Peabody Energy: A Resounding Hold Despite Being The Class Act In Coal

Feb. 7.12 | About: Peabody Energy (BTUUQ)

Peabody Energy, (BTU) is best in class among coal producers. Until just 2 weeks ago, Peabody screened very cheap and presented as a compelling Buy. Instead of its traditional 1x - 2x forward EV/EBITDA multiple premium to peers, Peabody was trading at a ~0.5x discount. Given that Peabody has moved aggressively into Asian end-markets via expansion into Australia's premium hard coking coal regions, this historical premium valuation vs. peers is still warranted. Australian coal companies trade at a 1-2x EV/EBITDA premium to U.S. peers.

And then came the company's earnings and outlook for 2012, which were nothing short of a disaster. Analysts calmly lowered estimates, (a lot) and price targets as if nothing serious had happened. To be fair, this revised guidance was largely due to market conditions, but the company's commentary regarding the acquisition of Macarthur Coal (OTC:MACDF) was plain awful. In an instant, Peabody went from a compelling Buy to a strong Hold. Simply put, 2012 is now shaping up to be the dreaded, "transitional" year.

Peabody paid dearly for Macarthur last year, roughly an 8.5x EV multiple of 2014-15 EBITDA. However, this new guidance for the integration of Macarthur suggests that Peabody actually paid north of 10x for Macarthur. Despite earnings and lowered guidance, Peabody stock is up 14.7% YTD, second behind Walther Energy's impressive 25.8% gain, among the 8 U.S. coal producers. It appears that Peabody's stock has been re-rated to incorporate a premium valuation again, albeit a small premium of less than a turn of EV/EBITDA.

Analysts still love the stock, with 24 Buys, 4 Holds and 1 Sell. Yet the stock is now trading at a 6x EV/EBITDA multiple of an average of 2012-13 EBITDA estimates. While Peabody deserves to trade at a premium, the stock appeared much more attractive a few eeks ago before earnings. If not for the very poor earnings and outlook, Peabody stock would probably be trading in the low $40's today instead of $38 per share.

Instead, the valuation became materially richer (from about a 4x forward multiple to about a 6x multiple) but mostly due to materially lower EBITDA expectations, not improved sentiment. Earnings and outlook misses like this are doubly bad for a company because the miss tends to calls into question the sustainability of a premium multiple expectation going forward. Clearly sell-side analysts have given Peabody a free pass, which is fine for a company that has executed relatively well over the years. But, if Peabody messes up again, analysts and holders may not be so forgiving.

Equally important to the fact that Peabody is vulnerable to another earnings miss or setback at Macarthur is the fact that market fundamentals have weakened since the end of the third quarter of 2011. While conventional wisdom suggests that premium hard coking coal prices for 2q-3q 2012 might bottom at around $200-$225 per metric tonne, one now has to wonder whether Peabody would fully participate in a rally if coal fundamentals and investor sentiment turns. In other words, is Peabody at $38 per share dead money, or a value trap?

My guess is that Peabody is now a value trap. A good company with good management that is well positioned globally, but with earnings and acquisition integration overhangs, and a fair but un-exciting valuation. Peabody in the upper $30's is a Resounding Hold. In order for me to pull the trigger and buy more Peabody stock, I would need it to fall to $32 per share. At that price, the analyst consensus price target of $50 would afford me the chance of a 50% return.

Why do I simply default to the analyst consensus price target of $50 as my potential upside? Because I look at the consensus as the best case target not a base case target. With that in mind, I consider 3 scenarios,a 50% chance the stock goes to $50 a 25% chance it goes to $30 and a 25% chance it treads water around $36. The weighted average of those outcomes is $41.5 per share, which would be a 30% return if one bought the stock at $32.

Given the bullishness in stocks overall in 2012 and Friday's tremendous employment data, one could argue that my analysis here is too conservative. If one believes that an entry point in Peabody of $32 is unrealistic, then one should consider buying Alpha Natural Resources, (ANR) or Patriot Coal, (PCX). If markets unfold such that Peabody stock trades up to $50, a return of 31% from Friday's $38 closing price, then I'm confident that ANR and PCX would experience gains of 50% or more.

Bottom line, if one is bullish for stocks over the next few quarters, then investing in higher beta coal stocks is a good idea. But, don't fall into a possible value trap by picking up shares of Peabody.

Disclosure: I am long ANR, PCX, OTCPK:CLNMF, BTU, CNX, OTC:TMCGY. I am a consultant for SouthGobi Resources