|Shares Out. (in M):||61||P/E||6.7x||8.4x|
|Market Cap (in $M):||1,007||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||205||EBIT||250||203|
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Cloud Peak Energy (CLD) is a company that has been oversold due to the effects of a historic warm winter, even though the company is 98% hedged for 2012. CLD has the lowest multiple in the coal space, despite being part of an oligopoly and in the best position in the sector. This situation cannot persist, and the stock should have a nice reversion in the short-term. We see increasing evidence that West Coast coal ports will be built in the long term, which should lead to CLD increasing earnings 165% and the stock price being a multiple of today’s price, in just 18 months.
Short-term Opportunity (recovering from the warmest winter on record):
This past winter was the warmest ever recorded in the U.S. The warm winter was a direct hit to coal burn. Compounding the problem was the fact that natural gas prices, due in part to the weather, fell enough to displace PRB (Powder River Basin) coal in the power stack. This is highly unusual, because PRB is the cheapest coal. So when natural gas has to displace coal, it displaces other coals first.
PRB-to-natural gas switching is a temporary phenomenon and is unsustainable beyond a few months. Every PRB producer was quoted on their earnings calls, stating that some fuel switching occurs between $2.50 & $3.00 natural gas prices. This seems logical; looking at coal freight rates from Union Pacific (UNP) coal freight rates, a 1,500-mile trip using an 11,000-heat rate coal plant would put you at parity with an efficient combined cycle gas plant, with $2.50 nat. gas. Some of this switching may not even take place, since many plant operators lack the flexibility due to take-or-pay railroad contracts.
The industry consensus is that natural gas should be priced in the $4.00+ range; few—if any—suppliers would drill for a price lower than this. Natural gas below $3.00 is clearly unsustainable. Indeed, the forward gas strip exceeds $3.00 by December, is at $3.xx for 2013, and $4.xx for 2014. Investors point out that some natural gas is basically drilled as a waste fuel, since the driller is going after highly valuable natural gas liquids (priced closer to oil), and will drill, regardless of the price of natural gas. This production is a small part of overall natural gas production, and will not be able to sustain natural gas prices at current levels. Therefore, CLD is not in any long-term danger. The amazing thing is that CLD is 98% hedged for 2012, so the sell-off in the stock price down 23% in 6 months is puzzling.
PRB coal prices have been under pressure this year, falling from $15 per ton in Fall 2011 to about $x per ton today. We believe the forced selling into thin markets may have exacerbated the sell-off. Industry reports have stated that a buyer is unlikely to be able to acquire physical PRB coal at the market price. The PRB market is already starting to heal itself. PRB coal production has now fallen 10.4% YTD, according to EIA data. Production cuts have been even steeper, averaging close to 20% for the last month. Production cuts are now on pace to exceed even the most bearish prediction for the fall in consumption (estimated 40 million tons in decreased PRB coal burn) by year-end. Public PRB producers have already cut 2012 PRB production guidance by 29 million tons, with flexibility in their guidance to cut an additional 12 million tons. Production cuts and rebounding natural gas prices are pushing PRB coal spot prices back up, which has surprisingly had little effect on the stock price of CLD.
Long-term Upside from West Coast Coal Ports:
Currently, options to export PRB coal are very limited, with some coal being shipped to Canada, which has limited capacity and the extra transportation. Both of these factors take away a lot of the margin. The demand is there for probably 50-100 million tons (total PRB production is roughly 420 million tons) of exports to Asia; this demand should only grow, as a large amount of coal power plants are scheduled to be built. In response to this demand, developers are trying to build ports in Washington and Oregon. A port should take 2-3 years to build and permitting should take about another 18 months, making it four years before a West Coast coal port is built. Still, we believe the catalyst will clear permitting, which will force investors to recognize the earnings power coming down the pike. The only concerns are environmental, which we will discuss later.
Potential for CLD:
We believe the proposed ports could more than double CLD’s EBIT and nearly triple the company’s net income in less than 5 years. With 95.6 million tons of total PRB production, we believe CLD is uniquely advantaged to export at least 20 million tons through potential West Coast coal ports. CLD’s Spring Creek mine produces approximately 20 million tons annually. Spring Creek is located 235 miles closer (lower transport cost) to the West Coast than the rest of PRB. The mine also produces 9,350 Btu coal vs. the 8,800 Btu (more powerful per ton means lighter, which lowers shipping costs) standard throughout the rest of PRB. CLD already exports close to 5 million tons a year through Canada. Even with the added cost of having to rail coal to Canada, CLD was still expecting close to $7.00 per ton in additional margin (after royalties) on coal exports when they last gave details on this in 3Q 2011. Without the added cost of shipping to Canada, we believe our $7.00 per export ton ($140 million increased EBITDA) of additional uplift is conservative. For CLD’s roughly 75 million remaining domestic tons, we estimate $2 per ton (under $3 pre 27% royalty), or $150 million of additional uplift, for the tightening PRB coal market (see Incredible economics section below).
Between exported coal and higher domestic prices, there is potential for CLD to increase EBIT (& EBITDA) by $290 million, compared to $203 million (2012 consensus). The potential uplift to EPS would be $3.09; adding this to an already depressed 2012 Consensus EPS ($1.87) would yield an EPS of $4.96. If you were to put even a low multiple of 10.1x on these earnings you would get a share price of over $50, a triple from today’s price.
Why west coast coal ports will be built:
PRB coal is an oligopoly, with CLD, Peabody Energy (BTU) & Arch Coal (ACI) responsible for most of the region’s production. Therefore, any involvement with a port from these PRB operators would allow them to double dip, benefitting from higher-priced exports and increased prices on domestic coal. Netbacks to the mine in the $20s vs. the low teens today, are as CLD has demonstrated with their Canadian exports—very realistic.
