region including BHP Billiton, the seaborne market for met coal will continue experiencing depressed coal prices. Demand will not be as robust as before; however, expansion projects are nearly nonexistent through 2015-2016 without any major investments. The U.S. seaborne market will continue to be affected by increased supply from Australia, Mongolia mines directly supplying China, and slightly offset by U.S. steel growth. The U.S. met coal market will depend highly on the European and Asian steel markets improving from current demand and additional supply cuts from existing high cost mines throughout the world. This is a huge disadvantage for Arch Coal, Alpha Natural Resources, and Walter Energy.
Peabody also has a significant exposure to Powder River Basin in the United States and no exposure to high cost Appalachian coal that is being replaced with Natural Gas at significant rates due to the proximity of the shale formations along the east coast. Along with Peabody Energy, it would be worth researching Cloud Peak Energy, Cliff Natural Resources, and Alliance Resources for a possible investment in the coal industry. However, for the reasons I will briefly show below, Arch Coal, Walter Energy, and Alpha Natural Resources should be avoided despite the prospects of their share prices advancing greatly when the cycle reverses course.
What do Alpha Natural Resources, Walter Energy, and Arch Coal have in common?
They all sold a part of their business for idled assets, some of which have been closed down permanently. The management and board of directors of Arch Coal, Walter Energy, and Alpha Natural Resources have a dismal track record for creating shareholder value; however, reading the shareholder's letter from each company would lead you to believe differently. Due to large share and debt issuances for additional coal mining assets, the future earnings per share and net income guidance will be much lower when conditions improve. Granted, Peabody and Cliff Natural Resources made acquisitions in 2011 during the market top; however, they didn't dilute existing shareholders nor did they buy assets that are idled or uneconomical in today's environment. Shares outstanding from 2010 to current conditions for Arch Coal went from 163.2 million to 212 million shares outstanding, Alpha natural resources went from 121.7 million to 220.8 million shares outstanding, and finally Walter Energy went from 53.7 million to 62.6 million shares outstanding. Put another way, Arch coal sold 29.9%, Alpha Natural Resources sold 81.4%, and Walter Energy sold 16.5% of their respective businesses for idled and non-productive assets.
Excessive debt burdens and addiction to tougher credit agreements will weigh heavily on the equity and debt prices for almost all U.S. coal miners. Liquidity concerns and increased interest payments will heighten if market conditions persist for several more years. Bankruptcy is plausible if China, European, or U.S. growth slows dramatically and steel demand declines. Granted, being in a commodity industry that has been particularly hit hard due to climate change legislation, competitive alternative fuels from natural gas, and the cyclical nature of steel and coal markets makes every company in the industry struggle financially. It would be wise to learn the mistakes these coal companies made in 2011 that put them in this financial hardship today. As history tends to rhyme, those that turn boom profits into assets that erode shareholder value during a down market will likely do so again. I understand that the market and every cycle has a bottom, but timing the market is of less importance than it is to invest in a business who you can trust with your money and earn respectable returns years down the road rather than turn it into pennies on the dollar.
In summary, the coal cycle is going through a typical cycle, maybe even a super down cycle. One cannot know how long the downturn will last nor when conditions will improve. Therefore, it is imperative to do diligent research and analysis to understand which mining companies will offer positive returns of capital and offer significant value for the price paid. I believe Arch Coal, Alpha Natural Resources, and Walter Energy would not be the strongest options; however, Peabody along with Cloud Peak Energy, Alliance Resource Partners and others not listed could potentially offer better shareholder returns due to a list of factors including more shareholder friendly management, diversity of incomes, and business models. The coal market is in a depression and there is the potential to find excellent opportunities, which is why I wrote this article. However, prudence and care should be exercised before investing in any particular security or company to best eliminate the risk of losing capital.