Market Cap Vs. Enterprise Value of Coal Stocks
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Investors looking to play a beaten down sector like coal need to understand the difference between Market Cap, "MC" and Enterprise Value, "EV." Most investors recognize MC, the number of shares outstanding multiplied by the share price. This simple metric serves investors well if there's not much debt on the balance sheet.
In short, market cap ignores debt on the balance sheet
However, if a company employs debt, then MC alone will not suffice in comparing investment opportunities. EV = MC + debt - cash (& cash equivalents). Therefore, EV explicitly takes into account debt and cash, both of which are of vital importance these days. Peabody Energy (NYSE: BTU), Arch Coal (NYSE: ACI) and Walter Energy, (NYSE: WLT) stocks are down 81%, 94% and 91%, respectively, from all-time highs. Naturally, these stocks may appear to be quite cheap or oversold.
Comparing EV to MC puts these dismal stock charts into perspective. Back in 2008, Peabody traded at an all-time high of $88 per share, on 272 million shares, for a MC of $24 billion. Friday, the share price was $16.8 and there are 270 million shares, for a MC of $4.5 billion. Looking at EV, at Peabody's peak, the EV = MC + (debt-cash) was $27 billion! of which the (debt-cash, aka, "net debt") component was $3.2 billion. Thus, net debt was 11% of Peabody's total EV.
The Relative proportion of debt as a percentage of EV has soared
Friday, Peabody's EV = MC of $4.5 billion + net debt of $5.5 billion = $10 billion. Therefore, while Peabody's stock price is down 81%, it's EV is, "only" down 63%. While that might not seem very helpful to know, that's just part of the story. It's essential to also understand the relative weight of the net debt in the capital structure. From 11%, that figure has spiked to 55%. Therefore, the relative weight is up by a factor of 5.
Without any further calculations, one can see that the financial strength of Peabody has plunged along with its stock price. Therefore, the earnings multiple an investor should be willing to pay is lower. This is an essential exercise for framing the rebound potential of Peabody's stock. Will this stock bounce back into the $80's? Not a chance. Earnings prospects are far weaker and relative net debt is 5 times higher. Investors hoping for a 3-5 times stock return in Peabody are in for a big disappointment.
The same debt challenges for Arch Coal and Walter Energy
What about Arch? At its peak, the MC was 144 million shares x $75 per share = $10.8 billion. On Friday, the MC was about $900 million. While Arch's stock price is down 94%, its EV is down just 56%. Like Peabody, Arch's net debt to EV ratio was 11% at its peak, but now that ratio stands at 82%. That's greater than a 7 times increase in relative net debt. Arch stock trading near $4.25 per share is simply not as cheap as it looks.
Walter Energy's stock is down 91% from its all-time high. However, the company's EV is down a mere 69%. Walter's net debt was 21% of its total EV at its peak, but is 73% of its EV now. On Friday, Walter announced that due to market conditions it was not proceeding with a planned debt refinancing, sending its stock down 17%.
A final example among coal producers is Master Limited Partnership, Alliance Resource Partners LP (NASDAQ: ARLP). Alliance's unit price is down only 15% from its peak in March, 2011. However, as a MLP, Alliance pays a substantial distribution. Adding the distributions paid since March, 2011, investors have received $9.17, making the total return on the units since the peak closer to down 5%.
Looking at the stock charts of Peabody, Arch, Walter and Alliance, which company looks the least "cheap"? Alliance. Yet, I would buy Alliance over the others because it has a growing distribution, and currently yields 6.4%. I believe the yield required for investors to own these units could fall 50 - 100 basis points, (the yield was 4.13% at the peak unit price). With five year treasury notes yielding about 1%, this MLP's growing distribution should stand out.
Investors hoping for spectacular 3-5 times returns for beaten down coal stocks will be highly disappointed. Looking at both the MC and the EV of these companies, the relative portion of net debt to EV as completely changed the investment profile. Walter's 17% decline on Friday demonstrates how risky the market perceives these stocks to be. With added risk sometimes comes added reward, but I prefer Alliance to any of the seemingly cheap coal stocks.
The coal industry in the United States has been in a state of flux since the arrival of a cheaper alternative for energy production: natural gas. Exports are becoming a much bigger part of the domestic coal landscape, and Peabody Energy has deals in place to get its cheaper coal from the Powder River and Illinois basins to India, China, and the EU. For investors looking to capitalize on a rebound in the U.S. coal market, The Motley Fool has authored a special new premium report detailing exactly why Peabody Energy is perhaps most worthy of your consideration. Don't miss out on this invaluable resource — simply click here now to claim your copy today.
Peter Epstein owns shares of Alliance Resource Partners, L.P.. The Motley Fool recommends 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!