Profiting From Rising Coal Demand

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

With the abundant supply and cheaply priced natural gas in the U.S, the clean fuel has successfully replaced coal in many industries. While coal prices have declined by nearly 25% over the last year, the rising domestic gas demand and increasing liquefied natural gas (LNG) exports have pushed up gas prices by nearly 30%. As a result, electric utilities now prefer coal over natural gas due to its low price. In fact, for the first four months of 2013, coal’s contribution to the total power generation rose by 410 bps year-over-year, while the natural gas share slipped by 370 bps year-over-year. So the question arises, how do you profit from this trend?

Coal manufacturers

Since coal demand is on the rise, it would be obvious to think that top coal manufacturers stand to benefit here. But that isn’t the case.

Peabody Energy (NYSE: BTU) is the world’s largest private-sector coal company with around 9.3 billion tons of proven reserves. The coal behemoth generated almost around 54% of its FY 2012 revenue from the U.S, while its Australian mines accounted for the rest.

To boost its revenue, Peabody recently ramped up its Australian coal production (by 30%) to record levels. This might give the advantage of economies of scale, but will most likely lead to higher foreign exchange losses. With the slowing Australian economy and recovering U.S economy, analysts at Fidelity estimate that the Australian dollar will go in free fall. In my opinion, the coal industry is already challenging, and mounting forex losses could nullify Peabody’s earnings growth, in case there’s a free fall.

On the other hand, Arch Coal (NYSE: ACI) is the second-largest coal producer in the U.S with around 5.5 billion tons of proven coal reserves. But the company operates with a debt/equity ratio of 184%, which is one of the worst in the entire industry. Its long-term debt aggregates to $5.1 billion, while its quarterly interest expenses amount to $95 million.

The company posted a loss of $755 million in FY 2012, which is further expected to worsen since coal prices have depreciated by nearly 25% year-over-year. Its cash and cash equivalents stand at just $730 million, which are not enough to bear another loss-making year. This leads me to believe that Arch Coal will tend to leverage further, just to stay afloat. Thus, I wouldn’t recommend Arch Coal.

How to proceed

Since the idea is to profit from higher domestic coal demand, and not rebounding coal prices, I believe that investing in the railroads sector would be a great idea. For this reason, Norfolk Southern (NYSE: NSC) pops up as one of the prime beneficiaries.

Norfolk Southern is one of the largest railroad operators in the U.S., owning or holding interests in over 20,000 route miles of the railroad network. The company operates on a fee-based structure, which means that its profitability depends on higher coal volumes rather than its market pricing.

The best thing about it is that Norfolk Southern generates around 25% of its revenue from the transportation of coal, which is mainly provided to electric utilities. Although the company generates 20% of its revenue from intermodal transportation, it is still 400 bps to 500 bps more leveraged toward coal, as compared to its peers

Since it is these electric utilities that are driving up coal demand, Norfolk Southern doesn’t have to look for potential clients to bolster its growth. Additionally, it already has an established and well-connected network to service these electric utilities, which suggests that its growth will come almost immediately at a minimal expense.

On the fundamental’s side, its shares appear to be undervalued with a forward P/E of 11.7x. The company enjoys better-than-average net margins of 16.1%, which have been the key to its sustainable growth. And due to the expansion of its intermodal network amidst recovering industry-wide prospects, BMO Capital Markets recently upgraded Norfolk's shares to outperform with a price target of $91 per share (23% premium).

Final words

With that said, I think Norfolk Southern is a great company with solid growth prospects. But it's worth noting that coal is in greater demand because of its low price. If its price increases dramatically, it would leave little reason to prefer coal over natural gas. Thus, the investment thesis of this article holds true for oversold coal prices.

Piyush Arora 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!

blog comments powered by Disqus