Coal Stock Will Generate Serious Heat

03/15/2011 2:45 pm EST

Focus: STOCKS

Michael Tian

Senior Equity Analyst and Equities Strategist, Morningstar Opportunistic Investor

Cloud Peak Energy is a leveraged play on rising Asian energy demand, write Michael Tian and Paul Larson in Morningstar StockInvestor.

One company is likely to take advantage of Asia’s long-term growth without bearing its share of risks. It’s Cloud Peak Energy (CLD), the fourth-largest thermal coal miner in the US.

Unlike base metals, thermal coal (which is used to generate electricity) is highly leveraged to long-run GDP growth.

Despite all the imbalances in Asia, the continent still benefits from an increasingly educated workforce, millions of people moving to cities, and so on. I believe Asian economic output and electricity demand will be much higher in 2021 than in 2011.

Of course, generating all that electricity will require a lot more thermal coal, even if nuclear and renewable energy become much more prevalent. Moreover, China and India have both become significant coal importers in recent years amid soaring demand.

Cloud Peak has not fully taken advantage of these trends and is trading for an exceptionally low valuation. We believe both are poised to change.

No Need to Dig a Hole
The company mines nearly 100 million tons of coal per year, and is a “pure play” in a geological formation known as the Powder River Basin (PRB), a small oblong blotch straddling northeastern Wyoming and southern Montana. This unassuming square of prairie holds one of the largest reserves of fossil fuel in the world.

Unlike Appalachia, where four-foot thick seams of coal are often buried hundreds of feet underground, the PRB features flat coal seams up to 80 feet thick that can be excavated with steam shovels. On the flip side, the energy content is some 30% below that of Appalachian coal.

Unsurprisingly, PRB coal is cheap—it can be mined for $9 to $10 per ton, whereas costs are closer to $60 per ton in Appalachia. As a result, the PRB has been one of the fastest-growing US basins for the past three decades and currently accounts for half our domestic supply.

Of the four big producers in the area, Cloud Peak is the only one that exclusively focuses on the PRB. This is the main reason it’s my favorite thermal coal miner.

Margins Can Only Go Up
The stock is cheap. We expect the company to generate roughly $330 million in earnings before items (EBITDA) and roughly $2.20 in earnings per share in 2011. At $21, the stock is trading for something like 5.5 times EBITDA and ten times earnings. [Shares have dropped below $20 today, down from a high above $24 on February 3—Editor.]

It’s safe to say the market is not pricing in much earnings growth at all. This is a mistake. While production will only grow slowly, there are at least four ways for margins to expand. This will drive earnings much higher in the next five years.

The first two are low-hanging fruit. Cloud Peak has a very conservative management team that likes to sign long-term contracts for its coal. Many of these contracts are signed at below today’s prices. As they expire and are renewed, margins will naturally expand.

Second, futures investors expect higher prices for PRB coal in the future than today. If we merely assume Cloud Peak sells its coal in the forward market today, margins will expand as well.

However, Cloud Peak’s biggest potential is to export more coal to Asia. Such exports are currently limited by a lack of necessary port infrastructure, but that will change as facilities are built out over the next several years.

If the export story works out, investors will make a ton of money. However, if not, Cloud Peak’s low costs and ability to fall back on US utility demand will help to limit downside.

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