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Taking a short-term profit on hard-to-value Peabody Energy [ClearOnMoney]
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Taking a short-term profit on hard-to-value Peabody Energy

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Investment

Taking a short-term profit on hard-to-value Peabody Energy

22 Oct 2012 by Jim Fickett.

Recently I took a small position in Peabody Energy, as a way of betting that the market for coal had been unfairly beaten down by excessive pessimism. As of this morning, that position was up 41%. Since my continuing study of Peabody shows that an objective valuation is very difficult, I took my short-term profits and will look for a more transparent company for future investment.

Take Peabody's reports with a grain of salt

In Peabody's 2011 annual report one finds the following impressive graph:

That looks somewhat less striking when one includes one more year and compares to the price of coal:

So most of the impressive performance is due to the period covered being one of a strongly increasing coal price. (Concerning the period covered: the company has existed in a number of different forms for more than a century; the latest incarnation began with an IPO in 2001, so 2002 is the first full-year result.)

Here is a long-term view of the real price of bituminous coal:

Clearly there is a large cyclical component to coal prices, and the recent runup is not necessarily going to continue.

The above is just one example of the company reports being too much under the control of the PR folks, and not really geared to the needs of a rational investor. There are many other examples: reserves, basic to any mining company, are not given in the annual reports at all; you have to go dig through the SEC filings to find them. And “tons [of coal] sold”, which figure prominently in the annual reports and 10-K's, turn out to include trading; the number of tons produced is much more modest.

Where is the cash going?

But the main point I want to concentrate on in this post is cash flow produced and what is done with it – a key measure of the successful operation of any business.

Over the period 2002-2011, Peabody has had average free cash flow of -$173 million. Negative free cash flow is not necessarily a problem, if the money is being used to grow the business. Indeed, capital expenditures and acquisitions have been high, and shareholder's equity has grown from $1.1 billion in 2002 to $5.5 billion in 2011. So it would seem the company has grown significantly.

In what way has it grown? Most often, when one analyzes a growing resource company, one finds purchases of new land, exploration and development, and the growth of both reserves and production over time. But while equity grew 400%, reserves shrank slightly, and production grew only 30%:

It could be, of course, that the quality of reserves and production has increased, or that the reserve of unexplored land has been built up.

For example, Peabody has worked hard to increase its business in Asia. 2% of Peabody's reserves were in Australia in 2002, but 13% were Australian by 2011. In particular, this year Peabody bought MacArthur, an Australian coal miner, for $2.8 billion. Since Australia is close to China, the increased emphasis on Australia was good for business over the last few years (though much less so this year, as the slowdown in China has hit mines in Australia very hard). On the whole a shift to move part of the company's business from the US to Asia is a good one, even if future Chinese growth is generally over-rated.

Metallurgical coal might provide another example of improving asset mix. Metallurgical coal, used as both a heat source and a chemical reactant in the production of steel, has fewer impurities and fetches a higher price than thermal coal, used in power plants. Peabody often brags about its metallurgical coal, and occasionally offers data. Part of the reason for acquiring properties in Australia was probably that the deposits are rich in metallurgical coal. While only about 4% of production was metallurgical coal in 2011, Peabody's Australian reserves are about 32% metallurgical, allowing for increased future production.

Unfortunately, although these examples provide some qualitative evidence that the company really is using cash to increase value, it is impossible to make a quantitative case. For example, since mine acquisitions are listed on the books at cost, there is some suspicion that the Peabody has bought mines at peak prices and that, therefore, assets are overstated on the balance sheet. More generally, there is simply not enough information in the company filings to tell

  • whether this year's reserves, in toto, are more valuable than last year's
  • whether capital expenditures on mines overall can provide increased production over time, or are simply maintenance
  • what the company's overall strategy is in which deposits to keep, which to dispose of, and which to acquire

All in all, looking simply at P/E and the historical share price, I suspect Peabody is reasonably valued. However without being able to do a serious free cash flow analysis or reserve valuation, I not willing to make Peabody a long-term holding. So today I will took the short-term profit of 41% and began looking for a more transparent company.

Other past commentary on coal