3 Coal Stocks to Buy

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

The U.S coal industry has been going through difficult times in the recent past. Lower natural-gas prices, rising environmental regulations and excessive coal supplies have shaped extraordinary pressure for the coal industry. In the last two years, Market Vectors Coal, an ETF, has dropped 61% in price.

However, I believe the coal industry will improve in the future as lately natural-gas prices have been trending upward, coal supply management is improving and demand for met coal will increase by China and India. Therefore, I believe the three coal stocks best positioned in the industry to buy in anticipation of coal market recovery are Peabody Energy (NYSE: BTU), Arch Coal (NYSE: ACI) and Cliffs Natural Resources (NYSE: CLF).

The leader 

Peabody Energy is the largest private-sector coal company of the world. The company is the leading low-cost coal producer in the U.S. region, and also has been increasing its operations in Australia. Peabody Energy's recent efforts to expand its operations in Australia will bode well for the company as the region is among the leading coal exporters of the world. In 2011, Australia was the world’s second-largest coal exporter. Currently, more than 40% of the total revenue of the company are earned from Australian operations.

Another promising sign for Peabody is that in comparison to its peers, it has a higher gross margin of 24%. The following table shows the gross margin of Peabody compared to its peers in the industry.

<table> <thead> <tr><th> </th><th> <p><strong>Peabody Energy </strong></p> </th><th> <p><strong>Walter Energy</strong></p> </th><th> <p><strong>Alpha Natural Resources</strong></p> </th><th> <p><strong>Arch Coal </strong></p> </th></tr> </thead> <tbody> <tr> <td> <p><strong>Gross Margin</strong></p> </td> <td> <p>24%</p> </td> <td> <p>20%</p> </td> <td> <p>17%</p> </td> <td> <p>17%</p> </td> </tr> </tbody> </table>

Source: Yahoo! finance

For the 1Q 2013, Peabody posted better-than-expected financial results. The company was successful in registering an earnings surprise of 64% in the last quarter. Bottom-line performance for Peabody is likely to benefit from its ongoing cost-reduction efforts. For the year 2013, U.S. mining expenses are expected to be reduced by 2% to 3% as compared to last year.

I am also bullish on these two coal stocks, are you? 

Arch Coal is among the coal stocks which I believe offers investors an attractive investment opportunity. With coal reserves of more than 5.5 billion tons, Arch Coal is the world’s third-largest private-sector coal producer. The company has been taking steps to increase its operations in China so that it can effectively tap the market opportunities available in China and neighboring markets. Recently, Zhang Shijie has been hired by Arch coal to lead the Chinese operations. China offers a huge market potential for Arch Coal, as China is the leading steel producer and met coal consumer of the world.

Despite the ongoing slow coal market environment, Arch does not seem to encounter cash flow problem in the near future, as there is no significant debt repayment until 2016. In 2016, the company is expected to repay $600 million of debt followed by $1,638 million in 2018. Analysts are also bullish on Arch Coal and have forecast earnings growth rate of 5% per annum for the next five years.

Another coal company on which I remain bullish is Cliffs Natural. The company is primarily involved in providing met coal and iron ore to the steel industry. In recent times, Cliffs Natural has diversified its production and geographical base. Steel production is expected to increase by 3% in 2013, which will be positive for the company as it supplies met coal to steel producers.

Cliffs Natural delivered healthy financial performance in the recent first quarter, by posting earnings per share of $0.60 as compared to analysts’ consensus of $0.32. The company is expected to deliver healthy financial performance in the future as analysts have projected a decent five-year growth rate of 4% on average. Earlier this month, Cliffs Natural announced the extension of a supply agreement with Essar Steel for eight more years. This announcement is viewed positively as it provides volume visibility in the upcoming years.

Foolish risks

If natural-gas prices lose their upward trend and drop to a level where coal loses its cost competitiveness, this will adversely affect the coal industry. Also, a slowdown in China, India and other emerging markets' infrastructure spending will translate into lower met coal demand and hence a depressed environment for the coal industry. 

Foolish final words

As stated above, due to increases in natural-gas prices, better coal supply management and increases in steel production, the coal industry is likely to get better in the future. Therefore, I remain bullish on the three aforementioned companies as they have strong fundamentals and are superior to their peers.

These companies are working to improve their cost structures, which will support their bottom-line performance in the ongoing tough industry environment. Also, decent five-year growth projections by the analysts (as discussed above), indicate bottom-line expansion for three companies going forward. 

Cliffs Natural Resources has grown from a domestic iron ore producer into an international player in both the iron ore and metallurgical coal markets. It has also underwhelmed investors lately, especially after its dramatic 76% dividend cut in February. However, it could now be looked at as a possible value play due to several factors that are likely to remain advantageous for Cliffs' management. For details on these advantages and more, click here now to check out The Motley Fool's premium research report on the company.

Faizan Chudhry has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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