What Needs To Happen For U.S. Coal Stocks To Be A Buy?

by: Peter Epstein

I've written 10 articles on the coal sector in February. A common theme throughout is that earnings estimates for 2012 and 2013 are at risk. I backed this up with quotes from industry consultants and company executives and a warning on the implications of the imminent benchmark coking coal settlement. With both coal prices and coal company stocks lower, I recommend further caution.

However, there may be light at the end of the coal shaft. Frequently, when coal stocks bottom, the rebound can be ferocious. A prime example is the massive rally from the bottom of October 3rd, 2011. In just 19 trading days, from October 3rd to October 28th, the average U.S. producer was up 62%! Walter Energy, (NYSE:WLT) was the worst relative performer, up "only" 43%. Peabody Energy, (BTU), Consol Energy, (NYSE:CNX) and Cloud Peak, (NYSE:CLD) were each up 48%. James River, (JRCC) was up the most, from $5.55 to $11.44 per share, for a gain of 106%. Stick that in your hat and annualize it.

Since that 10/28/11 high mark, the average coal stock is down approximately 30%. In fact, Patriot Coal, (PCX), JRCC and Arch Coal, (ACI) are each less than 10% from their respective October lows. Are we approaching another aggressive buying opportunity? Sadly, no. At current stock prices, there's little possibility of an explosive rally, but downside below last October's levels is quite possible. Back in early October, the coal stocks were really cheap AND coal fundamentals were way better than they are today.

To understand my thinking, consider Alpha Natural Resources, (ANR). According to YahooFinance, (which gets its data from Capital IQ), in the past 90 days, EPS estimates for 2012 moved down to $0.84 per share from $1.88. This means that ANR was trading at a 1-yr forward (2012) multiple of 8.5x its October low of ~$16 per share. Today, ANR is trading at a 10.2x multiple of that prior $1.88 estimate, but with the consensus down to $0.84, 2012's P/E is now 22.9x.

Some will argue that I'm not comparing apples to apples. Back in October investors were looking at a 1-yr forward, (2012) EPS multiple, so to make a fair comparison I should use today's 1-yr forward, (2013) EPS estimate. Doing that generates a P/E of 14.9x. To repeat, on October 3rd, Alpha stock bottomed at ~$16 per share with a then 1-yr forward, (2012) P/E of 8.5x. Today, at ~$19 per share, the stock is trading at a 1-yr forward, (2013) P/E of 14.9x.

For ANR to trade as cheaply as it did last October, the stock would have to fall to [8.5 P/E x $1.29 equals approximately $11 per share]. Even if one argues that ANR is still a Buy at a 10 or 12 2013 P/E, I have more bad news for you. I'm pretty sure that Alpha's consensus 2013 EPS figure remains too high. Of the 9 published research reports (that I've seen) issued subsequent to ANR's recent earnings miss, the average EPS estimate is $0.92, almost 30% below the official $1.29 average.

According to YahooFinance, 2013's consensus is comprised of 25 estimates. I argue that of the remaining 16 EPS estimates that were not updated via a published note, many are probably stale. Simple math shows that if 9 of 25 EPS estimates average $0.92 per share, then the other 16 estimates must average $1.50 per share to reach the consensus of $1.29. However, only 2 of the 9 reports that I've seen have 2013 EPS estimates at or above $1.50 per share, and the other 7 reports have an average 2013 EPS estimate of just $0.46.

Okay, a lot of numbers have been thrown around. Please re-read the last few paragraphs if necessary because I believe the implications of my reasoning is inescapable. ANR and peers will have great difficulty rallying unless coal fundamentals improve markedly. And as I've been writing all month, there's scant evidence of any meaningful improvement.

By no means am I picking on ANR. The same reasoning can be applied to each of the coal names. None are attractive at current prices. If in the coming weeks or months the stocks trade materially lower AND coal fundamentals improve, that might set up the potential for a rip-a-thon like that of 10/3/11-10/28/11. In the meantime, we're nowhere near that scenario.

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

Additional disclosure: I'm a consultant for SouthGobi Resources.