Deal Puts Peabody on China’s Doorstep

07/07/2011 3:06 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Mongolia has chosen China Shenhua Energy (1088.HK or CSUAY in New York), a Russian-led consortium, and Peabody Energy (BTU) to develop the western portion of its Tavan Tolgoi deposit of coking coal.

Tavan Tolgoi contains an estimated 6.5 billion metric tons of metallurgical coal, and the western block accounts for an estimated 1.2 billion tons of that.

Development rights were divided, with 40% going to China Shenhua, 36% to the Russian consortium, and 24% to Peabody Energy. The projected cost of developing the western block is $7.3 billion.

Winning the right to develop 24% of 1.2 billion metric tons of coal is a big deal. Getting the rights to 24% of 1.2 billion tons of metallurgical coal next door to China is an even bigger deal for Peabody.

The company’s coal current coal production is slanted to thermal coal, the kind burned in power plants, and to US thermal markets at that—84% of 2010 sales went to US electricity generators. This win gives Peabody more exposure to the metallurgical coal market and to China, the world’s biggest market for coal of any sort.

Peabody has been busy at work adding capacity in Australia to put some of its supply closer to big-end markets in China and India. But as of 2010, only 12% of the company’s total production of 211 million metric tons came from that country.

Access to the Tavan Tolgoi deposits will increase the company’s non-US production. (Peabody Energy already operates a coal and mineral joint venture in Mongolia.)

Increases in demand for coking coal, used in steelmaking, are expected to outrun increases in supply in 2010 to 2015. Peabody estimates that seaborne demand will grow by 85 million to 95 million metric tons in that period, but that seaborne supply will increase by just 65 million to 75 million metric tons. That gap should fuel rising prices for metallurgical coal.

Tavan Tolgoi isn’t going to add to Peabody’s revenue or earnings this year or next—but even without that production, Standard & Poor’s is projecting a 24% increase in revenue for 2011, on a 6% increase in production and a 17% increase in price.

Over the last five years, Peabody Energy has traded at an average 8.6 times EBITDA (earnings before interest, taxes, depreciation, and amortization.) The current price values the stock at just 7.2 times estimated 2011 EBITDA.

At the five-year average of 8.6 times EBITDA the shares would sell for $76. I think that’s a reasonable 12-month target price.

But I’d wait on these shares until we’ve turned a few more pages on the calendar, and we’ve put some of August and September’s volatility behind us. I added these shares of my watch list on April 20, and they’re down 6.7% since then. I’d be patient just a little longer.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did not own shares of Peabody Energy as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.

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