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I Want (BT)U
Posted by: Toddius (IP Logged)
Date: June 24, 2012 08:18PM

I’m no expert in macro-economic cycles. I’m not an expert in economic drivers of energy prices. I’m certainly not an expert in coal. I have no experience in coal mining. I don’t typically invest in cyclical commodities companies. My initial interest in Peabody (BTU) was sparked because it’s in an out of favor sector and appears to be very cheap. The price appears to be so low, on various metrics, that I believe the company is worth a closer look.

Company History and Business

As I alluded above, BTU is primarily in the business of mining for coal. From Yahoo Finance: “Peabody Energy Corporation engages in the mining of coal. It mines, prepares, and sells thermal coal to electric utilities and metallurgical coal to industrial customers. The company owns interests in 30 coal mining operations located in the United States and Australia, as well as owns joint venture interest in a Venezuela mine. It is also involved in marketing, brokering, and trading coal. In addition, the company develops a mine-mouth coal-fueled generating plant; and Btu Conversion projects that are designed to convert coal to natural gas or transportation fuels; and clean coal technologies. As of December 31, 2011, it had 9 billion tons of proven and probable coal reserves. The company was founded in 1883 and is headquartered in St. Louis, Missouri.”

Valuation

“If you need to use a computer or calculator to make the calculation, you shouldn’t buy it.” -- Warren Buffett[1]

This is what makes this sector, and BTU in particular, so interesting. The company is currently trading at just above its 52-week low of $22.18 [2] (down from a 52-week high of $61.85). It’s price-to-earnings ratio stands at 6.44, with a forward PEG below 1. The price-to-book value of the company sits at just above 1.

Using the Discounted-Cash-Flow calculator on Gurufocus (which they point out is actually a Discounted-Earnings-Calculator), which assumes a 20% growth rate annually for 10-years, the calculator assumes an approximate fair value of $113 and a Margin of Safety of 80%. Even if we alter that growth assumption input to a much more conservative 5%, the estimated fair value is $42, nearly twice the current price.

Especially interesting about large cyclical commodities players, is their ability to decrease production of commodities when prices wane. BTU has been decreasing coal production. April shipments were approximately 150 million tons lower than 2011 shipments--representing the lowest monthly shipments in over 15 years.

Meanwhile, the International Energy Agency expects demand for coal to increase by 65% by 2035, larger demand growth than that of oil, natural gas, nuclear or hydro (this increased demand provides the most obvious catalyst for BTU stock). [3]

BTU has a proven track record of growth, growing operating cash flow more than 250% over the last 5 years. BTU also represents a “best of breed” sort of opportunity, producing superior margins in comparison to their competitors...while simultaneously offering a cheaper share price.

Risks

“The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.” -- Seth Klarman

Every commodities company is a slave to macro-economic factors. The company is extremely cyclical. Oil, natural gas and alternative energy prices create risks related to the demand for coal. The cyclicality of this business creates increased risks as well--but of course if you’re going to invest in something this cyclical…you want to invest during a down cycle.

Regulatory factors present risks as well. Energy companies are exposed to high levels of regulatory risks that affect their businesses. Coal has risks due to environmental regulatory factors as well.

Finally, energy companies maintain an extremely complex web of hedges. The aim of these hedges is to level out some of the cyclicality and to provide some earnings stability, but obviously not every hedge works as it is contemplated. Black swan events happen…especially when you’re trying to predict commodity prices.

Conclusion

BTU is cheap based on pretty much any metric you can think of. An upward move in demand for coal should correlate to stronger market conditions for this very cyclical company. While you wait, you can collect an attractive 1.5% dividend. I think the low stock price curbs a great deal of the downside risk. While BTU is unlikely to be a homerun type pick (4x or higher), it provides a compelling and significant margin of safety that should make it very attractive to value investors with longer time horizons (the core advantage of the individual investor over the institutional investor). Feedback and criticism is welcome…I’d actually love to hear some thoughts from an analyst that works in this space.

Disclosure: Long BTU


About the author: Todd Metheny is an attorney, entrepreneur and value investor living in St. Louis, Missouri. He is one of the founders of Passerby, a crowdfunding platform exclusive to film--and focused on offering equity investment opportunities in films by sometime in 2013 (currently offering a donation platform). Besides an interest in all things investing, he is also an avid fan of film, the St. Louis Cardinals, the St. Louis Rams, technology, law, web development/programming and folk rock. Follow him on twitter for a random mish-mash of the above: @toddmetheny. If you know filmmakers, send them to :9877:http://passer.by:/9877:.


