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Coal is an important part of an energy portfolio and is likely to hold a dominant position as an energy resource in the future. In recent years, coal markets and stocks have been experiencing a roller coaster ride due to imbalances between coal supply and demand, which has kept a lid on a coal price recovery. Last year, 2013, U.S. coal companies took corrective measures, including reducing capital expenditures, lowering operating costs and improving financial flexibility, to navigate through the ongoing tough business environment. I have a long term bullish stance on the U.S. coal industry; however, in the short term, U.S. coal stock prices could be uncertain due to the imposition of environmental regulations. In this article, I will be briefing discussing the coal industry outlook and recommend long term investors to buy two coal stocks, Peabody Energy (NYSE:BTU) and Arch Coal (NYSE:ACI). Both BTU and ACI are likely to benefit from a coal price recovery and a recovery in global economic trends.

Strict environmental regulations have taken a toll on coal consumption in the U.S. Also, lower natural gas prices have prompted a coal-to-gas switch. However, the worst has been priced in and U.S. coal stock prices have bottomed out. Given the ongoing weakness in the coal markets, U.S. coal companies are likely to burn cash in 2014, in a range of 0%-12% of their total liquidity. As the imbalance between demand and supply will be addressed, liquidity conditions of coal companies are likely to improve in 2015-2016. Also, thermal coal markets are showing more signs of a recovery in comparison to met coal markets.

Rising natural gas prices, an increase in coal-fired electricity generation, better-than-expected U.S. coal exports and falling coal inventories support my long term bullish stance on the U.S. coal industry. Rising natural gas prices has recently led to a reverse coal-to-gas switch, and coal inventories at power producers are falling, which will portend well for the industry. Falling coal inventories at power producers will lead to higher coal demand and higher coal pricing contracts for 2014 and beyond. Coal-fired electricity generation is expected to increase by approximately 5.5% and 1.9% year-on-year in 2013 and 2014, respectively. The following graph shows the falling coal inventories at power producers.
(click to enlarge)
Source: eia.gov

Also, U.S. coal exports have stayed strong as of late. Coal exports from Hampton Roads have increased in 2013, despite the sluggish demand and prices. In 2013, coal exports from Hampton Roads were up 2.7% year-on-year to 49.7 million tons, higher than analyst projections. Coal exports are expected to stay healthy in future due to forecasted flexible Eastern rail rates.

I remain bullish on BTU and ACI, the two leading U.S. coal companies. BTU has operations in the U.S. and Australia. The company has done well to lower its cost structure and improve the economics of its exiting mines. The company has lowered operating costs for its Australian mines by approximately 10% and is working to improve its cost structure further in 2014. Also, to strengthen its balance sheet and address demand and supply imbalances, the company has lowered its capital expenditure to $350-$400, down by $50 million. As the company has operations in Australia, it is expected to benefit from the depreciation of the Australian Dollar. Also, the company does not have any significant debt maturity until 2018, which reduces balance sheet risk. The following chart shows the debt maturity profile for BTU.
(click to enlarge)
Source: Company Reports

Also, due to the ongoing tough industry environment, stock price valuations remain depressed (as shown below), which presents a good entry point for long term investors.

Price to Sales

Price to Book Value

EV/Revenue

BTU

0.65x

1x

1.4x

Source: Yahoo Finance

ACI is also among the leading coal companies in the U.S. The company has been aggressively working to lower its operational costs and improve its margins. Also, the company has taken several measures, including sale of assets, to strengthen its balance sheet and improve financial flexibility. Despite the difficult coal market conditions, the company has increased its total liquidity to $1.6 billion in 2013, up from $1 billion in 2010. Also, the company has efficiently managed to extend its debt maturities and reduce balance sheet risk. Also, current valuations for ACI stay attractive for investors and offer significant stock price appreciation once the coal market fundamentals start to improve. The following chart and table show the debt maturity profile and depressed stock price valuations for ACI, respectively.
(click to enlarge)
Source: Company Reports

Price to Sales

Price to Book Value

EV/Revenue

ACI

0.25x

0.35x

1.3x

Source: Yahoo Finance

Conclusion
I believe BTU and ACI remain good investment options for long term investors, looking to play a coal market rebound. The U.S. coal industry will benefit from rising natural gas prices and higher coal consumption. As we move forward coal demand and supply imbalances will improve and portend well for BTU and ACI, as both stocks are trading at depressed valuations.

Source: Peabody And Arch: The Hallmarks Of Coal-Based Energy Portfolios