|Shares Out. (in M):||270||P/E||N/A||19.8x|
|Market Cap (in $M):||4,440||P/FCF||13.8x||9.3x|
|Net Debt (in $M):||5,651||EBIT||385||710|
Recommendation: LONG BTU with price target of $30.00
An industry is currently under the siege of negative publicity, poor capital allocation, and a temporary slowdown in demand. Nevertheless, presented before you is an opportunity to buy a market leader in the mining industry with solid liquidity to ride out the storm.
The Coal Industry:
Before I assess Peabody specifically, I would like to draw a map of the coal industry and then place where on the map Peabody is, where it is sailing to, and where the wind is blowing.
The coal industry is extremely cyclical and seasonal and highly dependent on worldwide energy demand and pricing. There are 2 types of coal. Metallurgical coal, or hard-coking coal, is required for global steel production. As steel is extensively used for commercial and public construction, met coal is highly dependent on the state of the economy. Thermal coal, or steam coal, competes more directly with other fuel sources, namely other hydrocarbons like oil and natural gas. In America, for example, the 2012-drop in natural gas made coal relatively less attractive oil on an energy/price basis. Unfortunately, unlike oil, coal has various prices based on the type of coal it is, where it is mined, and the concentration of certain elements found in the coal (high sulfur –> worse quality coal –> lower price).
As a sector, coal mining is extremely capital intensive (high fixed costs), with the equity value being a true leftover pool of cash flows after debt payments are considered. In turn, earnings are generally difficult to predict. Here, the largest operators have the greatest leverage due to their more modest capital structure and ability to run through troughs in the cycle.
Revenue is broken down by quantity of coal sold times price per quantity. When looking at such energy-commodity companies, I find that quantity demanded/supplied comes from global economic/political factors and price serves as its derivative, paying respect to an excess/deficit in supply and energy elasticity. Of course demand is also connected with price and vice versa but for the sake of understanding the industry, this is the path we will follow.
King Coal is still Loved by his Followers - Demand
In the year 2000, OECD nations required 2,482,277 thousand short tons of coal, while their Non-OECD counterparts required 2,784,901 thousands short tons of coal. In 2011, the numbers are 2,402,544 and 5,721,056 respectively. This represents a -0.3% CAGR from OECD countries and a 6.8% CAGR for Non-OECD countries. In terms of production the results have been similar with a 0.2% CAGR for OECD countries and a 7.1% CAGR for Non-OECD countries. Furthermore, from 2005-2011 more coal was produced than consumed each year. More recently, U.S.’s coal generation is on pace to recover approximately 75% of lost 2012 demand. In America, the Southern Powder River Basin and Illinois Basin utility inventories improved by 25% in 2012.
In terms of steel production, much has been written on the slowdown in China and other emerging markets that dominate the demand for met coal. However, conservative forecasts for global steel production still point north of 3%. As the price of natural gas picks up from its lows, over 75 GW of coal generation is expected to come on line in 2013, with around 70% from China and India alone. In Q1 2013, China’s coal imports increased by 30% and India’s by 25%. With the increase in urbanization, these emerging economies seek greater sums of energy and steel, with estimates showing an increase in coal imports from 480 to 655 million tons.
Past the numbers, coal has several other attractive characteristics. In terms of energy security, coal is present in almost every industrial country and is the most abundant fossil fuel. Looking past the carbon dioxide debate (which we will discuss), coal will be available for the next 118 years based on current consumption, compared with 46 years for oil and 59 years for gas. Furthermore, coal can be quickly transported to demand center by ship or rail, an attribute not found in natural gas where spot prices in North America, Europe & Japan differ greatly. Furthermore, since coal is a solid energy, it can be stockpiled at power stations and drawn down in a cheaper fashion relative to oil, gas, and alternative energy. Coal is also extremely affordable and outside of America is substantially cheaper than oil and gas.
