4 Compelling Buys In the Coal Space

by: Peter Epstein

No, I don't think that the world is ending, but this has been a very painful month, for investors in a wide range of natural resources and cyclical stocks. As a consultant in the coal space, in this article I focus on U.S.coal producers, picking 4 that are compelling Buys. Before I get to the picks, I take a stab at the big picture: Is this 2008-2009 all over again?

While a strong fundamental case can be made for beaten down coal stocks, fear of a 2008-2009 stock market outcome is on investors' minds.Trying to catch a falling knife in 2008-2009 was a bloody and sometimes fatal affair. Much has been written comparing 2008-2009 to 2H 2011. Frequently mentioned differences include 1) hedge funds and banks are deploying less financial leverage, meaning that forced selling of stocks is less likely to occur; 2) the worst part of the housing market collapse is behind us; and 3) interest rates are at historic lows. I add the following2 reasons which I believe are irrefutable.

First, the IMF recently cut its global GDP estimate for 2012 to 4.0% from 4.5%. To put that in perspective, in 2009 global GDP contracted by a bit more than 1%, the first decline in 50 years. Last year,global GDP rebounded by approximately 5%. Thus, global GDP is currently at an all-time high, and is forecast to grow at 4% next year. Today's global slowdown is worth watching and could get worse, but make no mistake -- this is nothing at all like that of late 2008 - early 2009. In the 4th quarter of 2008 and the 1st quarter of 2009, real global GDP fell by an annualized rate of 6.2% and 7.5% respectively. We are nowhere near such dire economic straits, yet coal stocks appear to be pricing in a greater than 50% chance that we will get there.

Second, the speed of the financial crisis caught many non-financial companies off guard. The ability to refinance debt became highly questionable for even strong and venerable companies. A meaningful portion of the stock market collapse of 2008-2009 came from the stocks of companies which looked like they might fail if they were not able to roll-over debt. Three years later, debt profiles are substantially better. For example, Peabody had net debt leverage of 3.0x on 12/31/08. As of 6/30/11, Peabody's net leverage is just 0.7x. On multiple financial and risk diversification fronts, the coal companies recommended herein are in far better shape than they were in 2008.

Peabody Energy (BTU): BTU is one of the largest producers in the world. While known for its dominant position in Wyoming's Powder River Basin (PRB), there's a lot more to the company than that. In the past 5 years, Peabody has become a top-10 coking coal producer from coal mines acquired in Australia. Australian coal production accounted for 53% of 2011 year-to-date EBITDA. Peabody is growing rapidly in Asia through proposed participation in Mongolia's Tavan Tolgoi (west) coking coal concession and a major thermal coal JV in China.

BTU has a trading operation that is not only nicely profitable, but also gives management unparalleled and timely market information.The company controls 9 billion tons of coal reserves, twice that of the 2nd largest U.S. producer. Peabody has a strong and deep management team that is well respected on a global stage. As the largest producer in the PRB, Peabody will be the main beneficiary of higher prices for PRB coal once west coast port capacity enables reliable exports to Asia.

BTU is trading at a 3.8x2012 EV/EBITDA multiple. In years past, Peabody has traded at a 1x-2x premium to the average U.S. coal player's 1yr forward multiple.Today, that premium is ~0.1x and the stock is down 52% from its 52-week high. BTU's fundamental strength and its relative cheapness to peers makes it a compelling Buy. (Disclosure: I'm long call options on BTU.)

Consol Energy (NYSE:CNX): CNX has a great coal operation and a sizable natural gas business including meaningful exposure to the Marcellus and Utica shale plays. CNX trades at a substantial discount to the sum of its parts as some coal themed investors won't own it because of its natural gas business and most natural gas investors won't own it due to its coal assets. CNX owns hard to replicate infrastructure including storage facilities, pipelines and100% of a Baltimore, Maryland port with export capacity of 14mm tons. After initial skepticism over the 2010 acquisition of Marcellus and Utica shale assets, management has regained investor confidence by expertly executing its goal of finding a strong JV partner for its Marcellus acreage, thereby de-risking the non-coal story.

CNX trades at the highest 2012 EV/EBITDA valuation.However,it screens rich to peers only because the company's natural gas business is still growing rapidly and earnings haven't caught up. Based on Consol's recent JV with Noblein the Marcellus, peer transactions of Utica properties and proven conventional natural gas reserves, it's difficult to come up with a value of less than $10 billion for Consol's nat gas business. (Consol presented at an investment conference on Sept 27th and described the gas assets as worth about $12 billion.)

