Investorsoapbox PM FRIDAY, JANUARY 14, 2011FBR Capital Market
We are dialing beta modestly in the coal group despite increasing our metallurgical-coal price (5%-11%), estimates (10%) and price targets (6%), essentially taking a breather after the phenomenal run in the space over the past six- and one-month periods.
As a result, we are downgrading Patriot Coal (ticker: PCX) and Walters Energy (WLT) to Market Perform from Outperform and would advise investors to move toward the lower-beta names in the space in the meantime ( Peabody Energy (BTU), Consol Energy (CNX), Arch Coal (ACI), Alpha Natural Resources (ANR), Cliffs Natural Resources (CLF), and Cloud Peak Energy (CLD)).
The risk to our downgrade is that rains [floods in Australia] reemerge and take additional met coal off the market (now forecasted at 13 million metric tons (tonnes), from eight million tonnes), but the rails and ports are starting to come back while the rains take a break. We are leaning more toward steam, as steam-coal prices are rising and supply/demand tightness is deeper and should last for at least another year. We are trimming our fourth-quarter 2010 estimates, too, but believe most investors are more focused on the rains' impact than the short-term and the traditional volatile earnings season. Presently, the coal group trades at 2011-2013 enterprise value/earnings before interest, taxes, depreciation and amortization (EV/Ebitda) estimates of 7.5 times, 6.3 times and 5.5 times, respectively (a one times expansion despite higher-forecasted met-coal prices) and has about 10% upside after the recent performance.
The risk to our downgrade is that rains [floods in Australia] reemerge and take additional met coal off the market (now forecasted at 13 million metric tons (tonnes), from eight million tonnes), but the rails and ports are starting to come back while the rains take a break. We are leaning more toward steam, as steam-coal prices are rising and supply/demand tightness is deeper and should last for at least another year. We are trimming our fourth-quarter 2010 estimates, too, but believe most investors are more focused on the rains' impact than the short-term and the traditional volatile earnings season. Presently, the coal group trades at 2011-2013 enterprise value/earnings before interest, taxes, depreciation and amortization (EV/Ebitda) estimates of 7.5 times, 6.3 times and 5.5 times, respectively (a one times expansion despite higher-forecasted met-coal prices) and has about 10% upside after the recent performance.
Since July 6, 2010, Walters had a phenomenal run (true alpha generation), appreciating 124% (26% for S&P 500 and 89% for group). While we continue to like Walter Energy and Western Coal's combined asset base and believe that there is a scarcity value associated with such a premium, high-quality, met-coal pure-play, we believe that it is now fairly valued, given our commodity-price outlook. Furthermore, heightened met-coal euphoria may create unnecessary risk for the stock. However, we will review our ratings as time progresses and a better assessment of met-coal pricing surfaces.
Similarly, Patriot Coal had a phenomenal run over the past month, with the stock appreciating 62.5% (3% for S&P 500 and 21% for group) since our Dec. 20, 2010, upgrade, primarily driven by potential met-coal supply disruption in Australia due to rains. While we agree with the earnings leverage from met-coal pricing (which is getting reflected), we believe that investors also face normal-CAPP risks (rail, geology, natural gas).
We are raising our 2011-2013 met-coal prices to $250 per tonne, $225 per tonne and $220 per tonne, an increase of about 5%-11% from prior estimates. While the risk is still to the upside, we are raising our view of the met-coal price curve and taking a breather for now. As a result, we are raising our earnings-per-share and Ebitda estimates by 14% and 6%, respectively, but trimming the fourth-quarter 2010 by about 10% to account for recent press releases and rail issues. We are raising our met-coal supply disruption out of Australia to 13 million tonnes, from eight million tonnes, with an additional 8.5 million tonnes of steam coal off line.
The Australian rain issue is discounted in the stocks. Met-coal names have rallied on the back of media reports highlighting the impact on coal mines and supply infrastructure. While it could be too soon to gauge the total impact, we estimate that about 13 million tonnes (versus an eight million tonnes estimate on Jan. 3, 2011) of met-coal supply is likely removed from the market. We believe that this situation is now becoming better understood (hyped, in some cases) and discounted in the stocks. While things could get worse, since it is still the rainy/cyclone season, we believe a near-term peak has been reached. Furthermore, we expect coal producers to devise ways (crossover tons, running mines harder, etc.) to make up for lost profit. Furthermore, steelmakers will identify alternate sources of supply, such as U.S. Northern Appalachia (NAPP) coal (which is thermal coal).
Overall, we believe that the coal group is likely to announce fourth-quarter 2010 earnings below consensus (unless expectations are lowered); but investors may shrug this off, given underlying positive trends (supply disruptions, demand recovery, and rising prices). The key themes that could play out/foreshadow this earnings season: 1) rising exports -- steam and met; 2) increasing capital spending; 3) tightening spreads supporting export of crossover product; 4) strategic discussion, including mergers and acqusitions; and 5) production issues/constraints.
We note that some companies (Arch Coal, Peabody, Massey Energy (MEE) and Consol Energy) have already provided revised guidance/production expectations.
-- David M. Khani
We note that some companies (Arch Coal, Peabody, Massey Energy (MEE) and Consol Energy) have already provided revised guidance/production expectations.
-- David M. Khani
-- Mitesh Thakkar
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