Coal demand has been squeezed since the sharp decline of natural gas prices. This decline in demand has caused a severe decline in prices, resulting in declining profitability for coal companies over the last two years or so. To make the situation worse, even the global demand for met coal is declining (due to a declining demand for steel). This has created a tough time for coal players with large met coal exposure that had been somewhat immune to local declining coal demand.
In these dire circumstances, the only question to be asked is: Is there any coal company that we can invest in?
Which coal company to invest?
While Arch Coal Inc (NYSE:ACI) demonstrated solid unit cost performance during the first quarter (-7% on a sequential basis), the overriding issue for Arch Coal (and for the group) continues to be weak pricing, most recently in the international met & thermal coal markets.
For Arch Coal Inc (NYSE:ACI), the issue of weak pricing is compounded by massive changes in the Balance Sheet in the past two years, leaving little equity value unless prices improve significantly.
Currently, Arch Coal Inc (NYSE:ACI) has over $4 billion of net debt, vs. $1.5 billion as of the first quarter of 2011. The company also has a share count that is 30% higher now than it was in the first quarter of 2011. Meanwhile, the Street estimates the company’s earnings before interest, taxes, depreciation and amortization for 2013 to be $445 million (and $540 million in 2014), which is way lower than its 2010 annual EBITDA as it was closer to $900 million.
As a result, even though the share price has collapsed from $35 to $5 over the past two years, Arch is still trading at 11.5 times its current year EBITDA (and 9.8 times its estimated 2014 EBITDA), whereas two years ago Arch Coal Inc (NYSE:ACI) was trading at 8.0 times its then-current EBITDA.
It is important to understand that this is not a liquidity/cash burn issue (Arch has approximately $1.3 billion of liquidity and is only burning around $120 million of cash in 2013), but is instead a leverage issue.
There needs to be a clearer path to at least $850 million of EBITDA generation for the company’s shares to have an interesting outlook at current levels. $850 million of EBITDA is needed to bring Arch Coal Inc (NYSE:ACI)’s EV/EBITDA multiple below 6.0 times given the company’s current capital structure.
Unfortunately, the met & thermal coal price assumptions needed to attain that level of EBITDA generation are too optimistic with the current underlying thermal & met coal supply/demand drivers.
Can a good management team turn things around?
Alpha Natural Resources, Inc. (NYSE:ANR)’ management deserves credit for controlling what they can (costs, production, and its selling, general, and administrative expenses). These company specific benefits are offset by current weak metallurgical coal prices that continue to be the main EBITDA driver for Alpha Natural Resources, Inc. (NYSE:ANR).
The company’s management deserves credit for improving the company-specific cost structure and aggressively closing higher-cost unprofitable assets. The remaining volumes and EBITDA remain significantly levered to metallurgical coal prices (i.e., an approximately $20/mt swing in met prices off of a $170/mt base translates to a nearly $400 million swing in EBITDA), which in turn will normalize at higher-than-current levels over time (due to industry-wide cost pressures.)
Accordingly, 2013 should mark the trough in earnings for Alpha Natural Resources, Inc. (NYSE:ANR), and the pricing level required to reach EBITDA that is necessary to justify buying the shares is more attainable than it is for some of the company’s closest coal peers. Barclays has set a price target of $11 based on the 6.0 times 2015 EBITDA estimate of $800 million. This translates to an upside of 55% from current levels!
Another well-run company that is not recommended as a buy
Contrary to popular belief, however, this does not make Cloud Energy immune to poor coal market conditions.
Cloud Peak Energy Inc. (NYSE:CLD)’s export thermal coal business, which generated outsized EBITDA contributions in 2012, is essentially unprofitable (currently) due to weak global coal prices. Meanwhile, even though natural gas prices are higher, excess capacity and limited “discipline” in the Powder River Basin will limit sustainable pricing power for at least the next two years. To this end, Cloud Peak Energy Inc. (NYSE:CLD) and other coal companies continue to lock in 2014 volumes before the expected recovery in price materializes. Currently, Cloud Peak Energy Inc. (NYSE:CLD) has sold approximately 6 million tons of 2014 PRB coal at an implied price of around $11/ton, which is not far from current cash costs of $10.37/ton.
The bottom line is that the “normalized” EBITDA for Cloud Peak Energy Inc. (NYSE:CLD) is meaningfully lower than the consensus expectations (i.e., approximately $250 million, vs. approximately $300 million based on 2014/2015 consensus.)
Final word
A secular decline in coal demand has been a nightmare for coal investors. To add fuel to the fire, met coal demand has also been declining which has made the outlook on stocks like Arch Coal Inc (NYSE:ACI) bearish. Some companies have been neutralizing the impact of declining prices by locking coal futures into 2014, however. Though this might help companies like Cloud Peak Energy Inc. (NYSE:CLD) to cover their operating costs, they will not add significantly to their EBITDA (and will hinder profitability if the coal markets improve before 2014.) In case of a revival, only well-managed companies like Alpha Natural Resources, Inc. (NYSE:ANR) will be able to benefit from rising met coal prices.
The article Finding the Right Company To Invest in This Industry originally appeared on Fool.com is written by Zain Abbas.
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