King Coal's Leading Stock Is Tempting

03/07/2012 9:45 am EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

There has been a lot of turmoil in the energy markets, especially as natural gas supplants coal in global markets and regulatory issues hurt margins in the US. But this company has been ahead of the curve, restructuring and preparing for coal's second act, writes Elliott Gue of The Energy Strategist.

Following are the key takeaways from Peabody Energy (BTU), one of the world's leading coal producers, in its recent earnings report:

  • Initial forecast calls for 12 million tons to 13 million tons in Australian thermal coal shipments, and 14 million to 15 million tons of Australian metallurgical coal sales
  • Expected US thermal coal production already sold under contracts, limiting exposure to price weakness after unseasonably mild winter
  • Has placed Wilkie Creek Mine in southeast Queensland on sales block to reduce debt incurred from acquisition of Macarthur Coal
  • Management warns that 2012 will be a year of transition for Peabody Energy, as operational mines acquired from Macarthur Coal will require significant investment to upgrade equipment and remove waste rock
  • Management’s guidance calls for first-quarter earnings per share of 50 to 75 cents, well below analysts’ consensus estimate prior to the call

After surging 42% in 2010, shares of Peabody Energy gave back these gains in 2011, hit by uncertainty surrounding steel production and economic growth in China and other key emerging markets.

Despite these worries, Peabody Energy still managed to report record full-year results, including revenue of $7.97 billion (up 18%) and earnings before interest, taxes, depreciation, and amortization (EBITDA) of $2.13 billion (up 15.7%).

After weather-related disruptions in early 2011, and equipment moves and a roof fall at its North Goonyella mine in the third and fourth quarter, the company’s Australian operations (36% of 2011 revenue) shipped 25.3 million tons of coal—down slightly from 27 million tons in 2010. This total included 9.3 million tons of metallurgical (met) coal, the varietal used in steelmaking, and 10.1 million tons of seaborne thermal coal, the varietal burned at power plants.

Nevertheless, strong pricing in 2011 for both met and thermal coal enabled Peabody Energy’s Australian concerns to grow their revenue by 28% from a year ago, while a 26% improvement in margins led to a 22% surge in EBITDA.

The firm’s US operations (55% of 2011 revenue), which are located primarily in the low-cost Powder River Basin and the Illinois Basin, enjoyed a 5% uptick in coal shipments during the year, largely because of a record 109 million tons of low-sulfur coal output from the North Antelope Rochelle Mine in Wyoming.

During a conference call to discuss fourth-quarter earnings, Peabody Energy CEO Gregory Boyce indicated that the company expects the “two-speed global economy” to continue in 2012, with emerging markets such as China, India, and Brazil leading the way and the developed world posting subpar growth.

Meanwhile, depressed natural gas prices and efforts to reduce carbon dioxide emissions continue to prompt some utilities to switch to gas from coal. Rick Navarre, Peabody Energy’s chief commercial officer, told analysts that the company expects fuel replacement among US power companies to eliminate between 35 and 40 million tons of coal demand in 2012, largely from mines in Central Appalachia.

After spinning off its assets in Central Appalachia, Northern Appalachia, and less-desirable parts of the Illinois Basin in 2007, Peabody Energy has little exposure to rising production and regulatory costs in these mature mines.

Today, the company operates primarily in Wyoming’s Powder River Basin, which contains thick seams of low-sulfur coal that are relatively easy and inexpensive to mine, and the Illinois Basin, another low-cost region that produces coal with higher sulfur content. With many plants scheduled to have advanced scrubbers installed over the next few years, the addressable market for Illinois Basin coal is growing rapidly.

In addition to its low cost base, management’s prescient decision to sell the firm’s planned 2012 production under contracts will insulate earnings from the recent deterioration in prices. The firm has 45% to 55% of its planned 2013 production priced under contracts. These moves, coupled with the company’s extensive operations in Australia, give the firm a leg up on US-based competitors.

The Verdict
Peabody Energy is the world’s largest pure-play coal producer, and remains our top long-term bet on rising coal demand in China, India, and other emerging economies. For investors with a longer horizon, the stock trades at an attractive valuation.

That being said, the stock lacks near-term catalysts and could pull back if economic growth and steel production in China disappoint. Pricing trends on met coal volumes should become clearer during the second quarter. Buy Peabody Energy Corp up to $45.

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