While many investors are too afraid to invest in coal due to the industry's volatility, I believe that reward far outweighs risk. The global economy is more likely heading towards a recovery than a double dip. Based on that expectation, I recommend a sizable investment in coal. In this article, I will run you through a DCF model on Patriot Coal (PCX) and then triangulate the result with a review of the fundamentals against Arch Coal (ACI) and Peabody Energy (BTU). I find that Patriot meaningfully undervalued despite operational challenges.
First, let's begin with an assumption about the top-line. Patriot finished FY2011 with $2.5B in revenue, which represented an 18.1% gain off of the preceding year. I model a 5% per annum growth rate over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 88% of revenue versus 5% for SG&A and 5% for capex. Taxes are estimated at 0% while the company bleeds on the bottom-line.
Based on these projections, I find that Patriot Coal will generate enough operating cash flow in around 3.5 year to break-even with the current market capitalization. Put differently, the company trades attractively at less than 4x my 2012 operating cash flow projection.
All of this falls within the context of market correction. According to Arch's management:
There is a positive momentum building for met demand. Global steel production rates ticked up higher in March and supply constraints out of Australia began setting a price forward. Over the next five years, we believe the met markets will remain under undersupplied with normal cyclical volatile…
The third driver that will help fix coal markets is rationalization of supply. We believe that we are in the midst of a dramatic restructuring of domestic thermal supply, whereby some players will exit the market.
From a multiples perspective, Patriot isn't the only undervalued player. Peabody trades at a respective 7.8x and 8.1x past and forward earnings with a dividend yield of 1.2%. By contrast, corresponding figures for Arch are 19.4x and 64.2x past and forward earnings. Even still, I find that Arch is meaningfully undervalued.
Consensus estimates for Peabody's EPS forecast that it will decline by 29% to $2.67 in 2012 and then grow by 35.6% and 19.9% in the following two years. Assuming a multiple of 12x and a conservative 2013 EPS of $3.59, the stock could rocket to $43.08 for 47.1% upside. Discounting backwards by a WACC of 10%, the intrinsic value of the stock is at a 21.5% premium to today's market value. In short, there is a high margin of safety that justifies saying reward far outweighs risk.
Consensus estimates for Arch Coal's EPS forecast that it will turn negative at -$0.42 in 2012 and then enter positive territory the following year before hitting $0.77 in 2014. This is a rocky ride, but I still advise investors to open a long position in the company. The stock is around 80% more volatile than the broader market and thus has the potential for abnormally high risk-adjusted returns if a full recovery materializes quicker than expected.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.