Big Upside Potential in Coal Stocks

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The coal sector has been beaten and bruised over the last years. Companies like Peabody Energy (NYSE: BTU), Alpha Natural Resources (NYSE: ANR) and Arch Coal (NYSE: ACI) are trading at historically low prices, even below levels observed during the financial crisis. The sector is volatile and quite risky, but things may be starting to turn around, and coal stocks have some very exciting upside potential.

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Turnaround Prospects

Coal competes against natural gas as an energy source for utilities and other business, so cheap and abundant gas is a problem for coal prices and the companies which produce it. This has clearly affected the sector over the last years, and the natural gas revolution will be an important headwind for coal consumption in the US in the middle and long term.

The US will have plenty of cheap energy available thanks to the natural gas boom, and this means that some of this energy will be exported. But when it comes to energy exports, coal should be the primary beneficiary, since it’s much more easily exportable than gas.

Besides, demand for coal is still strong in other countries.  Electricity production in emerging markets like India and China is heavily focused towards coal because the fuel is abundant, cheap, and not controlled by cartels like OPEC. Carbon emissions could be a problem since coal is a dirty source of energy, but these countries are clearly prioritizing economic growth and energy supply over environmental considerations.

Nearly 500,000 megawatts of new coal-fired electric generation capacity came online in China between 2000 and 2011. And the U.S. Department of Energy estimates that between 2013 and 2016 another 315,000 megawatts of addition coal-fired capacity will likely be built in the Asian giant.

In 2011, four Asian countries — China, Japan, South Korea, and India — made up more than a quarter of U.S. coal exports. And coal consumption in the region is expected to double by 2020, which bodes very well for US exporters.

Sales to Europe have also been very strong lately, natural gas in the old continent is generally sold on contracts linked to the price of oil, which is still relatively strong, and this makes gas more expensive as a source of power than cheap US coal. Cash strapped European countries are also prioritizing cheap energy over environmental concerns.

The Energy Information Administration estimates that the US is on track to achieve record coal exports in 2012 with 125 million tons for the year, surpassing the previous all-time high set in 1981. Coal exports are booming, and the fundamentals for that industry over the following years look very promising.

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Investment Alternatives

International demand should help stabilizing coal prices, and this could be bullish for producers, which are trading at historically depressed prices. On the other hand, the sector still leaves much to be desired in terms of fundamental quality and financial soundness.

Alpha Natural Resources and Arch Coal have been losing money over the last years, and they would probably need a material recovery in coal prices to become profitable again. Peabody Energy has positive earnings figures, but capital allocation hasn't been very convenient lately.

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Peabody purchased Australian metallurgical coal producer Macarthur Coal in 2011 for an expensive valuation of AUD 4.8 billion, implying more than 30 times trailing sales. Metallurgical coal prices have been falling since then, and the acquisition has increased leverage levels at Peabody in a considerable way. Coal stocks will probably react positively to stabilizing coal prices, but the industry doesn't look very attractive in terms of profitability and fundamental strength.

Diversification could be a convenient way to reduce risks while still capturing upside potential in the coal business, and Market Vectors Coal ETF (NYSEMKT: KOL) is the most popular ETF to invest in the sector. The instrument holds around 35 coal related companies from around the world, not only coal miners, but also businesses in coal transportation and mining equipment.

Norfolk Southern (NYSE: NSC) may not be a pure coal play, but this well managed railroad makes more than 30% of revenue from coal shipments, so it stands to benefit from surging exports demand. Norfolk has operating margins in the area of 28% and a rock solid track record of cash flow generation, so the company provides an alternative of superior fundamental quality in comparison to coal producers.

And Norfolk is cheap too; the company carries a P/E ratio around 11.3 and a dividend yield of more than 3.2%. This is quite attractive for such a high quality business, especially if the company sees improving sales growth from higher coal volumes over the next quarters.

Bottom Line

Cheap natural gas has been a problem for coal companies over the last years, and many stocks in the sector are trading at dramatically depressed levels. But the commodity is still highly demanded in other countries, and exports markets look very promising.  International demand may provide the necessary fuel for a turnaround in the coal sector, and there is a lot of upside room under that scenario.

acardenal has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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