Mark Mansfield's  Instablog

Walter Energy is a Tampa producer of metallurgical coal for the global steel industry. Walter’s export markets according to Walter’s 2008 annual report are: North America 3.2%, South America 31.5%, Europe 62.3%, and other 3%. Walter is the largest US exporter of coal to the South American metals industry. This annual report may be viewed at: http://www.walterenergy.com/investorcenter/ars/2008/pdfs/WIAR08.pdf  Walter’s coal is of very high quality, high BTU content. Additionally Walter has traditionally maintained higher margins than its competitors in its coal business. Walter has transitioned this year away from a diversified conglomerate to focus on its coal business, spinning off homebuilding and REIT business. This is certainly likely to be a good move given the current environment. There is little doubt that Walter is an attractive company on a fundamental basis.

However while a company may be attractive on a fundamental basis, that does not mean that it is attractive from a relative value perspective at this time. According to consensus estimates for 2009 earnings, Walter should earn $1.67 this year. At current stock prices that would make for a P/E ratio of 25.74. For comparison here are some other coal companies with their respective P/Es based on full year 2009 estimates arrived at by dividing current stock prices by Thompson/First Call estimates:

Ticker    P/E

ANR      12.71

FCL       16.54

BTU      15.42

MEE     17.45

These estimates would give us an average P/E for these companies of 15.53. Walter, by this analysis, trades at a 66% premium to its competitors. Is this a reasonable valuation? I certainly think not. If we were to apply a 15 P/E to the 2009 estimate we would arrive at 26.72, and if we were to attribute a more generous estimate of a 20 P/E, we would arrive at a value of 33.40, well below the current share price of $43.00. This sentiment was also echoed in the recent Brean Murray downgrade from buy to hold based on valuation given that WLT has surpassed their $37.00 price target, though they are still favorable on the stock from a fundamental/longer term basis.

What is the cause for this apparent price discrepancy? I would attribute this anomaly to four causes:

1.       Enthusiasm over China and the “reflation trade,” which does not directly affect WLT, as WLT does not export to China, but may have a tertiary effect if indeed China demand were to push up metallurgical coal prices.

2.       Speculation over M&A in the coal space, particularly after ANR’s bid for FCL. However after the recent run up in WLT share price and market cap, it is likely that coal producers may look for less costly acquisitions.

3.       Momentum and technical traders who are viewing recent chart patterns and apparent breakouts as positives. Given the low average volume traded in WLT relative to a more liquid issue like BTU, momentum players can much more easily bid up an issue like WLT. Additionally with a relatively low float shorts are easily pushed out of this stock.

 Once again Walter Energy is an attractive company from a fundamental perspective, and may well be worth far in excess of its current price when the economy, and therefore the metals industry, returns to normal growth. However it is premature to speculate on any resumption in metals production on a scale even close to that seen in early 2008. If one does wish to make such a bet on economic recovery, they should do so in the most cost effective manner possible. Accordingly, if one is looking for metallurgical coal exposure, it would be far more reasonable to purchase the shares in a company such as ANR, which trades at a very reasonable P/E. For those looking for a pairs trade, long ANR/short WLT may be appropriate. If one is looking merely for coal exposure, without a preference for metallurgical coal, an issue like JRCC with a P/E of approximately 6 looks significantly more attractive. For China exposure, BTU, which exports metallurgical coal to China, is likely the best play and trades at a very reasonable P/E of just over 15.

While technically WLT appears to have “broken out” recently, the stock is now significantly overbought from an RSI and/or stochastic perspective. This stock is very much due for a near-term pullback on this basis. If earnings disappoint from Peabody and particularly from Walter itself this week, that correction could be rather severe given how crowded this particular trade has become. WLT is an attractive fundamental issue, but relative value has become excessive. 

This article is a reflection of my opinions and analysis and should not be construed as an investment recommendation. You must evaluate for yourself what investments are appropriate given your individual circumstances.

Disclosure: Short WLT