We think Alpha Natural (ANR) represents one of the most compelling valuation plays on the market. We think it fits perfectly within Valuentum's stock-picking methodology, which focuses on undervalued stocks that generate significant economic value for shareholders, as measured by the spread between return on invested capital and a firm's cost of capital.
There are many schools of thought on valuation, but we feel a comprehensive discounted cash-flow process (that is, one with a forecasted and complete income statement, balance sheet, and cash flow statement) coupled with a rigorous relative value assessment versus peers is the best way to identify stocks poised for material capital appreciation. Simply put, we don't take valuation shortcuts.
What really gets us excited about Alpha Natural is its valuation as determined by our DCF process, which is why we are considering the firm in the portfolio of our Best Ideas Newsletter. We provide the highlights of our report on Alpha Natural below. In the spirit of transparency, we make all of our reports available here.
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Alpha Natural earns a ValueCreation™ rating of "excellent," the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 20% during the past three years.
Alpha Natural's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers. The peer group we've chosen is Peabody (BTU), Arch Coal (ACI), Consol (CNX), and James River (JRCC).
Alpha Natural has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 3.5% in coming years. Total debt-to-EBITDA was 0.7 last year, while debt-to-book capitalization stood at 22.1%. The firm posts a VBI score of 9. We like the firm's prospects as an investment candidate on this basis. In fact, very few firms score above an 8 on our scale.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Alpha Natural's 3-year historical return on invested capital (without goodwill) is 20%, which is above the estimate of its cost of capital of 11.1%. As such, we assign the firm a ValueCreation rating of excellent. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Alpha Natural's free cash flow margin has averaged about 13.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively strong.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Alpha Natural, cash flow from operations increased about 103% from levels registered two years ago, while capital expenditures expanded about 150% over the same time period.
Our discounted cash flow model indicates that Alpha Natural's shares are worth between $28 and $58 each. The margin of safety around our fair value estimate is driven by the firm's "high" ValueRisk rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $43 per share represents a price-to-earnings (P/E) ratio of about 53.9 times last year's earnings and an implied EV/EBITDA multiple of about 5.3 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 25.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 27.8%.
Our model reflects a 5-year projected average operating margin of 5.6%, which is below Alpha Natural's trailing 3-year average. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 5.1% for the next 15 years and 3% in perpetuity. For Alpha Natural, our model uses a 11.1% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $43 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Alpha Natural. We think the firm is attractive below $28 per share (the green line), but quite expensive above $58 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Alpha Natural's fair value at this point in time to be about $43 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Alpha Natural's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $62 per share in Year 3 represents our existing fair value per share of $43 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements