Signs Of Life In This Beaten Down Industry

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

To make a lot of money in the market, many times it's necessary to invest when popular opinion is against the sector. The trick is to make sure that there are improving fundamentals before you jump in. A segment of the market seems to believe that coal production is going to disappear. With many of the companies down over 30%, if this industry isn't going to disappear, opportunistic investors could potentially make big profits. One leader in the sector that could be a good long-term value is Peabody Energy (NYSE: BTU).

The coal industry has suffered from a two-pronged problem in the last few years. First, the price of natural gas has dropped tremendously, which makes coal less attractive on a relative basis. Second, coal is still seen as a dirty fuel versus natural gas or green energy options. The good news for long-term investors is natural gas prices have more than doubled from their lows. While coal would have trouble being compared to green energy options like wind or solar, clean coal technologies have made the industry more competitive. In addition, there are multiple positives coming from coal companies showing that a rebound in the fuel is likely more than just rhetoric.

Consider that in the last three months, Peabody saw sales volumes up 6%, and competitor Alliance Resource Partners (NASDAQ: ARLP) saw volumes up 7%. However, this positive volume increase didn't necessarily equate to a rising tide lifting all boats as another competitor Arch Coal (NYSE: ACI) saw its shipped volumes decrease 6% sequentially. This is why investors need to make sure they are selective in trying to pick winners in this industry. One challenge that the industry is running into is making investments for growth in the future, while also trying to manage costs to increase EBITDA. This was a challenge for Peabody in the quarter as the company's EBITDA was down 9.56% on a year-over-year basis. Most of the issues facing Peabody stem from challenges in the domestic market.

In North America, Peabody saw revenues increase 1%, and demand rose because of higher natural gas prices and increased cooling days. A positive for future results is the company suggested that during the third quarter, U.S. stockpiles fell by “70% more than the five year average.” This is good news longer-term because a challenge for the company has been domestic utilities working through excess inventory. In another sign of recovery for the fuel, the “U.S. Energy Information Administration projects coal consumption to rise by more than 40 million tonnes in 2013.” While domestic production has been a challenge, Peabody's international sales have been excellent.

One of Peabody's most important markets is Australia, where revenues increased 39%. The company saw strong demand from China with net coal imports up, and Japan's coal generation is up 26% year-over-year. India is seen as a new growth driver for the coal industry and this seems to be occurring slowly, but surely, with thermal coal imports up 15% year to date. Even in Europe where nearly every international company has suffered from challenging comparisons, coal-fueled generation is up 14% year-over-year. As you can see, international sales are not the issue for Peabody, and in the meantime the company's financials are still fairly strong.

Since coal is a commodity, I would expect the company with the highest gross margin is the most efficient operator. While some might argue this approach, this gives us at least an insight into how each company competes. While competitor Alliance Resource sports a gross margin of 32.77%, this company is a limited partnership with a different structure than Peabody or Arch Coal. Of these two more pure plays on the industry, Peabody has a gross margin of 26.70% versus 17.14% at Arch. Clearly Peabody is the more efficient operation. In addition, of the three companies Peabody and Alliance both have consistently generated positive free cash flow. In fact, Peabody generated over $300 million in free cash flow in the last three months, and paid out just under $23 million in common stock dividends. In the short-term, investors shouldn't need to worry about Peabody's dividend. In addition, the company's operating cash flow actually increased 7.15% on a year-over-year basis, something few other coal companies can claim. The company also improved its balance sheet, going from a debt-to-equity ratio of 1.19 last year to 1.04 this year. Since it looks like Peabody is holding up well even during this challenging time, investors can imagine what the company might do if demand does continue to increase.

According to research firm Wood Mackenzie, coal is expected to, “overtake oil as the world's largest energy source in 2013 based on global demand.” Since Peabody is one of the largest integrated coal companies, this argues well for the future of the company. There is no question that Peabody is a contrarian play today, but that is where big profits are possible. I see coal stocks like homebuilding stocks a year or so ago. Many investors scoffed at the idea that homebuilders would do well a year ago. However, some of the top homebuilders like Lennar and Toll Brothers are up over 50% in that timeframe. In the same way, if coal demand increases companies like Peabody will benefit. Analysts are calling for slow growth in the next few years with just 2.5% growth expected in EPS. However, these are the same analysts that were similarly calling for slow growth in housing as well. I still think that Alliance is a great play in the sector, but if you want a pure play on coal, Peabody is the way to go. There are signs of life in this industry that are being overlooked, and patient investors could find today's prices an ideal entry point.

MHenage owns shares of Alliance Resource Partners, L.P. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Alliance Resource Partners, L.P.. 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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