This is not to say coal is without its setbacks. It is by far the dirtiest of fossil fuels and hosts a much dirtier mining process than other energy sources. President Obama himself has stated countless times the need to reduce our dependence on coal; however, he has asked the EPA to come up with a ‘draft proposal by June 2014’ concerning ways to cut coal demand. Sure coal miners have felt the brunt of anti-coal political measures but there is no chance of the industry disappearing. If anything, we are noticing that the past decline in coal demand was more to do with an increase in natural gas use then simply legislation. Furthermore, I am a perma-bear on the government and deny that they will do serious hostility to an industry that employs so many people in such ‘battleground’ states. At the end of the day America’s coal demand drop from 2011-2012 is reversing with coal demand going from 890 million tons in 2012 to an EIA estimated 950 million tons in 2013 and 966 million tons in 2014. And where I see risk in America’s demand for coal I see renewed confidence in emerging economies believing it is their turn to use the energy source (much like America did during its industrial boom).
Where is the Increased Supply? - Supply
Having proven that coal demand is strong both nationally and internationally; it is time to look at the flipside – supply. This is incredibly important, as it will also help us understand the pricing power of the industry. In the U.S., exports are expected to decline approximately 25 million tons in 2013. This is on top of the decrease from 1,094 million tons in 2011 to 1,016 million tons in 2012. Also, around the developing world, coal mines face strikes and idling, tightening up supply. Furthermore, constraints will arise in the rest of 2013 as legacy-priced contracts expire and marginal production is rationalized. Production cutbacks have been announced in the U.S., Australia and Canada.
Currently, Indonesia, Australia, Russia, and the USA are the 4 largest coal exporters, followed by Columbia, South Africa, and Kazakhstan. Indonesia has proposed doubling royalties for miners within a year, threatening margins that were already at stressed levels due to coal prices decreasing in 2012. Australia, on the other hand, has a fairly vibrant coal economy with demand steadily increasing from 115 million tons in 1980 to 476 million tons in 2012. More specifically, the AUD vs. USD has decreased over 12% YTD with similar metrics for other countries. A cheaper AUD means coal imported from Australia is more attractive. All in all, we see a disparity between coal supply and demand in the near future.
The Inflection Point - Price
In 2008, coal prices hit record highs with met coal tripling within a year to nearly $300 per ton and thermal coal reaching $90 per ton. This occurred mainly because of snowstorms in China and floods in Queensland, Australia. Peabody’s price, for example, hit $84 a share, a mark that has since been a distant past. Though a sad black-swan event could be the only catalyst for such a drastic event, the market is ripe to regain some of the pricing power it has lost over the last 4 years.
The EIA is expecting US exports to decline over time, citing possible reason to believe utilization/price increases in the future. Currently, they predict a decline of US exports from 126 million tons to 112 million tons in 2013 (despite record exports in March) and to 108 million tons in 2014. This estimate leads me to believe that the 2H 2013 will be relatively attractive compared to the past years. US coal inventories are planned to drop from 239.9 million short tons in 2012 to 215 million short tons in 2013 and to 214 million short tons in 2014. Hence, mid 2013 may prove to be the inflection point in coal pricing dynamics.
On top of all this, alternative forms of energy have become more expensive over the last 6 months. The EIA stated in April 2013:
"All parts of the country, except for Florida, saw a significant year-over-year decrease in electricity generation from natural gas due to the significant increase in natural gas prices," EIA analyst Tosha Richardson said. "Generation from coal and other fossil fuels displaced natural gas generation."
Making up the gap was coal, EIA said, which saw its consumption rise 7% year over year in a month that saw a 13% increase in heating degree-days.
Also, please see utah1009’s pitch on NG to see why gas prices should continue to move up, freeing the lasso around coal price’s neck.
Man of Steel
Steel production in our big 3 focal points is going up. China is expected to grow by 3.5% in 2013 and 2.5% in 2014. India is expected to grow 5.9% in 2013 following 2.5% growth in 2012 and 7.0% in 2014. And finally, the US grew 8.4% in 2012 and is expected to grow 2.7% in 2013 and 2.9% in 2014. Of course, Europe is seeing heavy contraction, but not to the point where global demand is sufficiently threatened, furthermore the EU27 is expected to see 3.3% growth in 2014. All in all, we expect met coal to have enough demand with solid future steel demand.
