Financial economists have long held the belief that there is a positive correlation between portfolio risk and long-term returns. This makes sense because investors heavily discount future streams of income based on short-term uncertainty. In the long-run, however, the fundamentals prevail over behavioral anomalies. Coal provides an ideal way to generate higher risk-adjusted returns.
In this article, I will run you through my DCF model on CONSOL Energy (CNX) and then triangulate the result against a review of the fundamentals for Patriot Coal (PCX) and Arch Coal (ACI). I find that while free cash flow will stay limited for these three firms, earnings multiples will drive appreciation.
First, let's begin with a review of the top-line. CONSOL finished FY2011 with $6.1B in revenue, which represented a 16.8% gain off of the preceding year. I model a 13.4% 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 eating 64% of revenue versus 8.7% for SG&A and 20% for capex. Taxes are estimated at 22% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around 0.5% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $13.65, which implies that roughly one-half of CONSOL's current valuation will be lost. The firm currently trades at around 45.8x my FY2012 free cash flow estimate, which is slightly elevated against the 3-year historical average. With that said, there are reasons to be optimistic: management is attempting to hedge against various risks:
Risk cannot be avoided, but it can be mitigated. And the main way that CONSOL Energy mitigates these risks is through the strength of our balance sheet. We have the scale and the financial means to absorb the inevitable cyclical downturns that occur in the energy industry. We entered the quarter having liquidity of $2.7 billion, including cash of nearly $400 million. We entered the quarter having nearly all of our thermal coal sold and having nearly 1/2 of our gas production hedged as $5.25 per Mcf.
And from a multiples perspective, the stock is cheap. It trades at a respective 12.6x past earnings versus 16.7x for Arch. Patriot Coal is still expected to bleed on the bottom-line and thus cannot be assessed by an earnings multiple. If CONSOL can trade at just the current level of Arch - let alone the level of the S&P 500 - substantial appreciation will result.
Consensus estimates forecast Arch's EPS turning negative in 2012 and then hitting $0.57 two years later. Of the last 27 revisions to EPS, all but one have gone down for a net change of -172.6%. According to NASDAQ, the stock is still rated around a "hold" on the Street and offers a dividend yield of 1.5%. With a beta of 1.7, Arch has the potential to recover much of this year's lost shareholder value.
Patriot Coal carries even greater risk. Significant losses are expected over the next three years and 18 of the last 20 revisions to EPS have gone down for a net change of -22%. Any signs of losses abating quicker than expected will result in meaningful outperformance. After the S&P 500's worst week for the year, investor pessimism towards Patriot is only going to grow. Sovereign debt concerns, sluggish economic growth, and environmental regulations represent substantial headwinds for coal. With so much to be negative about and little to be optimistic about, the bar has certainly been set low. Ultimately, I anticipate Patriot exceeding this bar and generating high risk-adjusted returns in the process.
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.