Consol's coal business is one of the best in the country. It dominates the Northern Appalachia (NAPP) coal fields, is a large and growing exporter through its owned Baltimore port, has the lowest cost per ton on the east coast and operates probably the single-best premium low-vol coking coal mine in the U.S. Ascribing a 5xmultiple to CNX's 2012 coal-only EBITDA implies a $10b valuation for the coal assets. Including $1 billion for infrastructure assets, that's $21 billion of value. Backing out net debt and legacy liabilities leaves $14 billion of equity value or ~$61per share.

CNX stock is,"only" down 37% from its 52-week high compared to ANR and PCX which are down 72% and 69% respectively.The reason for this outperformance is that Consol has met or beat production and cost guidance all year while other producers have missed. And on the gas side, CNX's JV went a long way towards de-risking and validating the overall value of Consol's non-coal assets. (Disclosure: I'm long call options on CNX.)

Alpha Natural Resources (ANR): ANR is both the most diversified U.S. coal producer and the largest in Central Appalachia (CAPP). Post the company's acquisition of Massey Energy, ANR bills itself as a holder of "one of the world's largest and highest quality coking coal reserves." While I think this statement is a bit aggressive, it's a fact that pro-forma combined 2010 coking coal production and sales ranked # 3 in the world behind BHP Billiton (NYSE:BHP) and Teck Resources (NYSE:TCK). Importantly, the company has access to more export capacity than any of its peers (although it doesn't own a port like CNX does). ANR is poised to generate the most free cash flow among the top 3 U.S. producers next year.

Trading at a 3.5x 2012 EV/EBITDA multiple, ANR has incredible upside.The stock is down 72% (!!) from its 52-week high. The knocks on ANR are that they are in the midst of a very messy integration of highly troubled Massey Energy and that the combined company has the largest exposure to CAPP. Massey was a poorly run operation, so there's fear that ANR got stuck with a bigger basket of problem assets than it bargained for.

CAPP is a blessing and a curse because thermal coal from the region is facing regulatory, safety, environmental and cost inflation headwinds, but CAPP is home to the majority of coking coal produced in the U.S. Another knock is that market participants feel that ANR paid too much for Massey, leading some to question the competence of management. Last week's production cut and market commentary didn't help management's case. Still, the assets speak louder to me than management blunders.

Fundamentally, ANR is a high-beta coal stock, but a strong Buy for those with a strong stomach. This is my favorite stock to buy right now. I don't mean to minimize the risks of operating in CAPP, of which there are many, but with the 3rd largest coking coal company's stock down 72%, I argue that most of the risk is priced in. A year from now when Massey is fully integrated, ANR will itself be an attractive takeout target. (Disclosure: I'm long call options on ANR.)

Patriot Coal (PCX): Patriot is a high risk/reward stock that's currently showing off the risk side of the story. The company took 3rd quarter guidance down significantly, and therefore will suffer from higher costs per ton in 2H 2011. Stepping back, PCX is an east coast thermal and coking coal producer. The company was spun off from Peabody in 2008. Patriot has some very good hi-vol "A" coking coal that does not appear to be appreciated by the market. Importantly, PCX has underwater sales contracts rolling off in 2012-13. As the coal assigned to these contracts gets marked to market, PCX will earn sustainable incremental EBITDA. There's high visibility on this enhanced EBITDA, which is supportive of the share price.

On the risk side, PCX has by far the biggest legacy liability problem in the industry. When times are good and the stock market is strong, investors largely ignore the legacy liabilities.In today's market, the liabilities are not being ignored. That, combined with the 3rd quarter earnings warning, makes PCX especially risky at this time. However, the stock has been severely punished. At some point, the stock becomes too cheap to pass up.

PCX is trading at just a 2.6x 2012 EV/EBITDA multiple. Despite the horror show depicted in the stock chart, there may be light at the end of the coal tunnel.The ONLY good thing that's happened lately is the hiring of coal veteran Ben Hatfield, former CEO of International Coal, as COO at Patriot. Ben is widely considered one of the best operators in the business. I am confident that he's way too smart and coal savvy to join a sinking ship.The announcement of Ben's new role came just days before PCX announced the terrible guidance revision. Ben stepped up and bought 30k shares of PCX stock at $12 per share. If anyone can save the day at PCX, my money would be on Ben. In fact my money is on Ben, as I'm long PCX calls.

Disclosure: I am long BTU, CNX, ANR, PCX.

Additional disclosure: I am an independent consultant for SouthGobi Resources, a coal producer not mentioned in this article.