Finally, in the recent quarter Peabody stated: “The second quarter metallurgical coal price benchmark for high-quality hard coking coal settled at $172 per tonne, rising for the first time in nine months. Benchmark low-vol PCI pricing settled at $141 per tonne, with the price spread to hard coking coal improving to 82 percent. The annual thermal price benchmark for Newcastle-quality coal settled at $95 per tonne.”
In conclusion, do not fear coal. Sure I love a world where we could have enough renewable energy that was cheap and didn’t annoy people off that their ocean view is hampered by wind turbines, but I don’t see that happening soon.
Peabody Energy Corporation:
Catching the Falling Knife:
I have aimed to give a nonbiased opinion on the state of the coal industry. Of course, you may have noticed preferential treatment given to US, China & India. This is because Peabody is highly levered to the demand set by those regions, due to operations in America and Australia. In America, Peabody has a presence in the South Power River Basin and Illinois Basin.
Currently, Peabody considers themselves a global pure-play coal investment with 28 active mines in the US and Australia and 9.3 billion tons of reserves (8.2 billion in US & 1.1 billion in Australia). They have a balanced product mix by revenue with 44% coming from Australian Mining Operations (levered to India/China), 36% in Western US Mining, and 17.4% from Midwestern US Mining. The Australian presence received a boost when Peabody Energy won full control of Macarthur Coal. This puts them in a great place to profit from a future increase in steel demand in the Pacific Rim. Furthermore, this global platform affords Peabody diversity in an overall scary industry (see Patriot). With average gross margins ~30% above US peers in the past 3 years and a leading position in growth regions of South Power River Basin and Illinois Basin (see NRP pitch), Peabody doesn’t seem like your average coal company. In terms of SPRB and Illinois Basin, Peabody expects total demand to increase by 130 million tons from 2012-2017, namely from basin switching. This can’t be said about the Central Appalachia region, which is expected to decline by 15 million tons.
Peabody has also been very conscious in cutting costs. As of the end of the 1st quarter, Peabody’s Australian production is over 80% owner-operated, a drastic increase from the 30% seen in early 2012. This model allows Peabody to more aggressively cut costs by reducing contract drilling and focus on in-house contracts. This is important as many of Peabody’s Australian mines are currently high in the cost curve, represented by Peabody’s massive $900+ write-down of the asset in the recent year. Peabody has hedged out over 50% of the Australian contracts, such that they are less levered to currency fluctuations. In the recent 10-K Peabody expects to cut capital expenditure by half in 2013 relative to 2012 (to $450-$550 million which we estimate is mainly maintenance capex). This concerted effort to maximizing free cash flows by lowering expenses is exactly the type of management you wish to be behind in an all-out turnaround effort.
Management has transitioned this focus on maximizing free cash flows to eventually tightening up its balance sheet. As of the last filing, Peabody has $6,145 million of debt, approximately $100 million less than the quarter before. Furthermore, management has stated that its highest priority right now is to focus excess cash flows into repaying its term loan facility going forward. It should be conservative to say that $100 million of prepayment per quarter is a conservative run-rate moving forward.
Light at the End of the Tunnel – What to make out of 2013?
Peabody surprised to the upside in the last quarter with initial trading showing an increase in the equity value, only to decrease over the following months. Nonetheless, the company’s targets of total sales of 180 to 190 million tons in the US and 33 to 36 million tons in Australia should be acknowledged. With expectations of revenues per ton down 5 to 10 percent form 2012 levels and full year DD&A up 10% form 2012, it is easy to see why the income statement shows a bearish picture.
Assuming sales of 230 million tons (low end) with revenue per ton down 10% (low end), I get top line of slightly short of $6.75 billion. This is down from $8 billion in 2012. On the high end with 250 million tons sold at a 5% decrease in revenue per ton, I get top line above $7.7 billion. Both scenarios are down but give us a decent range to work with.
