Bullish On Peabody And Arch Coal

Includes: ARCH, BTU
by: Takeover Analyst

As the global economy picks back up, two companies that I am especially bullish about are Peabody Energy (NYSE:BTU) and Arch Coal (NYSE:ACI). Having lost around half of their value over the last twelve months, these coal producers are gearing up for a solid turnaround story. Cost benefits from expansion are materializing while uncertainty in met coal has overly depressed multiples.

At the third-quarter earnings call, Peabody's CEO, Greg Boyce, presented the optimistic backdrop - one that I agree with:

Coal prices remain favorable. Met coal prices settled at $285 per metric ton for the benchmark, and low-vol PCI sells at $208 per metric ton and the Newcastle Thermal Coal recently settled for one-year contracts at $126.50 per metric ton, some 30% above prior year levels.

Now in the United States, the coal supply-demand equation has been balanced despite a dormant economy that has resulted in reduced electricity generation from gas, nuclear and coal. With a very strong summer burn, increasing U.S. export demand and reduced western shipments due to rail flooding issues, coal inventories have declined the most since 1993. And PRB stockpiles are currently at target levels. So while such our Appalachia prices have declined since the start of the year, coal pricing in the PRB and Illinois Basin have continued to increase.

The company is putting its money where its mouth is by hiking up capex (a sign of confidence), which is likely to peak sometime in 2012. The Australian projects will largely determine the fate of the producer and analysts are indicating that development is proceeding well. The Wilpinjong project is undergoing a $90M expansion that will allow for thermal coal production at a comparatively inexpensive rate. Australian coal production may spike to a high of 40M tons by 2015 while efficiencies are realized from increases to scale. In addition, free cash flow is on the rise and projected to reach possibly $1.7B by 2013.

Consensus estimates for Peabody's EPS are that it will grow by 31.1% to $4 and then by 30.3% and 11.9% more in the following two years. Assuming a multiple of 12x - below peers - and a conservative 2012 EPS of $5.15, the rough intrinsic value of the stock is $5.15, implying 77.3% upside. Even if the multiple were to fall to 8x and 2012 EPS turns out to be 4% below the consensus at $5, the stock would still appreciate. Analysts, accordingly, rate the stock a near "strong buy."

From a multiples perspective, Peabody is cheaper than Arch Coal. It trades at a respective 10x and 6.7x past and forward earnings while Arch Coal trades at a respective 18.8x and 5.7x past and forward earnings. At the same time, Arch Coal has gross margins that are around 310 basis points higher than that of Peabody. Ironically, however, I view this as a catalyst for the latter, since it has greater leeway in trimming SG&A and marginal costs.

In addition to its higher beta, Arch Coal is a riskier investment due to recent poor execution. Third-quarter earnings were strikingly low at $0.08 versus a consensus of $0.22. While much of this was admittedly due to lower PRB shipments from rail flood disruptions, underperformance still reflected. The company is still targeting 15M tons in met coal production by 2015 from Tygard longwall, which I view as a low benchmark that allows for upside. Moreover, strong demand for Beckley and Sentinel will help attract investor entry despite the obvious risks.

Consensus estimates for Arch Coal's EPS are that it will grow by 5.3% to $1.20 and then by 118.3% and 17.9% more in the following two years. Assuming a multiple of 9.5x and a conservative 2012 EPS of $2.53, the rough intrinsic value of the stock is $24.04, implying 61.9% upside. Even if the multiple were to decline to 7x and a 2012 EPS turns out to be 16% below the consensus at $2.20, the stock would still appreciate. Increased economic activity will drive energy consumption and make the first case, in my view, a reality.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BTU, ACI over the next 72 hours.