As can be seen in the image above, coal has seen a drastic loss in shareholder value. From its local high around 12 months ago to its current valuation, the Dow Jones U.S. Coal Index has seen a decline of nearly 50%. The Chapter 11 filing by Patriot Coal devastated the bears, including myself, but it is not emblematic of the market's future. And it is the future, not the past, that matters. Plus, financial theory asserts that investors are compensated for bearing greater risk. At this point, I believe the worst is priced in, and coal stocks are trading at a discount to intrinsic value. Since some producers will go under water and struggle while others will survive, I advise very broad diversification in the industry. 3 stocks to consider diversifying in are Arch Coal (ACI), Peabody Energy (BTU), CONSOL Energy (CNX). Below, I consider the various pros and cons of an investment.
Arch has the 2nd largest moat in coal, but it still has a powerful brand name that can survive a macro downturn. It trades fairly high for the risk at 13.6x past earnings, and analysts rate the stock a 2.6 on a 1 to 5 scale where 5 is a "sell". ROA, ROE, ROI are all in the low single-digits while beta is 82% greater than the broader market.
Over the past 5 years, the company has seen EPS decline by 16.3% annually. Analysts expect 7.7% annual EPS growth in the years ahead, but the PEG ratio is still well above 1 at 1.76. More than 1 year, the company agreed to acquire International Group, which put the company $4B debt and was seen as a poor investment at the time. And while many bulls assert that export markets will save coal, international coal prices remain low. Careful reductions in capital expenditures will be the solution to maintaining meaningful free cash flow over the next year.
With that said, the company has and still remains a bet on met coal prices. Met production will expand by 50% going towards 2015, and the company has established strong barriers to entry to ensure bargaining power. I also am attracted to the firm's leading role in the Powder River Basin, which management doubled down on with the $761M acquisition of Jacobs Ranch. Arch's focus on scale has yet to be appreciated by the market, and I believe it will pay off big when the industrial economy returns to full employment.
Since Patriot was spun off from Peabody and carried the legacy liabilities, the market is likely to be more skeptical about Peabody in the next few years. In terms of direct monetary loss, Peabody will likely be responsible for $180M of blank lung liabilities that Patriot has revealed. With that said, the company is dirt cheap at a respective multiple of 5.9x and 6.7x past and forward earnings.
Moreover, earnings power has not been fully factored into the stock value, as evidenced by the PEG ratio being 61% below 1. Annual EPS growth is expected to be 15% over the next 5 years, which means the future stock value in 2016 will be $61.20 at a low 12x multiple. Moreover, the average PE multiple of the firm has been 25.6x over the last 5 years. Nevertheless, if you discount my future stock value by an aggressive 12%, the present value of the stock should be $34.73, which is at a more than 50% premium to the current market value.
Analysts currently rate Peabody a "buy" with a price target of $43, according to FINVIZ.com. As can be seen below, all of the recent analyst reports have been bullish and all indicate major upside.
CONSOL is the most valuable U.S. coal company and has outperformed peers over the recent past. Over the last year, CONSOL has lost "only" 41.5% in value versus 61.9% for Peabody and 76.9% for Arch. Over the last three years, it has lost "only" 37.4% in value versus 50.8% for Peabody and 83.3% for Arch. Accordingly, if you want less volatility (i.e. less risk) in your coal investments, I advise opening a relatively larger position in CONSOL.
At a PEG ratio of 0.7, growth expectations are not being fully factored into the stock price. A low coal pricing environment, however, is disconcerting and will push volatility in the downward direction until the economy starts to actually beat expectations. But with a strong balance sheet, CONSOL is competitively prepared for the worst.
With a solid infrastructure of efficient longwall mines, CONSOL is the main producer in Northern Appalachia. I am also attracted to the company's diversification in natural gas, which is also at a low and likely to rise from foreign policy concerns and energy substitution. It may be considered more of a gas producer than a coal producer after the acquisition of gas holdings from Dominion. CONSOL is nevertheless cutting back on natural gas while coal inevitably builds up in inventory. Highly efficient met coal operations from the longwall Buchanan mine will also drive strong margins when volume ramps up.
Disclaimer: 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.