Coal Keeps on Cooking

One industry sustaining quite well in these increasingly difficult times for the market is coal, of which the U.S. is the world’s biggest exporter. We sat down with Zacks senior analyst Neil Malkin, who covers three main players in the coal industry, for his forward outlook on the commodity and its stock appreciation potential from here.

Among your coverage, where are you seeing particular strength these days?

I have my eye on the coal group in particular. These companies, particularly ones that have exposure to foreign markets, should do extremely well. Demand and supply fundamentals have strengthened and prices on a per-ton basis have significantly strengthened from the beginning of 2007.

As coal producers lock in contracts at these higher prices and as legacy contracts roll off, they should see appreciable gains in margins and earnings. Prices have more than doubled in nearly every basin, while costs have risen, but at a much slower rate.

On a macro level, support for coal prices on a global scale will be supported by supply and infrastructure constraints. Several key coal exporting countries have begun reducing or discontinuing coal exports as domestic need has increased substantially. In several developing economies the need for electricity, buildings, cars and roads has boosted demand for both steam and metallurgical coal.

For example, China, the world’s largest coal producer, a historic net exporter, became a net importer in 2007 due to energy needs for its growing economy. In Australia, the number one exporting continent, boat queues are standard operating procedure, and expanding port capacity is a timely and capital intensive process.

Do high growth expectations remain indefinitely for the coal industry?

Growth for the coal sector should continue through 2010 as companies will continue to lock in higher prices as lower prices legacy contracts roll off. At current price levels, the weighted average price of the coal producer’s production should peak around 2010. Earnings growth will be the largest in ’08 and ’09 then slow in 2010 and 2011.

At this point, production growth, not commodity prices, will be the driver of earnings growth. This industry still has room to run for the next couple of years, at least. The two main factors influencing the industry landscape will be the prices of coal in the medium term and the rate of production growth from the main coal producing countries.

Are your companies strictly commodity plays? Do they diversify in the types of materials they produce?

The vast majority of the companies I cover derive their revenues, cash flow and earnings from the mining and selling of coal to utility companies and steel manufacturers. However, some companies have a sales and trading arm for risk management purposes. Companies may also own non-core land assets including forestry as well as properties available for rent or leasing.

Which would you consider your top two or three Buy recommendations, going forward?

In the coal space, my top three picks would be Peabody Coal (BTU), Consol Energy (CNX) and Arch Coal (ACI). These companies have large presences in the major operating basins in the U.S. and exposure to seaborne markets as well.

Peabody in particular should benefit from the commodity boom as it has the largest international presence of the group. The company acquired assets in Australia in 2006 and has since more than double production. As prices for seaborne coal from Australia to the Pacific Rim have increased five fold over 2007 levels, BTU should see significant increases in operating margins and cash flow. This is a trend that should be expected from these three companies in the next several years.

How would you advise investors play commodity-driven stocks over the near- to medium-term?

From an investment standpoint, now is still a great time to get in. As the companies mentioned above should grow earnings by at least 100% in 2009 compared to 2008, there is still significant opportunity and upside remaining. As usual, the market has a more conservative price deck for this company’s realized average price per ton going forward. This understates revenues and earnings. Currently, I would advise investors who got in around 2006 or early 2007 to take some profits as stock prices have gone up significantly from recent levels, but still maintain a position as strength remains.

Neil Malkin is a senior analyst covering the coal industry for Zacks Equity Research.

Comments

[svkoho]

Zacks: I would be interested in your thoughts on Alpha and Massey. Your article did not break down the producers into the two markets, steam and met coal and how do you view the producers in the two categories. Also why no mention of Canadian producers like eg Fordham which have had a good run of late? Your thoughts on the utility of the the coal etf KOL?

[False Profit]

Well, these companies aren't making any money now, and future profit expectations seem wildly inflated. They are based on companies being able to sell all their production at current spot prices, while their costs would remain flat. The problem with this is that as every producer tries to sell in the spot market, current prices are unlikely to hold. Also, costs are going up dramatically.

[Popska5125]

Western Canadian Coal is the best play in this sector.

[blink0404]

Here's another article on coal, including BTU and CNX.
www.greenfaucet.com/tr...

Stocks include BTU, CNX, DVN, RRC, BRNC, NBR...
BTU continues to outperform as well as NBR while DVN and RRC are having a hard time making a break out.

Check it out if you're interested in coal, nat gas producers, or nat gas services.