Coal may be one of the riskiest bets right now, but the upside is significant. In terms of companies, Arch Coal (ACI) and Peabody (BTU) are both valued significantly below historical levels, even as their fundamentals remain strong. While analysts bemoan their leverage to met coal, I believe the risk/reward profile is skewed significantly towards reward. Low multiples, the potential for an industrial recovery, and competitive strengths present an upside story for both companies.
From a multiples perspective, Peabody is the cheaper of the two. It trades at a respective 9.6x and 7.7x past and forward earnings, with a dividend yield of 0.9%. Arch trades at a respective 19.1x and 10.3x past and forward earnings, but offers a higher dividend yield at 3.1%. To put this in perspective, consider that Peabody is currently valued at only 40% of its historical 5-year average PE multiple versus 54% for Arch.
High betas will drive multiples expansion and buoy up other undervalued and smaller gems like L&L Energy (LLEN). L&L trades at just a mere 3.7x past earnings and is, in my view, unreasonably 68% below its 52-week high.
"2011 was a transformative year for Arch Coal as we executed on our long-term growth plans that boosted our reserves by 1.3 billion tons, added low cost productive capacity in our core operating basins, and expanded our reach into the global coal arena. To that end, we deepened and broadened our met coal profile with the acquisition of ICG. Facilitated continuing penetration into the overseas market with new offices in Asia and Europe, and bolstered our port access along the East, West and Gulf Coast. All supporting our objective of delivering even stronger financial returns in the years ahead.
Our fourth quarter results reflect these efforts. Arch generated $1.2 billion in revenues, $270 million in EBITDA last quarter, representing our best performance yet".
The $3.4B takeover of International Coal was poorly timed, but will still create value in the long term. The transaction rendered Arch more vulnerable to macro swings by essentially making a huge bet on met coal. On the other hand, Power River Basin will be a major value driver with excellent export connections to Asia. The opportunities for margin expansion are significant as natural gas prices rise and become less competitive. Investors are concerned about lower production and prices hindering 2012 and 2013 cash flow, but the secular trends remain strong. Arch has significant scale and its low-cost operations and the Powder River Basin are well positioned to capitalize off a recovery.
Consensus estimates for Arch's EPS forecast that it will hold flat at $1.07 in 2012, and then grow by 29.9% in 2013. Assuming a multiple of 14.5x and a conservative 2013 EPS of $1.37, the rough intrinsic value of the stock is $19.87, implying 39% upside.
Peabody has similarly increased exposure to met coal. The $5B Macarthur acquisition dramatically increases the focus on China. Some analysts have noted that the China is a risky play, since it makes up almost half of global steel production already and, should trends reverse, coal could be especially hard hit. My view is that this is a risk worth taking. Stimulus spending in China and continued growth will drive the industrial economy. At the same time, Peabody's scale grants it a kind of structural and strategic advantage that locks out competition.
Consensus estimates for Peabody's EPS forecast that it will decline by 13.2% to $3.29 in 2012, and then grow by 44.1% and 3.8% in the following two years. Assuming a multiple of 12x and a conservative 2013 EPS of $4.71, the rough intrinsic value of the stock is $56.52, implying 55.6% upside.
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