Newsletter Value Investor Insight carried an interview March 30th with Cobalt Capital's Wayne Coooperman, whose fund has returned 25.7% after fees annually since 1995, versus 9.6% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview in which Wayne Cooperman and colleague Sam Martini discuss Peabody Energy (BTU), which was trading at $40.35 at the time of the interview (current price here):
We’re guessing the coal industry doesn’t fit your definition of a high-quality business, so what attracts you to Peabody Energy (BTU)?
Sam Martini: Coal is clearly a tough business. It’s commodity-based, capital intensive, unionized, beholden to the railroads for transportation and, at the moment, high on politicians’ list of environmental evil doers. On top of that, we’re coming off one of the worst demand years for U.S. coal in the past 50 years, which threw the business into a meaningful state of oversupply. Growth in coal demand reliably runs at around 50-75% of GDP growth, but last year with a decent economy demand was basically flat. That was primarily weather related, but competing sources of electricity generation, like nuclear and hydro, also had good years with few disruptions in supply.
With Peabody, we’re trying to take a longer-term view on the market. The company is one of the two largest coal producers in the world, along with China’s Shenhua Energy, and we think it’s the cream of the crop in terms of assets and having a management that’s proven it can create of value over time. They have 50 years’ worth of reserves in the ground and diverse positions in the west’s Powder River basin, the Illinois basin, the Appalachian basin and in Australia, where they have high-grade metallurgical coal that they sell to steel makers in Asia.
Even with the negatives, there are reasons to be optimistic about coal. fired plants generate roughly 55% of the electricity in the U.S., at 50-75% less cost than plants fired by natural gas, which generate 20% of the electric supply. While that cost advantage might not matter today to people like [California Senator] Barbara Boxer, you can be sure it matters to her constituents who are looking at rising utility bills if big taxes on coal make electricity prices go up.
WC: At a time when we’re concerned about dependence on foreign oil, it’s important to be thoughtful about how we treat the one energy resource we have – the U.S. has 250 years’ worth of coal reserves in the ground – that can help lessen that dependence. That’s not taking anything away from efforts to promote alternatives or to more cleanly burn coal, but it’s hard to imagine other sources of supply really denting long-term coal demand. Nobody wants to build nuclear – we have no place to put the spent uranium anyway – and we’re certainly not putting dams on more rivers to create hydro capacity. On top of that, there’s not enough natural gas out there to take much share from coal, even if coal’s cost advantage narrowed.
Is your bet on things looking much better for Peabody when the cycle turns up?
WC: Basically, yes. We think we’re close to the bottom of the cycle. Coal producers have been fairly rational in responding to last year’s low demand, and almost everyone has been cutting high-cost production. In Central Appalachia coal production will be down 30-40 million tons this year on a base of a little over 200 million, so the capacity drawdown is meaningful. At the same time, electricity demand this year in coal-fired regions is so far running about 6% ahead of last year.
With conservative assumptions about production levels and assuming current depressed prices, we think the company would earn $3 per share in 2008. At the current share price of around $40, that’s a 7.5% earnings yield. We’re pretty comfortable that’s within a few dollars of as low as the share price is going to get.
What then do you see as upside?
WC: If prices get back to what we consider a normal level – not a peak level – the company should earn $4.50-5.00 per share. For the best company with the best management in the business, at that earnings level we’d expect the share price to be closer to $60. With little downside, that’s an attractive risk/reward proposition.
Is political risk your biggest concern?
WC: On the one hand the government talks about energy independence, while on the other hand they’re looking at putting big taxes on carbon emissions. Taxing coal to make it cost prohibitive would only serve to increase U.S. dependence on foreign oil. In the end, we don’t think government will cripple the coal business, but you can’t ignore the risk it will do something that isn’t very smart.