3 Undervalued 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.
After skydiving a few years back, investors are rightfully fearful of coal. In my view, however, the reward outweighs the risk...
Arch Coal's (NYSE: ACI) HUGE Upside!
As risky as the coal market is right now, Arch is worth the bet. After taking over International Coal, the company became burdened with $4 billion in leverage at one of the worst times possible. As Morningstar has emphasized, natural gas prices hit a low as utility inventories rose to seeming endless peaks. This has resulted in a weak margin outlook that will be complemented by a leverage ratio of around 4x as debt maturities near. However, the worst looks like it is factored in.
In my DCF model on Arch, I make several assumptions: (1) double-digit growth ranging from 10% to 21% over the next 6 years and 2.5% into perpetuity, (2) consistent operating metrics, and a (3) 10% discount rate. Based on these inputs, I find that the fair value of the stock is $14.31, which implies significant double-digit upside should the company just close its value gap. Fortunately, it comes on top of strong momentum from the company adding in low cost operations that helped boost reserves by 1.3 billion tons.
Going forward, much of the company's upside will come from metallurgical coal. Morningstar points to several bullish talking points that I agree with: First, Asian demand will keep volumes elevated even if competition cuts into margins. Furthermore, the company's leading control of the Powder River Basin will help limit any margin erosion that comes from emerging entrants and peer growth. With the potential to increase met production in the years ahead, the pricing power is thus strong and will grant the company great leverage to takeover struggling producers.
If you are looking for some safety, consider Peabody. At around 6x past earnings, the worst has been factored in. By contrast, growth has not been fully factored in, as evidenced by the PEG ratio of around 0.3x.
If the company meets expectations, it will be worth $51.72 at a 12x multiple by 2016. At a discount rate of 10%, the present value of the stock is $32.11, which is at a significant premium to yesterday's closing value. In terms of operations, fundamentals are trending surprisingly smooth. At around a price of $165 per ton, the company has 3.6 million tons of met coal that can be delivered to the market. Put differently, Peabody has an excellent ability to meet demand.
Although the company is reserved on the next quarter given Australian cost inflation, Europe appears to indicate a movement towards cheaper coal sources. As a takeover target, the company's operations could be catalyzed through greater scale that spreads out costs and reduces costs even more in a way that is attractive to beleaguered economies.
I am further optimistic on CONSOL, which is even safer than Peabody. At a PEG ratio of 0.5x but a high beta, it is positioned technically to gain from a price multiple expansion and a full recovery. Management has taken the right steps to prepare itself for the full recovery by cutting corporate sales and reducing unnecessary steps in the supply chain to pass savings onto customers for greater volumes.
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