Upside Winners Arch Coal And Peabody Top Patriot

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 |  Includes: ACI, BTUUQ, PCXCQ
by: Takeover Analyst

Despite a strong correlation with the overall macroeconomy, coal producers are considerably undervalued. Recent weakness has caused a bit of a panic and presented the opportunity for investors to buy at an irrational low. Over the last six months, Arch Coal (NYSE:ACI), Peabody (BTU) and Patriot Coal (PCX) fell by 43.3%, 28.3% and 59.8%, respectively. The first two are favored on Wall Street, while the last is rated a "hold" due to losses being coupled with misses.

From a multiples perspective, Peabody is the cheapest of the three and preferred by analysts with its near "strong buy" rating. It trades at a respective 10.6x and 7.2x past and forward earnings. Arch Coal trades at 19.4x past earnings, but offers a dividend yield that is 200 bps higher at 2.9%. The company also has leading efficiency in operations, as evidenced by how it has gross margins of 24.8%, which is meaningfully above that of its competitors.

On the third quarter earnings call, Arch Coal's Chairman and CEO also presented an optimistic outlook amidst challenges - one I agree with:

"We’re seeing a recovery in October and expect to end the year with a strong fourth quarter performance at our PRB operations. In addition, we experienced difficult geology and a longwall outage at Mountain Laurel during the third quarter that reduced our sales of met coal and raised our quarterly cost in the region.

To remind everyone, Mountain Laurel re-entered the final panel of the Alma seam in August. This is the same panel that costs us an outage in the first quarter. The final panel are two of any coal seam often represents the most challenging job geology of a coal mine, and this is proving to be the case at Mountain Laurel. As such, we produced our met coal volume expectation for the full year largely due to lower high-vol B sales out of Mount Laurel."

Yes, third quarter earnings of $0.08 were well below the consensus estimate of $0.22, but the company is showcasing strength in production control with strong demand for Sentinel and Beckley. The company is well positioned to maintain solid capacity. While met coal is likely to depress to $210 per metric ton in 2012, it will start to recover in the second half.

Consensus estimates for Arch Coal's EPS are that it will grow by 5.3% to $1.20 and then by 107.5% and 20.1% more in the following two years. Assuming a multiple of 9.5x and a conservative 2012 EPS of $2.53, the rough intrinsic value of the stock is $24.04, implying 57.1% upside. Even if the multiple were to decline to 7x and 2012 EPS turns out to be 11.6% below the consensus, the stock would still appreciate. Accordingly, I believe that the bar has been set overly low for the company and that the high beta will drive significant risk-adjusted returns.

Peabody, similarly, is undervalued and well positioned to weather the storm. Stock returns largely hinge on the success of the Australian plants and management is showcasing confidence through hiking capital expenditures in 2012. The Wilpinjong project for example is seeing a $90M expansion.

Consensus estimates for Peabody's EPS are that it will grow by 30.8% to $3.99 and then by 27.6% and 13.2% more in the following two years. Assuming a multiple of 12x and a conservative 2012 EPS of $5.06, the stock has 65.6% upside. Even if the multiple were to decline to 8x and 2012 EPS turns out to be 5.1% below the consensus, the stock would still rise. In my view, the company also has less risk than Arch Coal due to consistency in returns and, not coincidentally, its lower beta.

Patriot is the black sheep in the pack. Analysts rate the company a "hold", which I more or less agree with for the time being. Patriot missed expectations in the third quarter largely due to inflationary input pressures in Appalachian. EPS of -$0.69 were below the consensus estimate of $0.62. Furthermore, costs are likely to risk and the company predicts expenses of $72 per ton, at best. This is $5 per ton worse than in the first half of 2011. With that said, around October, the segment was contracted for 500K tons of met coal in 2012 at current prices, which limits downside.

Consensus estimates for Patriot's EPS are that it will stay negative until 2012. After it turns positive at $0.37, EPS is anticipated to grow by 110.8% the following year. Assuming a multiple of 20x and a conservative 2012 EPS of $0.35, the stock would fall considerably. Accordingly, I recommend holding out until it becomes clearer that the firm will shift to met coal from thermal.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.