Diamond in the Rough or Lump of Coal?

10/14/2009 10:49 am EST

Focus: STOCKS

Joseph Hargett

Financial Analyst, Schaeffer's Investment Research, Inc.

Joseph Hargett, contributor to Schaeffer’s Investment Research, says coal producer Peabody Energy is at a key level where investors will decide whether it will move up or head down.

Peabody Energy (NYSE: BTU) has a bright future ahead of it, at least if current projections for global coal usage are on spot. According to Barron's, increasing demand from China and India should increase global need for coal by 55% by 2025 (“For Peabody, Australia Is Coal Country,” October 5th—subscription required).

However, the [US-based coal company’s] security has not been immune to the turmoil in the stock market. In fact, BTU shares plunged from last year's peak near $88 per share to as low as $16 per share earlier this year due to a global recession and increased competition from low-cost natural gas. As a result, the stock is now trading at a mere seven times enterprise value (market value plus net debt) to EBITDA (earnings before interest, taxes, depreciation, and amortization), according to Barron's.

Analysts see these fundamental indicators as a sign to buy now. "If world economies continue to improve, Peabody's stock is a good proxy for improvement," mutual fund manager Dan Rice told Barron's. Furthermore, while China is buying less coal now than it was in August, demand still is "double or triple [that of] the prior year," says Rice. He thinks Peabody's stock eventually could double.

Overall, Rice's optimistic outlook for BTU is in the majority on Wall Street. Specifically, 14 of the 17 analysts following the shares rate them a Buy or better. The stock certainly deserves some of this praise, as the equity has rallied more than 54% so far in 2009, easily outperforming the Standard & Poor’s 500 index's advance of about 13% for the same period. What's more, BTU continues to rally steadily along support at its rising ten- and 20-week moving averages, having closed only one week below this duo since March.

That said, BTU was recently rejected by overhead resistance in the $40-$42 region, site of its declining 20-month trend line.  (It closed just above $41 Tuesday—Editor.) What's more, this region is also home to Wall Street's current consensus price target. Both of these factors could keep BTU's up side in check for the time being.

Additionally, there is very little buying pressure left to be wrung from stock's sentiment backdrop. BTU's [recent] Schaeffer's put/call open interest ratio (SOIR) of 0.74 ranks near the midpoint of its annual range. Meanwhile, short interest accounts for about 3.5% of BTU's total float following a 2.5% drop in shorted shares during the most recent reporting period.

With sideline money nearly tapped out, and the shares now struggling with overhead technical resistance, the short-term outlook for BTU isn't burning very bright. In a best-case scenario, the shares enter a trading range between potential support in the $35-$36 region and resistance near $40 per share. In a worst-case scenario, the shares reverse course sharply as buyers take profits and feed the stock's recent rejection on the technical front.

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