Peabody Energy Corp (NYSE:BTU) is a pure play coal producer with assets in the United States and Australia. An acquaintance of mine first introduced it to me and I also realized that Harris “Kuppy” Kupperman also owns this stock.
At first glance, this is a very cheap stock in terms of valuation. I’m also surprised that it has very strong cashflow. With such a large margin of safety, I entered a small stake at US$8.90, thus forcing me to do my due diligence with urgency (Not recommended, a very bad habit of mine to fight procrastination). Suffice to say, I divested one month later as I felt the cons outweight the pros for this investment.
Background
A little background, US Coal producers have been sold down heavily in the past few months. Pressured by falling coal prices, poor quarterly results and domestic peers falling into bankruptcy, Peabody’s share price plunged the most compared to the 4 in the graph below.
Consol Coal Resources (NYSE:CCR), an Appalachian coal company, fared better as coal from Appalachia sells at the highest prices due to its quality, while Peabody’s coal came from Powder River basin, which has the lowest quality, dirtiest but cheapest to mine.
What has lead to this environment? US coal producers were hit by a double whammy of (1) falling US demand for coal and (2) overproduction by their falling peers in an attempt to produce and sell as much coal as they can in order to reduce inventories and pay their debts.
The first reason will probably persist but the second reason is only temporary. We are also starting to see a reduction in supply where Peabody closed an Illinois mine and Murray Energy, one of the largest coal producers in US, has declared bankruptcy, 1 of 8 to do so this year.
So where does Peabody go from here? Coal’s future looks bleak but it is not going to disappear overnight. In fact, we will still be seeing coal in the next decade or two.
Coal Outlook
Talking about coal’s impending doom is like flogging a dead horse.You can find tons of articles talking about their declining demand in developed economies like Germany, Canada and United States.
An article published by Yale Climate Connections says it best. The price of coal has been undercut by cheaper, cleaner competitors. The outlook for thermal coal, the kind used for electricity generation looks bleak indeed.
However, we are seeing opposing trends in the world’s largest economies: the efforts and announcements of the majority of countries that are phasing out the use of coal to produce electricity are being undermined by a number of countries that are increasing the share of coal in their power mix. We also have some 20 countries (eg. Kenya, Bangladesh, Panama, Vietnam and Myanmar) turning towards coal for electricity generation.
Projections made by energy consulting firm EnerFuture, forecasts that by 2040, the share of coal in the power mix is expected to decrease by only 10%. With a steady increase of electrification in some emerging countries, electricity demand will continue to increase in the medium to long term.
Even in a carbon-constrained world, significant positive impacts from coal can be felt in communities in the developing world and it still has a role in advanced economies.
A Tale of Two Coals
Up till now, I have been touching on the dim outlook of thermal coal. In fact, we tend to forget that there are two types of coal. Thermal coal, burned for steam to run turbines to generate electricity, and metallurgical coal or coking coal, used to create coke necessary for iron and steel making.
For coking coal, an important thing to note is that they are required in steel production and even though there are some breakthroughs in coal-less steel making, they are still far from fully-utilizing it in the industry. Hence, thermal coal, decreasing demand due to alternatives. Coking coal on the other hand, no alternative, no choice for now. We have to burn coking coal to make steel to make wind farms. Read more about it here (https://leard.frontlineaction.org/coking-coal-steel-production-alternatives/, https://www.letstalkaboutcoal.co.nz/future-of-coal/making-steel-without-coal/)
Hence, the point that I would like to make is that coal is dying albeit slowly. It will not disappear overnight and we are still reliant on it for industrial growth.
Minding Peabody’s Business
So it seems like the overall bearishness on coal is overblown, but Peabody’s numbers and current situation made me uncomfortable investing in them.
1 – The Jewel That Became a Headache
On September 27th 2018, the company discovered a fire deep within the North Goonyella mine, in Australia. Production was stopped after that. North Goonyella mine was their top metallurgical coal producing mine with the largest proven reserves within their portfolio of mines.
Due to this incident, Peabody has spent $58 million in 2018 on containment and idling costs, and there was provision of $66.4 million for equipment losses. These costs might be largely covered through insurance. However, in 2019 there have been idling and re-ventilation costs of $30-$35 million per quarter and an additional $110 million for capital equipment. That is not all.
If management decides to go ahead with the re-opening in 2020, there will be an expected expenditure of at least $62 million. The most worrying thing is, management have stated in their latest financial report that no meaningful coking coal production is expected for at least 3 years.
2 – Powder River Basin JV with Arch Coal
Peabody has proposed a joint venture with Arch Coal, another mining company, to join forces in working together in the Powder River Basin. The main consideration for this is the huge cost synergies the JV will provide. Management has estimated pre-tax NPV of $820mil in cost savings.
Currently the JV is still awaiting approval from the authorities and decision is expected to be made by 1H2020.
A concern would be the falling production in the PRB. 9 months 2019 production has fallen by 10 mil tons ( 11%) as compared to 2018. Whether the so-called cost synergies can offset the falling production and revenue remains to be seen.
3 – Failed Debt Refinancing
Recently, Peabody had given up on refinancing their debt due to unfavorable market conditions. Although the exact details are not made public, it is a concerning development and raises further doubts regarding their long-term future.
What is even more surprising is that they are only in a net debt position of $502.6 mil and total debt of $1.3bil while having free cash flow of $679mil. This means that they are able to repay all their debt using FCF in 2 years but still the bond markets are unenthusiastic to refinance their debt.
The lack of investor confidence is also probably why the share price looks so extremely undervalued. This situation may change in the future, but their inability to access to capital markets is an ongoing concern.
4- Poor 3Q19 Results
Their latest 3Q19 results has shown that recovery in this sector is still not here yet.
From their latest financial filing, metallurgical mining, which is supposed to be the segment that is bringing in the cashflow, is currently loss making and will be expected to do so in the next few quarters.
We can also see that their EBITA has decreased yoy across the board, which is expected to continue as coal demand falls in the United States.
Free cash flow was badly affected as a result, reducing by more than 50%. In 9M 2019, Peabody has returned $550mil to shareholders in dividends and share buyback and that is more than their free cash flow. This means that current rate of share buyback and dividends is unsustainable in the long term.
Making the Best of a Bad Situation
That is what I would call after my dive into Peabody’s predicament. It was all about surviving as a pure play coal company. Their management has launched their 4 pronged approach to maximize value for their shareholders with no hint of diversifying into other sectors like some of their peers like Alliance Resource Partners who ventured into oil and gas.
To comment on no.4 which is returning cash to shareholders, I would prefer Peabody to issue more dividends as opposed to share buybacks. Clearly it has not been working and is more value destructive considering the fall in share price.
Conclusion
Considering all the above, I felt that there is a slight hope that Peabody could still turnaround but there are a few mess that they have to get out of, North Goonyella being one of the more major ones.
However, I am still uncomfortable investing in this stock at this time and hence, I divested my Peabody shares at $10.10 for a 10+% gain.
I will still be monitoring this company for more updates from their management and look for opportunities in this unloved sector.
Also, it is not recommended to blindly follow others in the market. I did it so this time as I felt the MOS is very high and it forces me to dig deep as my money is in the company.
Cheers.
Note: Just before publishing, I learnt that there is insider selling this week. Not good news for the company.
