1 Coal Producer To Stay Away From, 1 To Aggressively Buy
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Coal ranks amongst the riskiest industries that an investor can back. However, with great risk often comes great reward. In my view, while Arch Coal (NYSE: ACI) has too much downside to warrant an investment, Peabody Energy (NYSE: BTU) is tremendously undervalued and worthy of a "buy". Below, I review the fundamentals of each company.
By nature of being in the red, Arch Coal is a pure speculative play. It has a dividend yield of 2% and has lost $1.66 per share over the TTM. A loss of $0.36 per share is expected next year. Over the past 5 years, EPS has gotten worse by 16.3% annually. ROA, ROE, and ROI are all in the negative lower single or double digits. Analysts put a $9.93 price target on the stock, which makes for tremendous upside given that the stock is currently worth $6.11.
Free cash flow for the TTM ending 2Q12 was -$165M. This compares to positive $503M in 2Q11 and $256.5M in 2Q10. As much as the firm seems too risky, one needs to consider that FCF has been in the $250M - $500M range from 1Q10 to 3Q11, and yet the firm is only valued at 3.5x the midpoint of that amount.
All in all, however, the risk is too significant. The firm had an adjusted net loss of $0.10 per share in 2Q due largely to the depressed coal market. Most importantly, the company is under some financial pressure with the debt-to-equity ratio being above 1. Management claims that it proactively addressed near-term refinancing issues through restructuring debt so as to eliminate all maturities until 2016. At the same time, it claims to have raised $500M while aggressively cutting costs. While Arch may be poised for strong upside, coal carries plenty of risk as a volatile resource - financial pressure only magnifies uncertainty. Better alternatives for ideal risk/reward are available.
Peabody is an ideal alternative to Arch. It has similar upside with not nearly as much risk. The stock trades at only a respective 6.2x and 8.3x past and forward earnings with a 1.6% dividend yield. And, unlike Arch, analysts are actually bullish about the stock and rate it around a "buy". The stopcock is 45% more volatile than the broader market and, like Arch, also has slightly more debt than equity.
But what attracts me so much to the firm is that bearish fears have overly risk discounted growth, as evidenced by the PEG ratio standing at only 0.34. Analysts forecast 18.3% annual EPS growth over the next 5 years, which implies 2016 EPS of around $4.31. A more reasonable PE multiple of 12x would put the future stock value at $51.72. It would take nearly a 20% discount rate to justify the firm's current valuation - simply way too much. This kind of discount rate would really only apply to an emerging company with an unproven product. As it stands, Peabody has a powerful brand that has seen earnings grow by 12.2% annually over the past 5 years. Not surprisingly, analysts put the price target attractively at $32.75, which implies that the stock is more than 50% undervalued!
Peabody has also seen fairly good momentum. 2Q revenues of $2B were consistent with prior year results and benefitted from Australian volumes and improved US pricing offsetting lower US production. DD&A went up from acquisition and expansion projects, which have led shares to become overly cheap at the current moment. These projects are ultimately investments in the future and those who become shareholders now will benefit from the myopic outlook of today's market. Peabody has a major catalyst in met coal - the company shipped 3.6M tons at an average price of $164/ton while the mix benefited from record production at low-cost Wilpinjong mine. As the company expands, it will further be able to spread out fixed costs and boost margins in the process. Accordingly, I recommend aggressively buying shares before the multiples become elevated from a macro recovery.
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