Discussions of relative performance always need to anchored with the question of "relative to what?". Peabody Energy (NYSE:BTU) has been one of the best-performing U.S. coal companies year-to-date and over the last year (edged out in both cases by Cloud Peak (NYSE:CLD), and handily beaten by quasi-coal company CONSOL Energy (NYSE:CNX)), but the coal sector has continued to get thumped on weak met coal pricing, long-term concerns about EPA regulations for thermal coal, and rail shipments from the Powder River Basin.
I continue to believe that Peabody Energy is the best-positioned U.S. coal company for the long term. This year may see the company go FCF-negative, but Peabody can generate positive free cash flow at coal prices well below the breakeven levels for Alpha Natural (NYSE:ANR) or Arch Coal (NYSE:ACI). I also like the company's asset base (Illinois and Powder River Basin in the U.S., Australian met coal). While Alpha Natural has more upside if met coal prices suddenly shoot up again, I think Peabody is the better risk-adjusted pick overall.
Coal Gets Squeezed, But Can't Produce Diamonds
Peabody had a better-than-expected second quarter, and management did point to signs of market improvement but also lowered third-quarter guidance relative to analyst expectations. All told, Peabody's performance supports the thesis that it is a very well-run coal company, but that there's only so much good management can do during bad times.
Revenue rose 2% yoy and 8% sequentially, beating expectations by about 7%, largely due to better pricing across the board. Overall volumes increased 1% from last year, with Midwest volume down 5%, Western volume up 7%, and Australia volume up 13% (thermal up 9%, met up 17%). Midwest realized prices declined 4%, while adjusted Western prices were flat (up 6% as reported). Australia prices declined 15%, as met coal continues to bump along the bottom.
EBITDA dropped another 37% yoy (and 7% sequentially) on an adjusted basis. Reported EBITDA was quite a bit stronger, down 16% to $213 million, but I'm backing out a $2 million gain on sale and a $35 million true-up tied to a pricing agreement with a PRB customer. Even this normalized figure is 12% above expectations, though, as better performance in Australia helped the result. The company's Western coal operations (largely PRB) are generating about 75% of the company's EBITDA, and have far and away the lowest operating costs (but also the lowest realized prices).
A Thermal Coal Recovery In The U.S.? Not So Fast...
There was some optimism about a coal recovery earlier this year, due in large part to a very cold winter that ran down inventories. Even now, coal inventories are below normal, and particularly so with utilities that burn PRB coal.
I'd be cautious about ringing the bell on a recovery, though. First, an improving appetite for PRB coal from electric utilities is being offset by lingering rail problems in the PRB - utilities won't bother ordering coal they won't get. Second, El Nino weather patterns usually mean milder summers, and utilities may feel more confident holding lower inventories. Finally, while there was a shift in fuel mix back towards coal on a year-to-date basis, higher production of natural gas (and lower prices) could quickly shift that back.
That's the short term. For the long term, I'm more bullish on the prospects for certain thermal coal producers. Peabody doesn't have the best cash costs in the PRB region (it trails Cloud Peak and Alpha Natural by around 2% to 6% per ton), but it does have a better cost position than Arch Coal and substantially more reserves than Alpha Natural. Peabody also has attractive assets in the cost-competitive Illinois Basin area, and no legacy assets in uncompetitive regions like Central Appalachia (where Arch and Alpha Natural still have considerable exposure). While there is a risk that incremental utility demands will be met by renewables in the future, so long as coal has a seat at the table, Peabody's assets will be in the mix.
Met Coal Still Looking At A Long Recovery
There are plenty of numbers to throw around in light of the ongoing weakness in met coal prices, including the fact that around half of seaborne met coal is uneconomical at this price and an even larger percentage of U.S.-sourced exports. The reality, though, is that Australian production continues to increase despite sluggish Chinese steel production, and the market still needs about 10Mt to 20Mt/year to go away.
Peabody has the advantage of producing met coal at an uncommonly low price (in the $70s per ton), so it is not as pinched as Alpha Natural, Arch, or Teck Resources (NYSE:TCK). Peabody also has ample liquidity and decent near-term cash flow prospects, so it doesn't have to go to the same lengths to cut costs, curtail mines, or raise money through secured lending. Given those circumstances, I think Peabody can do pretty well if or when met coal prices recover, even it takes several years to get to the $170/mt or $180/mt level that producers like Alpha Natural and Arch really need.
The Bottom Line
I'm not too concerned about management's weak guidance for the third quarter (about 17% below analyst expectations); 2014 wasn't going to be the recovery year, and a weaker second half of 2014 doesn't mean much for the long-term valuation. That said, I'd note that expectations for 2016 EBITDA have come down by about 12% over the past four months as more analysts have thrown in the towel on a near-term met coal recovery. Using a multi-year EBITDA approach, my valuation doesn't change as much; it's still centered around an 8.5x multiple to 2016 EBITDA discounted back, but my fair value only falls to around $20.
Generally speaking, I'd say that a recovery in coal prices will be much more significant for investors in stocks like Arch Coal and Alpha Natural. That's probably still true, though I worry that the extraordinary measures these companies have had to take to generate/preserve liquidity may crimp the upside in a recovery, and they don't have as much time to wait for the recovery. All things considered, then, I'm still relatively bullish on Peabody as a play on a coal sector recovery.
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