[1] I’ve also seen this quote as “to determine something is cheap”…this version of the quote can be found at [blogs.wsj.com]
[2] BTU closed on Friday, June 22, 2012 at $22.58.
[3][ Stats from a May 2012 BTU investor relations presentation.




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I Want BT U
Posted by: Bob_in_Maryland (IP Logged)
Date: June 24, 2012 08:54PM

Absolutely. The ideas expressed are spot on ... currently developing a hypothesis that when this sector turns around, the economy will show signs of improvement as well.

Bob



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I Want BT U
Posted by: Toddius (IP Logged)
Date: June 25, 2012 08:47AM

Hi Bob--I



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I Want BT U
Posted by: Toddius (IP Logged)
Date: June 25, 2012 08:53AM

Hi Bob--I agree. A turnaround in coal would be big. When Buffett invested in BNSF, many viewed it as a play on coal--since it's primarily shipped by railroads. Not sure what he would think of a pure coal play:)

New 52-week low in BTU made today.



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I Want BT U
Posted by: Toddius (IP Logged)
Date: June 25, 2012 03:11PM

Haha--of course I write this and BTU gets rocked further...reverse Klarman/Buffett/whoever.



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I Want BT U
Posted by: Bob_in_Maryland (IP Logged)
Date: June 25, 2012 08:52PM

Good Evening, Todd.

We will see what happens as time moves along.

You correctly identified that BTU is a super value. Unfortunately, given the sentiment that exists in today's equity market, we can probably agree that there are particular factors at play.

The "driver" for the demise can best be summed up in a single phrase: "liquidity issues".

I believe investors must be holding their dollars - concerned about market timing, risk management and the overall hedging of their portfolios. Waiting for strong upside signals. Corrective change. Results, even. I will continue to consult the technical and/or advisory but will consider buying into great values only when the bearish case is also analyzed and the risk is clearly identified. Anything short of this is not really a legitimate service. To be sure:. there will be no missing of the upside. Whenever that happens.

You are so right. What is it going to take to lift certain sectors? From my perspective, it's not just the coal industry. There so many lows in the basic metals. And in other industries as well. But staying on topic - with the extractive services - my specific attraction relates to: uranium, precious metals. Aside from coal. (Steel; aluminum. ... .)

If the investment community would only "talk this up", the general population might seek resolution and then we will see, eventually, some lift. It hinges on export/import markets and capital utilization;
governmental and industrial cooperation.

One can only ponder, the extent to which losses have traumatized investors. As well as corporate and political leaders.

Given the actions of central bankers, my watch list is partial to firms with very strong balance sheets.

Bob




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I Want BT U
Posted by: jjmenergy (IP Logged)
Date: June 26, 2012 07:29AM

I am looking at coal for the reasons you note. If you can time arbitrage the economy wil eventually recover and coal, selling below finding costs in many US areas today, is good value here. Mines are closing and layoffs are occurring. The consensus is coal is going to go away. Today coal represents about 38% of the fuel supply for electric generation in the US. That has come down from 42% just recently due to natural gas replacing coal.

The upside to coal is that it might decline more slowly than the consensus and like tobacco stocks provide excellent real returns for a decade or two despite falling demand in the US due to free cash flow and low valuations. That has to be a company by company analysis. Since coal may be in for several rough years it is important to get balance sheets that can survive to the recovery. Coal is being challenged by the EPA and by natural gas and both those forces are going to last for years. The upside is in exports to Asia. Exports are likely to be robust. The US is scheduled to close around 15% of coal plant due to EPA mandates. That is about 45 GW of plant. There are ten times that number scheduled to come on line the next three years across the globe.

The analyst then has to compare the likely decline with the offsetting increase in exports. Cloud Peak (CLD) for example went from approximately 90.7 mm tons of US sales to 90.2 mm tons over the last several years while at the same time exports to Asia went from near zero to 5 mm tons. Therein lies the opportunity for coal. As gas prices normalize coal will gain back some of the lost share in the US but over time the glide path is down not up. The growth will come from exports. Global coal demand is going to continue to rise for decades as nukes are now in retreat, natural gas is 4-5 times as expensive in Europe and Asia as it is in the US and renewable power is intermittent and has low capacity factors. The export market requires infrastructure expansions such as on the West Coast that are battlegrounds between environmentalists who view fossil fuels as evil and best left unburned and labor and politicians who want the jobs and taxes.

