Coal Stocks: A Cigar Butt Play, But Not Sound For The Long Term

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Includes: ARCH, BTU, CLD
by: Shane Legatzke

Summary

I believe coal stocks are oversold, at least looking at where the companies stand now, because coal is not dead yet.

They could potentially be a "cigar butt" play, through scooping them up off the bottom now and getting one last puff in the short or medium term.

However, I don't like coal companies for the long term because the business of coal is dying, facing numerous major headwinds that will eventually kill it.

In the beginning of his investing career, Warren Buffett sought out companies that were available for dirt-cheap prices in the market, taking lead from his mentor Benjamin Graham. After a while, however, he realized that a lot of these cheap companies were undesirable businesses with poor prospects of success in the long term. He called this the "cigar butt" approach, digging out the market's garbage in search of one final "puff" and a bounce off the bottom.

One section of today's market that is very cheap is coal. Take a look at the beating a few US coal companies have taken in the past year:

CLD Chart

CLD data by YCharts

With these kinds of losses, the value investor is intrigued. And taking a look at some of these companies' value metrics, that investor is extremely enticed. However, my opinion is that coal is a tremendously undesirable business and that investing in coal can only be effective with the cigar butt approach: looking for a short term bounce off the bottom and not long-term success.

Cheap Valuations

Their tumble in the last year has left coal companies extremely cheap, some people might even argue ridiculously cheap for any sort of company. Below is a table of coal companies along with their current and 5 year average price/sales and price/book ratios:

Company

Current P/S

5 yr avg P/S

Current P/B

5 yr avg P/B

CLD

.15

.7

.18

1.5

BTU

.05

1.1

.18

1.7

ACI

.01

.7

.20

.9

Does the fundamental reality of these companies justify the truly massive discounts that coal stocks are trading at compared to recent years? A sizable degree of price reduction is deserved because of the fact that all three companies have ballooning losses and deteriorating margins and ROE, resulting in balance sheets looking worse and worse.

However, I do believe that people have panicked with coal in this sell-off and excessive pessimism has led to coal stocks becoming undervalued, at least when you just look at where the companies stand right now. After all, coal is not dead yet - it still accounts for 30% of global energy and 40% of global electricity generation. The P/Book and P/Sales ratios above reflect companies in a dead industry, and coal is not that yet; there will be a bounce off the bottom for these companies when the market realizes that coal is still a sizable business with real global demand. People have dumped coal stocks by the masses and as a result cigar butts are available to sift out of the ashes.

Poor Business Prospects

Buffett quickly found his cigar butt strategy distasteful and ineffective for long term success because the companies he was investing in were such bad businesses- sooner or later, the puffs ran out. In the long run, poor businesses lead to poor stock performance regardless of how cheap they are; Buffett realized this and developed a modified strategy of still buying cheap companies but also ensuring that they were quality businesses.

I earlier mentioned that coal was not a dead industry. However, it is dying- coal faces major short-term and long-term headwinds that make it a business with awful future prospects. I'll describe some of those headwinds:

Natural Gas

Natural gas prices have been a major factor in sending coal prices down and are what has really been the number one catalyst in coal's particularly large decline this year. Strong US production, mild weather, and natural gas' price link to crude oil have all led to a massive drop in the price of natural gas:

Henry Hub Natural Gas Spot Price Chart

Henry Hub Natural Gas Spot Price data by YCharts

Cheap natural gas has meant that US electricity generators have an incentive to switch from coal to natural gas, driving coal demand down. Natural gas prices won't stay low forever, but an additional advantage of natural gas over coal is that it is much cleaner - natural gas produces not even half the amount of carbon dioxide per unit of energy that coal does. It has been regarded as a bridge of sorts between fossil fuels and renewable energy, allowing nations to cheaply lower emissions while developing alternative sources like wind and solar.

Global Economic Slowdown

Another short term factor to coal's drop has been the recent slowdown in global growth. Coal has been a major fuel of growth for China, India, and other Asian countries, and in these areas coal demand is still expected to grow in coming years. However, the recent slowing of economic growth in those countries has hurt coal, particularly the slowdown in China because it is projected by the IEA to account for three fifths of coal's demand growth over the next five years.

The two short term headwinds I have described will both pass eventually, and I speculate that the point when they do could be the period in time when coal stocks bounce off the bottom.

Dirty Image

People in the US are gaining more and more awareness about how fossil fuels hurt the environment, and climate change is something that a lot of people are really afraid of. Statements like "we only have one planet, we need to take care of it" are becoming more and more common, and one of the biggest enemies of this movement is coal, the dirtiest fossil fuel and the most hated by environmentalists.

This sentiment is not limited to the US. Europe is even more environmentally conscious than we are; the CEO of French energy company Engie, Gerard Mestrallet, recently stated that fossil fuels are on the way out and being replaced by renewables. And how long will the people of China and India endure terrible smog without taking up the anti-coal banner? There is a strong dislike of coal as a fuel globally, one that will never go away.

Threat of Government

Alone, people disliking coal isn't a problem for coal companies- people have hated oil companies for decades and decades and they have continued to thrive. However, there is a very real threat that, partially because of the public hatred for coal, global governments could develop regulations or legislation that would hamstring coal companies and slowly kill coal as an energy source.

For example, a few days ago, President Obama announced his Clean Power Plan, which among many other regulations will allow the EPA to give each state a goal for cutting greenhouse gas emissions from existing power plants. This is awful news for coal, as one of the principal ways states will have to do this is by cutting coal use. And a further portion of the plan dictates that future power plants produce approximately half of the pollution rate that current plants do, effectively eliminating the ability for new coal plants to be built.

While legal challenges or the electing of a new president with a different position on climate change could possibly limit the effect of the Clean Power Plan, there's also a chance that other nations follow the war on climate change that the Obama administration has started and come out with their own plans that limit pollution and harm coal. For example, China and Brazil have in the past year come out with pledges to control emissions, taking lead from the US. The number one target of the US to meet their emission reduction goals has been coal, and I could easily see the rest of the world following that example.

In the long run, I see increased regulation on pollution and also potentially taxation that will eventually drive coal out of business unless new carbon capture technology is developed that is cheap enough to make economic sense. Otherwise, it might take a while, but coal will eventually die.

Best Puff for the Risk?

I have followed Buffett's example and have no interest in cigar butt stocks. But, if I were to pick a coal company to pursue that strategy with, I would pick Cloud Peak Energy (NYSE:CLD). It is the lowest cost producer of coal in the US and still has positive margins and ROE while other companies are deep in the negatives. It also has a solid balance sheet when compared with the ballooning debts of Peabody Energy (NYSE:BTU) and Arch Coal (NYSE:ACI) and doesn't face as many liquidity concerns and as much risk of going bankrupt as a result. BTU and ACI have been hit harder and could potentially bounce higher, but they are too risky for my taste.

So my cigar butt plan would be to buy Cloud Peak now and wait for natural gas prices to go up or global economies to move to higher growth, giving coal a boost. I would then immediately sell CLD after that bounce (which could be considerable) and never stick around to see the day coal dies.

Summary

While I do think coal stocks are oversold at the moment, I am avoiding them because of their awful business prospects. Investors may have an opportunity in coal companies to pursue a cigar butt strategy, but I am following Buffett's lead and passing on it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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