Patriot Coal PCX
August 28, 2008 - 4:50pm EST by
2008 2009
Price: 59.77 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 4,600 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Patriot Coal (PCX)
We recommend the purchase of shares in Patriot Coal (PCX), the second largest producer of coal in Central Appalachia. The coal industry is enjoying a period of sharply rising prices due to increasing demand and constrained supply.  Patriot is poised to grow earnings dramatically for the next several years.  We believe EBITDA could reach over $2B in 2010 and as such is trading at 2.5x 2010 EV/EBITDA.   Applying a 4x EBITDA multiple to 2010 (peak) EBITDA, we arrive at a target of $100/share.
Stock Price:                                  $59.77
12 Month Price Target:            $100.00
Shares Outstanding (dil):              77M
Market Capitalization:                  $4.6B
Enterprise Value:                          $4.9B
        Revenues                         EBITDA                           FCF/Share
FY07A:                 1.07B                              -81M                                   ($5.92)                               
FY08E:                  1.76B                             230M                                    $0.37                 
FY09E:                  3.71B                          1,330M                                  $14.60 
FY10E:                  4.64B                          2,004M                                  $23.30
Industry and Business Analysis:
As mentioned above, the worldwide coal industry is experiencing favorable supply and demand trends which have led to significantly higher prices.  Demand for coal has climbed as worldwide electricity needs have grown.  Thermal coal is the main feedstock for electric utilities, and sales of thermal coal represented 65% of PCX’s 2007 revenues.  The strong demand for coal is also due to rising global steel consumption.  Metallurgical coal is an essential component to steel production and represented 35% of PCX’s 2007 revenues. 
Coupled with increasing demand have been supply disappointments.  The production at Chinese and Japanese mines has failed to keep up with rising demand in those regions.  This in turn has caused a dramatic shift in global coal trade, as Asia has become a larger importer of coal.  As an example, coal from South America normally directed to Europe is now moving to Asia, forcing Europe to increase imports from the US.  The increase in global demand has lead a sharp increase in coal prices as is illustrated below.
US Spot Coal Prices ($ per short ton):
Appalachian Thermal                                          Illinois Basin Thermal
Jan ‘07:                    40                                          Jan ‘07:                  34
July ‘07:                   45                                          July ‘07:                 30
Oct ’07:                    47                                          Oct ’07:                  31
Dec ‘07:                   55                                          Dec ‘07:                  33
Feb ‘08:                   80                                          Feb ‘08:                  48
May ‘08:                105                                          May ‘08:                55
July ’08:                 110                                          July ’08:                 67
Current:                 130                                          Current:                 88
Note: We estimate that 65% of PCX 2008 thermal coal production is from the Appalachian region. 
While met coal prices are not as readily observable as thermal coal, the trend has also been strong.  For example, PCX noted in their 2Q08 conference call that the spot price of the metallurgical coal of the quality they produce is currently trading at $225/short ton.  This compares to the realized price of $75 in 2007, demonstrating a year over year increase of 200%.  Note that steel prices have remained high even during the recent commodity selloff, which has affected the prices of copper, nickel, and other metals.
We believe PCX is the best way to play the favorable future trends for the coal industry.  PCX was spun out of Peabody Coal in November 2007.  Notably, the Peabody management team went with the smaller Patriot and has been buying the stock aggressively.  We consider PCX management to be the best team in the business.  Operationally, PCX is well positioned to grow through acquisitions and add to an impressive base of coal reserves in the Appalachian and Illinois Basin regions.  For example, PCX recently acquired Magnum Coal, which will expand production by approximately 50%.  We found it encouraging that ArcLight Energy Partners (the controlling investor in Magnum) accepted shares of PCX instead of cash and currently owns 14% of PCX outstanding shares.
Through both the Magnum acquisition mentioned above and the successful development of existing mines, coal production volume improvements will add another layer of growth on top of pricing.  We believe PCX’s impressive growth profile is a key reason why the Peabody management team spun themselves out and why ArcLight opted to receive (and hold) stock.  Estimates below are the midpoints of management guidance, which we believe to be achievable.
Patriot Coal Thermal and Met Unit Volume (tons in millions):
Thermal                                                                  Metallurgical
2007A:                     17.1                                       2007A:                     5.1
2008E:                      23.5                                       2008E:                      7.5
2009E:                      32.5                                       2009E:                    10.0
Roughly 30% of PCX’s 2009 production, and 70% of 2010 production, is currently unpriced.  We anticipate that the upcoming round of negotiations with both utilities and steel companies will result in contracts locked in at significantly higher prices.  These higher prices will produce strong EBITDA and free cash flow growth for several years.  We expect the synergies from Patriot’s acquisitions will lead to some earnings growth, but the majority of growth should come simply from the signing of new contracts.  Although we are assuming that 2010 is the peak year for coal prices, it is highly likely that the favorable coal cycle will continue for years after.  We believe we are being conservative by valuing the stock at 4x 2010 EBITDA and the upside could ultimately be far greater than our target of $100/share.


The signing of new contracts at higher prices with utilities and steel companies during upcoming fall renegotiations;
Continued M&A activity as steel companies purchase upstream coal assets and coal producers consolidate (Cleveland Cliffs - Alpha Natural, Severstal - PBS Coals)
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