While Cloud Peak (NYSE:CLD) has been written about a few times on Seeking Alpha and 15 analysts currently cover the stock, it still seems to get little respect among the mainstream financial media. It has been my experience when reading articles about coal that Cloud Peak is nowhere in sight as the two biggest U.S. players by production (Peabody (BTU) and Arch (ACI)) garner the lion's share of attention.
Perhaps it is due to its size or maybe the boring nature of mining coal. Regardless of what it might be, Cloud Peak is the third largest coal company in the country and remains the often overlooked gem in the most prolific coal mining region in the country.
For some time, there has been an increasing shift in the coal industry as production which was once so dominant in the eastern U.S. has steadily been giving up ground to the Powder River Basin (PRB). The basin stretches from Montana to Wyoming and is now the single largest source of coal mined in the country, supplying roughly 40% of the coal consumed in the U.S. As the environmental and political landscape continues to erode the once dominant Eastern coal producers, the future of coal in the U.S. resides in this coal rich region of the country. Within the PRB, Cloud Peak Energy represents an interesting opportunity to purchase shares in the third largest coal producer in the nation at a discount to the underlying value of its coal reserves.
The industry took a drubbing as overproduction in 2007-2008, coupled with relatively mild temperatures, saw coal inventories across the nation soar to levels not seen in over a decade. Despite the difficult headwinds that the industry encountered, these issues are largely resolved as inventory levels have been steadily dropping and coal companies are again seeing both increased demand from customers and increases in the spot price for coal.
The favorable industry conditions translated to better operating results and many coal companies saw sizable run ups in their stock price. Cloud Peak was certainly included in this peaking at over $24 per share (though the company still remains perhaps partially under the radar given its size.) Cloud Peak’s stock price has since fallen back to even more attractive levels and does not reflect the value of its coal assets, strong operating results, nor the position the company holds in the PRB.
If it holds true that every investment outcome is a result of a couple key variables, perhaps in the case of Cloud Peak these can be summed up in the following:
- The discount to intrinsic value of the coal assets in the ground.
- Solid long-term economics of coal.
- Potential acquisition target given its presence in the Powder River Basin.
- Tremendous shift from eastern coal to PRB coal.
Company carve out
Cloud Peak went public in December 2009 as a result of a distressed sale by parent company Rio Tinto (NYSE:RIO) in an attempt to help relieve their heavily debt laden balance sheet. In 2007, Rio Tinto bought Canadian aluminum giant Alcan for $38 billion. The financial turmoil that began unwinding in 2007 left the company in a difficult position and in need of divulging assets, leading to a carve out of Cloud Peak Energy.
Until December of 2010, Rio Tinto controlled roughly 52% of CPE before selling its remaining stake in a secondary offering, making Cloud Peak a stand alone business.
The company operates three mines out of the PRB and is the only pure play in the region. While not the largest player in the area, Cloud Peak runs two of the four largest mines in the basin. The PRB is also the lowest-cost coal-producing region of the major coal producing states in the U.S. which consists of Wyoming, West Virginia, Kentucky, Pennsylvania, and Texas. The coal from the Powder River Basin has almost become synonymous with electricity generating. The coal the company produces accounts for roughly 4% of the country’s energy needs, making Cloud Peak the third largest coal producer in the nation.
The four main drivers of the coal business are:
- The price with which the coal can be sold
- The volume of coal produced
- How well costs can be managed
- The quality of coal sold
The price with which the coal can be sold.
As is the norm in the coal industry, Cloud Peak generally enters into fixed price/volume supply contracts of one- to five-years with many of their customers. During 2010, 64% of Cloud Peak’s committed tons were with contracts that had three years or more remaining on their term, but roughly 97% of total revenues were from long-term supply contracts with a term of one year or longer. The company’s coal is sold to over 47 electric utilities with no single customer accounting for 10% or more of revenue for the year.
