Peabody Energy Corporation (BTU) is one of the largest coal producers in the world. Its share price has tumbled since 2011, due to the industry's cyclical downturn. However, I would argue that the coal fundamentals remain strong in the foreseeable future and Peabody has the strength to withstand the downturn to eventually rebound.
Peabody owns coal mines in both the United States and Australia. In the US, Peabody produces a majority of coal in the Powder River basin and Illinois basin, both of which have lower mining cost than the eastern Appalachia basin. Most of the coal is used for domestic electricity generation. In Australia, the produced coal is mostly supplied to the growing Asian countries for both electricity generation and steel making.
Coal Market and Peabody's Positioning
In the US, the coal industry is facing two headwinds. The first headwind is the competition from natural gas as an alternative energy source for electricity generation. In the past few years, natural gas had been abundantly produced due to the technology advance. This has led to the reduced gas price and the consequent switching from coal to gas for electricity generation. However, it is not profitable for gas drillers to operate at the price as low as in early 2012. As a result, the supply and demand rebalanced, which caused the price to rise to the current $3.3/mmBtu. At this price, Peabody's coal in the Powder River basin and Illinois basin is competitive, whose breakeven gas prices are $2.5~2.75/mmBtu and $3~3.25/mmBtu respectively. The most affected coal is in fact from the costlier Appalachia basin, where Peabody has little exposure. The second headwind faced by the coal industry is the clean energy regulation from the Obama administration. Although the impact of the regulation could be real, it is still uncertain how much cost will be incurred and when it will be realized.
In Australia, the coal industry is having a secular tailwind, which is from the growing demands of coal from the Asian countries, especially China and India. Although it is a major coal-producing country itself, China is encouraging the coal import from overseas in its recent five-year development plan, to preserve its own strategic coal reserve and alleviate the transportation bottleneck between its western coal-producing regions and its eastern cities. Additionally, Chinese government plans to restrict the import of low-grade coal to reduce its domestic pollution, which bodes well for the high-grade Australian coal but not for the competing low-grade one from Indonesia. For India, the recent blackout highlights the increasing demand of electricity in this country to meet the needs of its growing population. Even for Japan, it is uncertain whether it could restart its nuclear generators anytime soon. Consequently, Japan needs to import more coal for its electricity generation. In sum, all these demands from the Asian countries will be the secular tailwind to the industry in the long run. In the short term, however, the coal is oversupplied in the region due to the projects initiated a few years ago when the coal price was driven up by the demand. The corresponding price correction is currently impacting Peabody's profits. For example, from the first half of 2012 to the same period in 2013, Peabody's shipment of coal was increased by 14% but its operating income was reduced by 70% due to the lower coal price. Nonetheless, it shouldn't be a big concern for Peabody, because its recent capital program and owner-operator conversion have moved it down the cost curve, which leaves other costlier producers no choices but to cut productions in the near future. Eventually the supply and demand will rebalance at a higher coal price. Peabody will be at an advantageous position to reap the reward.
Peabody's financials for the past five years are summarized below, as well as my estimated 2013 and 2014 numbers:
EBITDA is calculated by adding both depreciation/amortization and interest expense to the reported operating earnings before tax. For 2012, I also add back the 900m write-down from Peabody's Australia operation. The impact of the coal price to EBITDA is clear from the table, where the decreasing price since 2011 has led to reduced EBITDA. The big CapEx in 2011 and 2012 is due to the capital program and owner-operator conversion in Australia, which improved equipment and increased the base of installed capacity. The big increase of interest expense since 2012 is from the debt incurred in 2011 to finance the acquisition of Macarthur Coal.
For 2013, the continuing soft coal price still impacts the operating earnings. By assuming there is no material improvement in the second half year, I estimate the full year EBITDA to be 958m, which is the annualized first half year result. CapEx of 400m comes from the management guidance.
Looking out into 2014, I expect the coal market should gradually bounce back, when the natural gas price in the US is stabilized around the current level and the overcapacity in the seaborne market is removed. With the continuing demands from China and India, it should bode well for Peabody. I assume its EBITDA will return to its 2012 level. For CapEx, it is reasonable to expect it will remain at a level similar to 2013. Actually, the management estimates that the sustaining CapEx will be less than $1.2/ton. If we assume the coal production is around 226 tons (2012 level), the sustaining CapEx will be 271m, well below the 400m assumption. For the purpose, I also assume interest expense and tax are the same as in 2012.
For 2014, the upside price is $39.4 by assuming a five-year averaged FCF yield of 6.5% and $2.56 FCF/share (692m FCF/270m shares). If we also add one year dividend of $0.221/share (after 35% tax), we get $39.6/share. For the downside, we can use its lowest price $14.5 in the past 5 years. Actually, this price is equivalent as if we assume a high FCF yield of 10% and $1.45 FCF/share, reasonably conservative assumptions. If we add the dividend, we get $14.7/share. Using the current price $17.2, we have the upside 130% and downside -15%, a decent risk/reward payoff. Even if the industry would take one more year to recover in 2015, the return on the upside is still attractive at 65% per annum.
Finally, we need to check Peabody's liquidity to make sure it can survive the current soft coal market. The company's debt schedule at the end of 2012 looks like below:
Since then, Peabody has repaid a 167m term loan, representing all of 2014 contractual principle repayments and a portion of 2015 contractual principle repayment.
The company's credit facilities include:
Senior unsecured credit facility
Accounts receivable securitization
And the predicted cash on the balance sheet for both 2013 and 2014 are:
*For 2013, the starting point is from the mid of 2013 and adjustments for FCF and dividend are made accordingly.
Before 2016, there is ample liquidity to cover the debt repayment. Even if the soft coal market persists into 2016 when Peabody will face the biggest near-term debt repayment, it would still have enough liquidity from both the cash on the balance sheet and the existing credit facilities. Though this scenario seems a bit stretching, refinancing debt or securing more facilities are still possible. I deem this an unlikely scenario as of now, since I believe there is still ample time for the coal market to return by then.
Coal will remain to be the number one energy source for the foreseeable future. The current downturn of the industry makes it a good entry point. Although the timing and extent of the recovery are still somewhat guesswork, the potential large payoff makes it a worthwhile investment at the current price level.