2 Coal Stocks to Avoid

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 suffered greatly due to weak coal demand. The Market Vectors Coal (NYSEMKT: KOL), which replicates the performance of coal industry, has an expense ratio of 0.59%. CONSOL Energy and Peabody Energy, with 7.56% and 6.13%, respectively, are among the largest components of Market Vectors Coal. Market Vectors Coal has underperformed the broad market in recent times. Year to date, Market Vectors Coal is down 28%. The following table shows the performance of some component companies of Market Vectors Coal.

<table> <thead></thead> <thead> <tr><th> <p><strong> </strong></p> </th><th> <p><strong>CONSOL Energy</strong><strong></strong></p> </th><th> <p><strong>Peabody Energy</strong><strong> </strong><strong></strong></p> </th><th> <p><strong>Alpha Natural Resources</strong><strong> <span class="ticker" data-id="206837">(NYSE: <a href="http://caps.fool.com/Ticker/ANR.aspx">ANR</a>)</span></strong></p> </th><th> <p><strong>Walter Energy</strong><strong> </strong><strong><span class="ticker" data-id="206071">(NYSE: <a href="http://caps.fool.com/Ticker/WLT.aspx">WLT</a>)</span></strong></p> </th></tr> </thead> <tbody> <tr> <td> <p><strong>Year to date Performance</strong></p> </td> <td> <p>-12%</p> </td> <td> <p>-38%</p> </td> <td> <p>-41%</p> </td> <td> <p>-66%</p> </td> </tr> </tbody> </table>

Source: Google Finance

Met coal stocks are getting squeezed lately on global economic growth concerns, hence volatility prevails. In contrast, the thermal coal business provides high level of visibility as it is priced and contracted for 2013. Therefore, I believe coal companies that are primarily exposed to the met coal business will underperform coal companies which are mainly engaged in thermal coal.

Despite the ongoing weak market conditions for coal, the coal industry is expected to rebound in the long-term as natural gas prices recover and demand for met coal for steel production increases. Improved coal supply management should also bode well for the industry. Therefore, Market Vectors Coal provides investors a good investment option for the long run. 

Met coal stocks getting squeezed

Met coal prices, which are thought of as important driver for the coal companies’ stock price, are expected to remain flat moving into 2H 2013. Weak met coal prices are likely to prevail due to lower coal imports by China, as its domestic production has surged, increased met coal supply by Australian producers, and weak met coal demand by steel producers due to the economic slowdown.

I expect met coal prices to remain depressed or even fall further going forward, therefore, I remain bearish on Alpha Natural Resources. Alpha Natural is likely to underperform its peers due to low thermal coal exposure and weak met coal prices to which it is mainly sensitive to. It is expected that Alpha Natural's met coal operations will generate almost 50% and 65% of the company’s total EBITDA in 2013 and 2014, respectively. Significant met coal exposure will not bode well for the company, as met coal prices have fallen from $172/MT benchmark price for 2Q 2013 to $145/MT benchmark price for Q3 2013. 

More than 25% of Alpha Natural's met coal volume for 2013 still needs to be priced for the year, which poses a risk as met coal prices are falling. It is also likely that the company continues to price some portion of its volumes below cost as was the case in 1Q 2013, where it priced 25% of its volumes below cost. If below cost pricing continues to happen, this will adversely affect the bottom line and the financial health of Alpha Natural. 

Alpha Natural has been working to counter the negative impact of weak coal market conditions. The company has done a decent task by focusing on high margin met and thermal coal assets and improving its cost structure following its Massey Energy acquisition in 2011. The factors that can positively impact the company’s performance are improved met coal demand and prices and cost control initiatives. 

Walter Energy is another coal stock with significant exposure to met coal. A weak met coal market has been an important reason behind the drop in price. However, other than weak market conditions, the significant drop in price of Walter is attributed to its highly leveraged balance sheet. Last month, Walter stepped back from a $1.55 billion debt refinancing plan. The announcement was negatively taken by the investors and the stock price fell.

In an effort to comply with debt covenants, the company is in search of modification of its debt agreement and covenants, which will be accompanied by additional conditions by the lenders. Due to Walter Energy’s ongoing liquidity and refinancing concerns, S&P and Moody’s downgraded the credit rating assigned to the company. As Walter is surrounded by weak market conditions and liquidity concerns, this can lead to a further drop in stock price. 

Final words

As met coal prices and demand remains weak, I believe met coal stocks will underperform thermal coal stocks. Concerns over global economic growth outlook, increased met coal production by Australia, and lower Chinese imports are the reasons that can lead to underperformance by met coal stocks. Moreover, concerns related to financial strength of coal companies, such as Walter Energy, remain a headwind for potential price appreciation.

Therefore, I remain bearish on Alpha Natural and Walter Energy. Positive global economic outlook and improved cost structures are the factors that can be positive for the companies’ stock price.

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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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