We believe that the new ports, which should be able to export over 50 million tons, would increase domestic PRB prices by at least $3.00/ton. CLD has made similar assumptions publicly from the 1Q 2011 call. Speaking about the magnitude of pricing increase from West Coast ports, CEO Colin Marshall said, “There's got to be a few dollars so it is not the same. . . . Taking a chunk of domestic PRB coal out and exporting coal from the other bases has got to be pretty positive.” We gain further confidence from the recent market performance; if a feared temporary 40 million ton decrease in PRB coal burn could push the price down more than $8.00/ton at one point, then surely a 50 million increase in PRB demand should increase prices by $3.00/ton.
The ability to double dip on exports and increased domestic prices creates tremendous economics. We estimate the payback on these projects to be under 1.5 years! Though coal prices could always turn down, the port economics are so powerful that coal companies would not even need to receive a premium for their exported coal. The anticipated price increase on their remaining PRB production would justify the cost. These economics create a strong incentive for coal producers and port developers to relentlessly pursue building West Coast ports.
Growing Signs Ports will be built:
PRB producers & port developers put their money where their mouth is:
Since May 2011, the last four winning bids for PRB federal coal leases have increased sequentially with Arch Coal’s most recent winning PRB bid of $1.35 per ton—nearly a 60% jump in prices since early summer (PRB prices were flat during that time). In fact, the last two auctions of 2011 set new records in prices per reserve ton. It is clear that PRB operators are pricing, with the increasing likelihood of West Coast ports being built.
|Exhibit 1: PRB Coal operators bid up PRB Coal Leases|
|Date||Buyer||Reserves||Price/ ton||% Change from prior||% Change from 5/11/2011|
On 11/23/11, Ambre Energy (which is developing the proposed Oregon Millennium port and planned initial 29 million tons of capacity in partnership with Arch Coal [ACI]), purchased Level 3 Communications’ (LVLT) 50% interest in two PRB coal mines. CLD owns the other 50% in one of the two mines (the Decker mine). Decker had only 8 million tons of economic reserves left at the end of 2010, but has a lot of additional reserve potential, if prices were to rise (making it a perfect option on West Coast ports). Ambre Energy should have insight about the chances of ports being built, and it appears they just doubled down.
A distinct change in rhetoric:
When we first looked at the potential of West Coast ports, industry executives were uncertain but hopeful that ports would come to fruition. We have noticed a distinct change in tone, though, over the last 6 months, with an ACI spokesperson openly declaring the company’s belief that the ports will indeed be built. At a February 2 industry conference, ACI CEO John Eaves said he is “very confident” of this. And in our talks with industry executives and investors they were nearly unanimous in their opinion that there will be ports.
Additionally, it was reported that representatives from Manyuan Coal (a Chinese Coal Company) were visiting Montana coal mines (some of these were owned by CLD) early last December, even meeting with the state’s governor Brian Schweitzer. A Chinese company’s only reason for this tour would be if West Coast ports were being built; otherwise, it is a rather boring sightseeing trip.
Weak environmental case against coal ports:
The only obstacle to the West Coast coal port development is environmental opposition. Environmental groups are already trying to block the ports. We find the environmental argument to be illogical. The argument is that coal is bad the environment, which is true and that no matter where it is burned, here or in Asia since it goes into the air it hurts our environment, true. What this argument ignores, is that Asia will be burning coal regardless of whether it is PRB or not. Since PRB is cleaner coal, burning PRB instead of Asian or other coal, is likely to help—not hurt—the environment. Port developers also have the tremendous carrot of good jobs for the towns where coal ports would be built. Port developers have been smart in their approach of courting these towns, in one case offering to donate money directly to the local school system. We believe the ports are in the best interests of these towns. Furthermore, we think that arguments in favor of port development will win over environmental groups’ objections.
|Exhibit 2: CLD Valuation|
|PE||EV/ EBITDA||PE||EV/ EBITDA||PE||EV/ EBITDA|
|Note: EV includes Asset Retirement Obligations, excludes federal coal lease payments|
While we cannot say for sure that West Coast coal ports will be built, we do believe—based on the confluence of the above indicators—that it is likely. What we can say with certainty, however, after looking at CLD’s valuation, is that the market is pricing a 0% chance that the ports will be built. We believe that CLD will revert to the low $20s by year-end, with a chance to get into the $40s in 18 months, if ports are permitted.
Since we define risk as the threat of permanent loss, we see very little risk in buying CLD. Even if the ports are not built, we see no downside to the shares. There is a chance, although we view it as minimal, that natural gas prices will stay below $3.00.
CLD has stated they are looking at an acquisition, and this could backfire. However, with a large amount of excess cash on the balance sheet—in a zero interest rate environment—almost any acquisition should be accretive.
There is some risk in government regulation for environmental purposes, but since PRB coal is the cleanest coal, this is likely to have a positive impact on PRB and, consequently, CLD.
Oil prices are a small risk, as a dollar change in oil price equates to a million dollars in CLD’s EBITDA.
While we do not see it as a risk, we do note that CLD’s accounting for federal coal leases is a little unusual, as it will reduce cashflow. We regard federal coal lease payments as a cross between maintenance and growth capex.
Reversion of PRB coal prices.
Permitting of a West Coast coal port.
CLD could be an acquisition target. CLD’s low valuation and lack of debt may attract buyers; we have heard rumors of private equity sniffing around the space. An international mining company could also be interested. Before 2009 CLD was owned by Rio Tinto, and they only sold CLD out of a need to raise money.
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