For 2011, the estimated average price per ton is expected to come in at around $12.95 with anticipated production of between 93-96 million tons. For 2012, Cloud Peak has contracted to sell 70 million tons with 56 million under fixed price contracts with a weighted average price of $13.08.
The volume of coal produced
Cloud Peak holds about 22 years of proven and probable reserves if production continues at the current pace. Most recently, they expanded their Antelope mine by acquiring 406 million tons in May and June for roughly $350 million or $0.85 a ton.
During 2010, the company produced close to 94 million tons of coal with future plans to acquire more leases as time goes on. The company has nominated around 800 million tons of PRB federal coal for lease that they plan on bidding on over the next three years.
For 2011, the company estimates production from its three mines will be between 93-96 million tons of which 87 million tons is contracted at a fixed average price of $13.05. For 2012, Cloud Peak has contracted to sell 70 million tons with 56 million under fixed price contracts with a weighted average price of $13.08.
Below is a breakdown of the proven and probable reserves of the company’s 3 mines:
As in any industry where long-term fixed contracts are the norm, managing costs effectively is of the up-most importance. There are quite a few factors that can affect the cost per ton such as labor, oil prices, production taxes, royalties, and equipment. Of these, royalties/taxes and labor accounted for the largest expenses at 44% and 19% during the year ended 2010.
The largest components of production costs are as follows:
It is difficult to compare the average cost per ton for another company operating in the PRB as Cloud Peak is the only pure play in the region. While Peabody Energy is the largest player in the PRB, its operations stretch all over the country and world making a comparison between the two companies an inaccurate representation of their ability to keep costs under control. Given that mining coal is unique to each respective area in which it is mined, comparing margins across the industry does not tend to lend much value.
There are 4 main types of coal with each varying based on the type of carbon it contains as well as the amount of heat energy it can produce. This also affects the price as the higher the energy and carbon content, the higher the price on the spot market.
The chart below shows the type of coal as well the percentage each variety accounts for with respect to total U.S. production.
Subbituminous or steam coal is the type found in the Powder River Basin and the variety that Cloud Peak mines. While there is no such thing as “clean coal,” Subbituminous, is considered “cleaner” when burned due to the lower carbon and energy content compared to Anthracite and Bituminous. It is also viewed as less valuable and fetches a cheaper price on the market.
U.S. coal consumption
The chart below speaks volumes as to how essential coal is to powering the nation. Given the fact that the U.S. is a developed country of 300 million people and how slowly change comes (particularly when it relates to something as important as energy), we can be pretty confident as to the future demand of coal over at least the next few years.
click to enlarge
Worldwide, coal consumption is expected to increase 60% over the next 20 years. Despite “clean coal” being a bit of a misnomer, twenty- first century coal plants emit 40% less carbon dioxide than the average 20th century coal plants and it is expected that technology to further clean coal emissions is only going to get better in the future.
According to the World Coal Institute, coal reserves in the U.S. will last for the next 119 years. The U.S. has the largest coal reserves of any country in the world and is the second largest consumer behind China.
While it is quite likely that the discovery of the Marcellus Shale will have an impact on the demand for coal over the next 20 years, it probably is a fruitless exercise to make any predictions as there are just too many unknown variables. Though the possibility exists that it could be a game changer. We can probably say with a bit more certainty (over the next few years at least) that the demand for coal will likely continue to be strong.
Rapid growth in the export market
With China and India’s growing and seemingly insatiable coal appetite, these markets will likely experience double digit growth rates for years to come. The statistics abound from China going a from net exporter to net importer of coal over the last ten years to India’s coal imports increasing some 80 million metric tons over the past decade.
While Cloud Peak’s export revenue is still quite small, it has grown quickly over the past few years as evidenced in the chart below:
As evidenced in the numbers above, Cloud Peak will maintain a heavy focus on exporting as much coal as is feasible. In June, the company signed a 10 year contract extension with Westshore Terminals Limited for the continued shipment of coal through its Vancouver B.C. terminal. This terminal is a primary gateway and will likely continue serving as a powerful springboard to the markets of Asia.
