Buy These 3 Supposedly "Risky" Stocks
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
For those willing to take on the fear of sudden crashes, coal may be one of the most attractive investments on the Street. When everyone says "sell" or "get out," often the best strategy is to do just the opposite and gain from the higher risk-adjusted returns. I am particularly bullish on Arch Coal (NYSE: ACI) and Peabody Energy (NYSE: BTU), both of which look tremendously discounted due to emotional anomalies.
Arch & Chesapeake
After the poorly timed takeover of International Coal, Arch has been swamped in $4 billion worth of debt. Considering how the company is now bleeding cash, it is understandable why many in the market want nothing to do with this stock. With the margin and pricing market looking soft for this year and next due to low natural gas prices, things aren’t going to turn around in the next few months. However, investors should know more about the firm's solid long-term fundamentals.
In order to deal with the ~4x leverage ratio, management is likely to cut capital expenditures as a way to boost free cash flow. More importantly, the success of the company will depend on net coal prices, which currently represent less than a tenth of the business but are expected to expand 50% by 2015. As the second largest producer of coal in the United States and an oligopolist in the Powder River Basin, Arch has a tremendous brand to leverage in its quest for expansion.
In particular, China will be a huge catalyst for encouraging investor entry. To date, the outlook on China has weakened, but I believe this pessimism will reverse in the longer term. And the Powder River Basin is very easy to mine at low costs – 20% cheaper than its Central Appalachian peers. This will enable Arch to continue to gain market share and dissipate fears over its financial position.
In many respects, Arch reminds me of Chesapeake Energy (NYSE: CHK), the second largest domestic producer of natural gas. Chesapeake has taken on considerable leverage and is in the position where it needs to sell off assets. Suitors of those assets are aware of Chesapeake's poor bargaining power and may be able to buy up resources at a discount.
However, the market has already factored in this headwind, as Chesapeake currently generates enough operating cash flow that in around three years it will exceed its market capitalization. Similarly, Arch generates enough operating cash flow in a few years to surpass its own market capitalization. When capex starts to meaningfully decline, investors will be made more aware of this.
For More Safety: Peabody
With greater safety often comes less upside. Peabody trades at a little over 6x past earnings, and analysts are bullish on the stock. With the PEG ratio at only slightly more than 0.3x, there is a considerable amount of value creation to be gained through pure growth.
Assuming the company is able to meet analyst expectations, it will generate 2016 EPS of $4.31, which, at a 12x multiple, translates to a future stock price of $51.72. Discounting backwards by 10% yields a present value figure of $32.11 - more or less in-line with analyst expectations. The firm is thus considerably undervalued and has plenty of upside potential.
On the production side, the firm is also better positioned than the market has recognized. Sure, production may be lower domestically, but trends in Australia look solid. DD&A expenditures are investments in the future and, with 3.6 million tons of met coal shipped at an average price of $164/ton, the firm has a strong amount of supply to meet demand. The discount to intrinsic value makes Peabody an attractive investment for those interested in backing companies with large margins of safety in speculative industries.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. 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.If you have questions about this post or the Fool’s blog network, click here for information.