Of course EBITDA can drop at a much more significant rate than revenue. With $280 million in EBITDA achieved in the first quarter and a range of $240-$300 in the second quarter, 2013 EBITDA is likely to be far below that of 2012. Nevertheless, if we can come up with a conservative run-rate EBITDA we can translate this into some sort of valuation.
Analysts have a wide range of estimates for Peabody’s 2013 EBITDA, ranging from $1,611 million to $966 million. Assuming that the second quarter is $270 million (remember they beat last quarter) we have 1H at $550 million. Over the past 5+ years, through the volatility, EBITDA for Peabody has been higher in the 2H than in the 1H. Let us assume that 45% of 2013 EBITDA comes from the 1st half. This gives us $672.2 million EBITDA in 2H 2013 (we will just use $670 million). This gives our 2013 EBITDA estimation approximately $1.22 billion.
In the first quarter, Peabody was able to generate approximately $130 million in levered FCFs. Though this number bodes well, much has changed since then on the bottom line shown by most analysts giving Peabody a total FY 2013 levered FCF of $300 million. I find this number pessimistic if anything because Peabody is decreasing capital expenditure significantly which should boost FCF generation overall.
Valuation / Margin of Safety:
Not a Simple Screen:
Great value investments don’t always show up on a screen. Their hidden value does not come out in income statements and cash flows since it requires an understanding of ‘normalized earnings’ and when those earnings are achievable. In turn, I find the simplest value to Peabody is to tell you how much you are paying today and then what type of bets get you to a price in 2014. At the end of the day, Peabody is a bet on steadfast cash flows from its American operation, which remain in the defensible portion of the American coal industry, and a call option on recovered met demand in the Pacific Rim through Peabody’s Australia operations.
Furthermore, I’ve learned that it’s extremely important to know what the street is basing valuations on, since improvement in said metrics will likely prove a catalyst in share price.
Currently, with 2013E EBITDA of $1.22 billion, we are getting a TEV/EBITDA of approximately 8.17x. This is in contrast with an estimated 11.9x for Arch, 10.4x for Alpha, and 8.6x for CONSOL. On a relative basis Peabody seems to receive no scale premium for its ability to maintain positive cash flows when others are struggling to stay afloat. With interest coverage ratios far above Arch and Alpha, I am surprised at the valuation difference.
The dice really roles in FY 2014. In my estimate, top line coal demand will lead to not only to greater quantity supplied but also better price points. Analysts peg EBITDA in 2014 at approximately $1.6 billion with FCF north of $500 million. I see this scenario as extremely likely but not needed for a proper rerate in the stock as many on the street expect more bad news than good. Furthermore, a fear discount that revolves around Peabody lighting its FCF on fire seems likely to decrease as they chip away at debt levels (which will be below $600 million in the new filing) and show fiscal responsibility. Also, Peabody is extremely liquid and though I find a 2015 prediction as good as nothing, Peabody can stand the heat longer than its peers due to a high degree of liquidity (cash above $630 million). Lastly, Peabody is an extremely asset backed company that can sell assets in the open market to improve liquidity, though I expect the likelihood of them buying distressed assets much higher than selling their own if conditions worsen.
On top of all this you a 2% yield to wait! Well it’s higher than 5-year bonds!
On the downside you are still buying a company with $300 of FCF on a down year relative to a $4.3 billion market cap. This 7% yield provides you with surety to get paid while you wait. 2% goes to you directly in your pocket while the other 5% (or so) goes towards paying down debt or raising the cash balance. Every quarter that goes by, BTU is better capitalized and more likely to be making more FCF.
My Price Target is currently 8.5x Peabody’s 2014E EBITDA of $1.6 billion. This gives an EV of $13.6 billion with net debt approximately $5.0 billion (its only $5.6 billion now). This would imply an equity value of $8.6 billion or 100% upside in 18months.
And Now, The End is Here:
If you want to tell me the coal industry is going to disappear (and there is a chance for everything!) well I assure you to look away from my pitch. But I see asymmetric upside in waiting for the best in class Coal Company. This company reminds me of a complete market dislocation and I believe its worth getting involved.
If I am wrong, expect to see a distressed debt pitch in the future.