So in the next 3-5 years coal will be challenged by low nat gas prices, the EPA driven reduction in coal power plants and limited export capacity. After that period we ought to see a better economic profile as nat gas prices normalize (not sure to where but above today's below production costs prices and at $3-3.50/mcf some share will be recovered for coal), and global demand is met by expanded US exports. Still even then the US is a high cost source of coal globally when you factor in transportation.

So my own investing analysis has lead me to conclude that if you are betting on a global economic recovery driving coal use up you can play that theme other ways that have better risk/reward profiles. A company like Expiditors International (EXPD) has the upside from a recovery, low capital intensity and excellent returns coupled with a pristine balance sheet. It isn't as cheap measured by multiples as coal (industry wide around 5 x TEV/EBITDA) but presents a better risk reward profile. Coal seems to be fairly priced today given the short and long term threats and opportunities. If we get a bad macro economic event most coal balance sheets are tenuous. So there is real risk of permanent impairment near term with good but not spectacular upsides even long term. If you can make it to the long term coal ought to do better than consensus. But you have to make it to the long term so I'd focus on CLD which will weather a downturn in better shape, has a strong b sheet and good export prospects. If you can buy it around book at $12.50 or so it would be very compelling.

That is taking a Phil Fisher approach. I believe in one of his books he says when a sector is down the companies closest to bankruptcy have the most upside leverage but the best companies with strong balance sheets are the conservative way to pursue value. So Arch or Peabody have more upside in a strong rebound but Cloud will survive even a sharp downturn and it has good upsides short and long term.





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I Want BT U
Posted by: Bob_in_Maryland (IP Logged)
Date: June 26, 2012 12:12PM

Great context. Very nice overall assessment. Thanks for the explanation related to CLD and EXPD. Just the type of framework required in systematically thinking about the future. The play involves not just a seeking of return; but a management of return. George Soros explanations on the concept of reflexivity come to mind as well.

Bob




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I Want BT U
Posted by: Toddius (IP Logged)
Date: June 26, 2012 04:16PM

@Jjmenergy--thank you for taking the time to write that analysis. You make a lot of great points. I completely agree that the opportunity in coal is in exports--especially exports into developing nations.

One divergent path:

I have not taken a dive into CLD's financials...but after a 5 second, cursory look, my question would be--is their financial footing really that much better than BTU's? Just boiling it down to a couple of simple numbers, Z-Score & F-Score, BTU has an argument.

The Z-score, focusing on financial health, gives CLD a score of 1.7 and BTU a score of 1.6.

The F-score, focusing more on how undervalued something is overall, gives BTU a score of 7 and CLD a score of 5.

I will readily admit that you seem to know the space better than I do. A closer analysis very well may reveal additional info that paints CLD as a company that is clearly carrying less risk than BTU. My knee jerk is that they carry a pretty similar financial risk profile. In that case, I think the cheaper, larger BTU has a legitimate argument as the better play.

Just my $.02. Appreciate your insight!



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I Want BT U
Posted by: jjmenergy (IP Logged)
Date: June 27, 2012 07:49AM

Toddius,

I haven't drilled down on either balance sheet much beyond your analysis which seems reasonable. The debt-to-equity and interest coverage ratios seem similar between BTU and CLD. CLD has nearly $500 mm of cash against $600 mm of long term debt so liquidity is outstanding. You need to factor in lease obligations as well as debt. In both cases you need to look at the cash flow available to service debt if the current low prices hold for several years or go lower and existing contracts and hedges roll over and are replaced by new sales and hedges. CLD having the lower cost supplies (100% PRB) looks to have better cash flow and earnings in a low case price environment than would BTU. I have seen one analysts presentation on cash flows and earnings in a low price environment and CLD was the best performer but I haven't done the work myself. I'm merely looking at the composition of the reserve portfolios and CLD's 100% low cost basis plus very strong liquidity looks to be one of the safest positions in the industry in terms of outlasting a prolonged down turn and its' export potential gives it good upside although it has no international reserves.



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