The Major Headwind for These Companies

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

China’s PMI continues to contract, which means a slowdown in the manufacturing activities in the country. One of the sectors that may be impacted significantly is the coal sector. Although the Market Vectors Coal ETF has declined 29% on a year-to-date basis, I believe the downside is not over. Hence, investors should steer away from coal companies.

Beware of the coal

Peabody Energy (NYSE: BTU) trades with a negative P/E. The company posted a decline of 10% in revenue to $1.7 billion in the previous quarter and a net loss of $23 million, down from a net income of $173 million a year ago. Further, its cash from operations declined $120 million to $272 million.

Overall, the company has not been profitable lately. Further, I believe that its revenue will continue to decline. China’s total coal demand tumbled in 2012 for the first time in the past decade by 32 MT, hit by slower economic growth and a surge in hydro power.

Analysts expect that Chinese domestic coal will capture a bigger share of the thermal coal market due to improving railroad and ports conditions. Hence, they forecast that coal imported to China “will fall by some 35 MT.”

The aftermath of dimming demand for coal has severely impacted the commodity prices, and Peabody may see its revenue decline since it is an exporter to China. Investors need to look for improving manufacturing activity in China in order to reconsider investing in Peabody Energy.

Arch Coal (NYSE: ACI) is the second largest coal producer in the United States. The company posted a decline in revenue of 21% to $826 million in the last quarter compared to the year-ago period. Further, the company ended the quarter with a net loss of $70 million compared to a profit of $1 million a year ago.

Its cash from current operations fell $12 million to $43 million. Its free cash outflow at the end of the period was $20 million, compared to $47 million last year. Analysts rate the stock a 4.0 on a 5-point scale where 5 is buy and 1 is sell.

The company’s subsidiary, Asia-Pacific Pte. Ltd., established operations in Beijing to increase the footprint in the region. However, the coal surplus in China will prove difficult for Arch Coal to export the product to the country. In fact, investors may expect a continuous decline in coal exports as long as China’s manufacturing activity remains weak.

Further, the company competes directly with Indonesia, which is the main coal exporter in the world. This adds another problem to Arch Coal’s export competition in the region. The company should try to enter the Indian market to try and offset a decline in revenue from China.

The big Aussie

BHP Billiton (NYSE: BHP) is a diversified miner with many resources. The company produces coal, copper, and even Uranium. The company trades at a price-to-earnings ratio of 16.1, well below the industry’s average of 48.3. The company’s revenue has declined 10% to $66 billion in the trailing-twelve months compared to last year. Its net income shrunk to $9 billion from $15 billion.

Several analysts suggest that BHP Billiton may be a dividend play because it offers a 4% yield. However, I believe this is not a wise idea. If net income and revenue are shrinking, the company may end up having issues paying its obligations.

Its free cash flow has been contracting since 2011, when it jumped from $7 billion to $18 billion. If we remove that year, its free cash flow has been shrinking since 2008. What’s more is that the company posted a free cash outflow of $6 billion from an inflow of $3 billion. If this continues this way, I would not be surprised if the company slashes its dividend payment.

Investors also need to look for economic improvements in China. One tailwind for the company comes from its copper mining business. China’s urbanization plans include an ambitious plan for the construction of homes. BHP Billiton could benefit from a stronger demand for copper in China in the coming months. However, we should wait until such strength for copper is present in the market. Otherwise, investing in this company should be regarded as a speculative play.

The Foolish message is…

The demand for coal is still weak. Thus, investors should steer away from these companies as long as China’s manufacturing activities do not improve. The coal surplus will affect the exports from Peabody Energy and Arch Coal. Lastly, BHP Billiton’s coal sector may continue to underperform, but the company’s revenue may be partially helped by a stronger demand for copper if China continues with its urbanization plans.

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Robinson Roacho 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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