3 Risky Coal Stocks to Buy
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
While coal is one of the most volatile commodities out there and is particularly risky with some investors speculating about a double dip, I encourage you to focus on the long-term. While the economy has only sluggishly recovered, it is still heading in the right direction while being supported by free trade agreements. The subsequent rise in energy demand won't be accompanied with burdensome EPA regulations due to the political risk over "cutting the economy short of a recovery." Determining which producers to buy, however, all depends on how much risk you are willing to take on.
Peabody's (NYSE: BTU) Reward Outweighs Risk
This coal producer has successfully navigated a challenging macro period and managed to turn around free cash flow from -$119.4 million for the TTM ending 4Q 2007 to $786 million five years later. At a valuation of $6.9 billon, this growing yield makes a takeover easily financeable for acquirers. Debt-to-equity is, indeed, manageable at 1.1x, especially when the PEG ratio stands at 0.5x.
While management has given a weak outlook for the next quarter amidst input inflation from Australia, I believe that the market will actually be better than expected as Europe seeks to move towards cheaper coal sources. The company is also well exposed to metallurgical coal, which is expected to see double-digit growth driven by industrialization.
Analysts forecast EPS to grow by 13.8% annually over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $2.79. At a multiple of 14x, the future value of the stock would then be $39.06. Discounting backwards by 10% yields a present value roughly in-line with the current market cap. However, the dividend yield of 1.3% makes the stock’s rewards worth the risk.
As I was hinting at earlier, I also see the company as a potential takeover play. With tremendous exposure to metallurgical coal and emergence from a local low in the business cycle, a suitor could buy out the business fairly cheaply and help spread out fixed costs to expand margins.
For the year to date, Arch has lost nearly half of its value. CONSOL has held up well by comparison, with a decline of only 6.4%. Arch is just starting to turn around from negative territory, and thus appears to carry tremendous risk. It also doesn't help that next year the company is expected to see a loss of $0.64 per share, preceded by 16.3% annual EPS decline over the past 5 years. Analysts are negative on Arch and rate it closer to a "sell" than a "buy."
However, investors that realize that businesses are valued based on the future and not on the past are poised for large returns. Roughly a third of the company’s float is being shorted, which makes it a perfect candidate for a short squeeze should performance be better than predicted. With analysts already setting the bar low, I believe this is likely to happen.
Management has also taken aggressive efforts to cut costs as a way to hedge against macro uncertainty. While coal demand has seen an unprecedented decline this year, debt financing has been restructured to push off maturities to no sooner than 2016. At the same time, cash holdings now exceed $500 million and will help lower borrowing costs to drive value creation.
CONSOL has the value of Arch without the risk. It trades at 12.9x past earnings and is forecasted for a tremendous 27% annual EPS growth rate over the next 5 years. That puts the PEG ratio at 0.5x and will easily compensate investors for taking on the 40% greater volatility. Although the company has pre-announced a negative outlook, the fundamentals are still stronger than what the market recognizes.
Cost structure at CONSOL has been terrific. Even during the last quarter, where production was reduced, costs fell. Corporate salaries were also amended to save $6 million in SG&A. Management has also been keenly aware of costs throughout the entire value chain beyond internal operations--a change in just one major part supplier has supplied the firm with a 3.3% per part discount. It is this kind of "self-growth" story that compels me to recommend CONSOL.
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