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Taking a small position in Peabody Energy [ClearOnMoney]
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Taking a small position in Peabody Energy

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Investment

Taking a small position in Peabody Energy

24 Jul 2012 by Jim Fickett.

Today the stock price for Peabody Energy dropped 11%, from a close of $23.16 yesterday to a close of $20.55 today. Today's price is approaching the 2008 low of $18.44. Although I have not finished my analysis, I thought this was almost certainly an over-reaction to bad news, in the coal market and in Peabody's quarterly results, and so began a small position (1% of the portfolio).

Although Peabody does have some assets in Australia, its fate will mostly be determined by the US electricity market. Recent financial news articles on US coal have been very negative for two reasons: (1) It is assumed that natural gas will remain practically free forever, and hence will undermine demand for coal. (2) It is assumed that stricter EPA regulation of pollutants will also drive a large fraction of generation from coal to gas. Both of these are exaggerated. It is very unusual for gas to be cheaper than coal, and it will not last much longer. And thoughtful analysts suggest that the most likely outcome from stricter EPA regulations will be to curtail US coal demand by something like 10 percent. Given the drop in demand we've seen so far, the adjustment may already have mostly taken place, accelerated by cheap gas.

So although many reporters seem to think the US coal industry is about to shrivel up and die, I think it is much more likely that production will be cut back by temporarily closing some of the less profitable mines, and the industry will bounce back.

Peabody shows a current trailing twelve month P/E of about 6, and pays a dividend yield of 1.5%. It is a little difficult to estimate sustainable P/E. The average of earnings per share over the last 10 years is $1.86 which, at the current stock price, would give a P/E of about 11. But this is somewhat misleading because there have been a number of large acquisitions that changed the company considerably over that period. Including only 2007 - 2011 (one bubble year, two crash years, and two rocky recovery years, with only one big acquisition) gives average earnings per share of $2.69, and a P/E of about 8.

Although Peabody disappointed analysts with quarterly results today, the company is not doing that badly. First half earnings per share were $1.39, compared to $1.69 last year. Sure, earnings are down and times are tough for coal. But profit is still in line with the five-year average.

Peabody has proved and probable reserves of 9 billion tons and says that, in the past, their estimates of proved and probably reserves have come in within 10% of actual production. Enterprise value is just over $12 billion, putting a price of $1.34/ton on reserves. In 2005 dollars, the coal price has varied between about $21 and $62 per ton over the last 60 years. Given that variation, if it is possible to get coal out of the ground and sell it for more than the cost of production, it is probably possible to add another $1.34/ton to the price and justify the company's current valuation.

So overall

  • The current news stream is exaggerating the bad news
  • Different valuation measures suggest the stock is somewhere between cheap and reasonable
  • The current price is near an 8-year low

Nothing is guaranteed in investing, but is is a pretty safe bet that (1) the US coal industry will recover and (2) future volatility, if nothing else, will bring higher prices than the current one.

Incidentally, in 2010 I sold my previous position in Peabody at about $40/share.

Other past commentary on coal