Decline in Appalachia Coal bodes well for Powder River Basin miners
For years, production in the Eastern U.S. has been in decline and is widely expected to continue to do so as evidenced in the chart above. Another issue with Central Appalachia is that it has declining reserves and continues to face tough regulatory and environmental issues.
This has directly translated to a tremendous shift towards the PRB. As eastern coal producers continue to supply less and less, the PRB will make up for an ever increasing amount of this and at some point in the future the scale will tilt heavily in favor of this coal rich region.
Unfortunately, management combined only own about 0.87% of the share count but option dilution last year stood at less than 1%. CEO Colin Marshall has been at the helm since 2006 working his way up as an analyst in the Business Evaluation Department in 1992. His 195,000 shares are currently worth about $3.9 million or just over 5.5 times his annual salary of $700,000. It also is perhaps a company where the underlying business is strong enough to where it becomes more of a bet on the horse rather then the jockey though Cloud Peak very likely has a good CEO in Colin Marshall.
Valuation was looked at through two different lenses the first of which values the Company based on a simple comparable sales transaction that occurred in March 2009 when Cloud Peak (then Rio Tinto Energy America) sold its Jacob's Ranch coal mine to Arch Coal for $761 million. This valued the 380.5 million tons of proven and probable coal reserves at the mine at roughly $2 per ton. As all three of Cloud Peak’s coal assets are located in the same area as the Jacob's Ranch mine as well as of comparable ore quality, it seems that using $2 per ton is as good a figure as any. Another factor is that at the time of the sale, PRB coal was selling for roughly $13 per ton whereas today a ton fetches about $14.60.
If we multiply this figure by the $2 that Arch Coal paid for the Jacob’s Ranch mine we end up with a $2.74 billion price tag for Cloud Peak’s entire portfolio of proven and probable reserves. The Company currently has $595.8 million in senior notes (due 2017 and 2019), $239 million in other long term debt (this relates to payment for federal and private coal leases as well as land purchase notes) and retirement obligations of about $170 million. If we back out the debt and add the $326.7 million in cash the Company has on its books, this yields an estimated intrinsic value of $2.062 billion. Dividing this figure by the 61.6 million shares outstanding and options issued gives an intrinsic value of roughly $33.50 a share or a potential upside of close to 90% from the current share price.
A little sweetener
The company's recent acquisition of the West Antelope II North lease also gave them access to an additional 80 million tons of coal that they already controlled but had not included it in their reserve estimates. To be conservative, these 80 million tons were excluded from the valuation.
As of May, Cloud Peak’s proven and probable reserves were as follows:
The company’s recent acquisition is currently pending as legal challenges have been filed by certain environmental organizations against the Bureau of Land Management and the Secretary of the Interior. These issues are not expected to have any material affect but to be extra conservative, if we assume a worst case scenario whereas the acquisition is reversed, the intrinsic value still comes to just over $20 a share.
Reserves: 966m x $2 =$1.93 b
L-T debt+other obligations $1004b
Shares outstanding+options 61.6m
Intrinsic value $20.30
The second method uses a DCF model and shows Cloud Peak trading at about intrinsic value. The weakness of this method is it cannot take into account future free cash flow generation from the recent acquisitions (assuming things go well) but nonetheless shows the Company generating plenty of cash. The method I used in calculating free cash flow was cash flow from operating activities (excluding one-time events and accounting for special adjustments to net income) and subtracting capital expenditures. Average free cash flow per share over the past three years was used as a starting point to hopefully get a more accurate representation of a business cycle. Conservative growth rates of 3% were used (though the company continues to add to their proven reserves) and a discount rate of 11% was assumed given the overall stability of the company’s operations. The results reveal an intrinsic value of just over $26.
It appears just about any way you figure it, CLD looks interesting at its current price and hopefully will continue to get cheaper.
Disclosure: I am long CLD.
Additional disclosure: If prices continue dropping, I will be a further buyer of CLD.