International Coal Demand Is Rising

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The coal market has been undergoing a cycle downturn in recent years, and investors are always looking for improved macroeconomic data to support a market rebound.

The current down cycle began during the Great Recession, and although market conditions improved in late 2010/early 2011, coal prices have slipped to near-record lows based on global macro weakness. Stock prices of coal producers have a high correlation with the underlying commodity price, and many companies find their market value of equity to be at five-year lows.

However, recent economic data seems to favor demand restoration in the coal market. Chinese manufacturing grew at the fastest pace in 14 months, according to the HSBC Flash Purchasing Managers’ Index released on December 14. The HSBC data is released one week before the final PMI number for China, and is formulated based on the survey results of both private and state-owned manufacturers.

In addition to the flash PMI data, it is clear the Chinese government is supporting urbanization based on increased electricity and gas consumption. Skeptics of the Chinese growth story often question the legitimacy of state-backed economic data, however Joy Global (NYSE: JOY) confirmed the improvement is authentic during its recent fourth quarter earnings report. Specifically, Joy Global cited the positive effect of government stimulus on infrastructure and stated that electricity demand is “discrete”, meaning the number cannot be tampered with.

The demand picture for coal is far different on an international basis vs. the United States, as coal consumption is expected to decrease on our home soil. In my opinion, there is no domestic recovery for U.S. coal producers, and future prospects for the entire North American coal industry are mainly export-driven.

As the industry continues to evolve based on market forces, one company stands head-and-shoulders above the rest. Here are five reasons why Peabody Energy (NYSE: BTU) offers the best investment for increased global coal demand:

  • Peabody is a diversified global coal operator, with approximately half of its 2011 earnings coming from outside the United States. The global nature of Peabody’s business is due to management’s continued investment in Australia. The company acquired Macarthur Coal in 2011, and ex-US EBITDA has grown from 17% in 2007 to 50% at present.
  • On December 14, management provided guidance for first quarter and full year 2013 based on pricing settlements for metallurgical coal. The company sees a trough in earnings during first quarter 2013, and improvement for the rest of the year. Keep in mind that stock prices generally reflect future business conditions at least six months in advance.
  • With it’s growing Australian presence, Peabody is uniquely positioned to service nearby demand centers in China and India. The company’s Australian sales were 24.4 million tons in 2011, and are targeted to reach 45  50 million tons by 2015.
  • Chinese demand for imported coal is expected to double during the 5-year period between 2011 and 2016. During 2011, China imported more than 200 million tons of coal, approximately 80% thermal and 20% metallurgical. The Chinese government projects imported coal to reach 400  450 million tons by 2016.
  • India’s coal imports are growing faster than China, albeit off of a smaller base. In contrast to China which chooses to idle its own production capacity, India is increasing domestic production but will be unable to meet thermal demand on its own. The historic power outages that took place in India during 2012 are indications for an improved power grid and increased coal imports.

Peabody has a valuation similar to most US coal producers, when it deserves a higher premium based on its global mining infrastructure. The company trades at 6 times Enterprise Value / EBITDA, while the industry average is approximately 8 times EV / EBITDA.

As I alluded to in the introduction, overall stock prices for the coal industry reflect weak fundamentals. The prevailing market price for coal during 2012 has been lower than the cash costs for numerous U.S. producers, including the St. Louis, Missouri based Arch Coal (NYSE: ACI). As a result of the low prices, producers have spent the past year deleveraging by cutting production and capital expenditure. Management at Arch Coal expects the supply/demand dynamic to balance out in metallurgical coal during 2013, as the company reduces supply coming to market.

Joy Global is also expecting a commodity price rebound, although the timing remains uncertain. An investment in Joy Global is an alternative way to play a rebound in U.S. coal producers, and the company should see an uptick earlier in the cycle based on the need to purchase and service mining equipment. Furthermore, Joy Global’s leading market position makes it a compelling acquisition target for either a domestic or international buyer, similar to Caterpillar’s acquisition of Bucyrus in November 2010.

Foolish Bottom Line

Market participants often associate finding a bottom in stock prices with the proverbial phrase "to catch a falling knife." While multiple forces are in play within the coal industry, it appears that producers have reached a trough in quarterly earnings based on collective assessment. Future revenue growth is contingent on increased demand and higher prices.

The picture for coal on a global basis appears very bright, despite the likelihood for tapered demand here in US. A near perfect correlation between coal usage and GDP growth offers a compelling argument for long-term investment in coal, particularly my favorite idea in Peabody Energy.

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johnmacris has no positions in the stocks mentioned above. The Motley Fool owns shares of Joy Global. 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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