Peabody Energy Corp.: Old King Coal Still Reigns

Includes: ARCH, BTU, CNX, FCL, MEE
by: Richard Shaw

Coal remains one of the world’s primary energy sources for electricity and industrial uses. Peabody Energy Corporation (NYSE:BTU) is the world’s largest private coal mining company, supplying about 10% of the fuel for US electrical power production and about 3% of the fuel for world electricity power production. We expect that when it is time to own coal, BTU is the better security to own.

The number 2 and 3 coal producers, Arch Coal (ACI) and Rio Tinto Energy America. Each produce about 60% of the volume of Peabody.

The chart below for BTU and ACI, indicates the consolidation the coal industry has undergone in recent years. BTU more than doubled its market share and ACI nearly quintupled its market share.

The chart also shows the steady increase in total production. BTU predicts a 50% rise in world coal demand by 2030 and an increasing U.S. share of supply for total world demand. The U.S. currently supplies approximately 18% of total world coal demand.

BTU’s proven and probable reserves are about 10 billion tons – equivalent to 243 trillion cubic feet of natural gas (10 times the annual U.S. natural gas consumption)

The five largest pure play U.S. coal producers are:

• Peabody Energy (BTU)
• Arch Coal (ACI)
• Foundation Coal Holdings (NYSE:FCL)
• Massey Energy (NYSE:MEE)

Of the top five, BTU, ACI and CNX have healthy earnings coverage of interest expense, which we suggest should be 3 times or more. FCL and MEE are each under 2 times coverage. BTU has 6 times coverage, ACI 5.5 times coverage and CNX 23 times coverage. Not surprisingly, BTU, ACI and CNX are the top three pure play US coal producers.

Of those top three producers, only BTU has free cash flow and it has the lowest dividend payout ratio. BTU also has a lower PEG ratio, but is more expensive than ACI and CNX in terms of P/E, P/B, P/S and EV/EBITDA. None are yield plays. For coal yield, investors need to look to partnerships such as Alliance Resource Partners LP (NASDAQ:ARLP) which pays over 5.7% distribution.

Coal is the fuel for about ½ of all electric power in the U.S., and unless we go the way of France with nuclear power, coal will likely remain the primary electricity fuel source for many years to come. (chart from Energy Information Agency )

The price of coal has increased significantly (2006 average price $23.59 per ton versus 2005 average price $18.37 per ton). Hot summers and increasing population in Sunbelt areas drives up demand and prices for coal.

Last year coal use increased 2.1% by electric utilities in the U.S., but decreased by 3.3% for U.S. industrial uses. The industrial decrease is probably more a factor of transfer of the manufacturing base out of the U.S. to other countries, such as China, where coal demand for industry is quite strong.

Coal is transported domestically primarily by rail and the price of coal is impacted by the price and availability of rail transport. Reductions or bottlenecks in rail capacity tend to increase coal prices. Some railroad stocks occasionally serve as proxies for coal prices as a result.

We think some coal assets have a place in a portfolio segment oriented toward energy. BTU, ACI, CNX or ARLP may be good places to begin researching opportunities in coal.

Disclosure: Author occasionally owns BTU and currently owns ARLP