Peabody Energy: A Value Play in Coal
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What investors seem to overlook when considering an allocation to coal is that it is a highly bifurcated market that must be evaluated as two distinct parts in many cases. There is, however, and interplay between the parts, so divorcing the two too completely can be problematic as well. Peabody Energy (NYSE: BTU) is attractive because it both offers an excellent valuation at current levels and gives shareholders exposure to both thermal coal and metallurgic coal, each of which have experienced significant positive catalysts recently.
Understanding the Great Divide
This discussion may be repetitive for those who follow coal companies carefully, but should serve as a good primer for everyone else. Coal comes in two varieties: thermal coal and metallurgic coal. Thermal coal is used in the generation of electric power, making utility companies the primary consumers of this type of coal. Power plants can run on coal or natural gas power, meaning that when natural gas prices are significantly depressed, thermal coal price must drop to remain competitive. As substitute goods, there is a close tie between the prices of these two commodities.
Metallurgic coal is used in the production of steel through the coking process. The primary driver of price for this variety of coal is the demand for steel, and thus construction and infrastructure projects can have a significant impact on price. Most of the big coal names participate in both types of coal operations, although Arch Coal (NYSE: ACI) and Alpha Natural Resources (NYSE: ANR) seem to have a heavier concentration on metallurgic coal and Consol Energy (NYSE: CNX) a stronger focus on thermal coal.
While coal stocks have gotten badly hurt this year (see chart above), the recent announcement that China has approved $156 billion in infrastructure spending drove the stocks significantly higher over the last week (see chart below). The projects are highly steel-intensive and should create stronger demand for steel, which has been weak all year. The demand weakness is largely attributable to general economic weakness and a contraction in large-scale construction spending. China is a critical consumer of steel; the weakened Chinese economy has been a big detractor from global demand. Increased demand in China should be a significant positive.
The other big catalyst for coal stocks came from the recent pop in natural gas prices. Using United States Natural Gas (NYSEMKT: UNG), the leading natural gas ETF, as a proxy, UNG popped over 5% in Monday’s trading session. This is a reversal from last Friday’s slump on the news that inventories remain high. While the news seems mixed, Monday’s recovery-and-then-some provides solid evidence that natural gas prices are consolidating and looking to go higher. Given the close tie between natural gas and thermal coal, this is bullish for coal prices.
The Value Call
Amongst the competitors mentioned above, Peabody is the best value at current levels. The company has a trailing P/E of 7.4 relative to 11.6 for Consol; Arch Coal and Alpha Natural Resources had no earnings. The PEG ratios are negative for ANR and Arch because each is expected to contract (negative growth). Peabody has a PEG of 1.54 and Consol is at 1.17. Another critical metric when companies are facing the types of pressures confronting the coal industry, and one in which Peabody excels, is operating margin. Peabody has an efficiency rating of 18% relative to 12% for Consol, 7% for Arch Coal and 2% for ANR.
Finally, Peabody has a nice balance between thermal and metallurgic coal exposure. News on China always gets big hype, so metallurgic coal has been the area of focus of late. With that in mind, the prices of both varieties are likely improve over the medium-term. While natural gas prices remain depressed, there are several positive signs that a meaningful rally is near. Coal investors have been using natural gas as a barometer for coal prices, and this is likely to continue. Ultimately, coal is a good space in which to have exposure; based on solid valuations and joint positive catalysts, Peabody is a buy at current levels.
Mr. Ehrman 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.If you have questions about this post or the Fool’s blog network, click here for information.