From Third Avenue Management's second-quarter letter:
In a beleaguered industry, Cloud Peak (CLD, Financial) seems to stand apart from its peers on several fronts. Its three non-unionized surface mining operations, which produce low sulfur coal, are located in the Powder River Basin of Wyoming and Montana and boast one of the lowest cost positions in the industry. Additionally, Cloud Peak's Spring Creek mine enjoys Canadian port access that connects it to growing Asian markets5, where coal consumption is expected to grow rapidly. Admirably, Cloud Peak's management team has maintained a strong financial position and has not followed its competitors by expanding through large acquisitions, moves that have saddled a number of the largest players with weakened balance sheets (implicitly strengthening Cloud Peak's hand). Its attractive valuation, equating to less than four times estimated 2012 EBITDA or $0.90 per ton of reserves, is well below private market values we estimate to be in excess of $1.50 to $2.00 per ton. Customer contracts equate to almost all of 2012 production and the majority of that for 2013, ensuring some cash flow stability and affording a comfortable degree of downside protection. While the contracts may become negotiable, they do provide a reasonable enough runway and timeframe for energy markets to balance. Additionally, though the company carries a net debt position, it faces no debt maturities until 2017.
A few more pieces to the puzzle, not all of which are necessary for a successful outcome, would make this an even more enticing investment. These include:
1) Cloud Peak management avoids a large, valuedestroying acquisition and watches closely its controllable costs, including labor, fuel, tires, and maintenance;
2) Natural gas producers recognize that $2 gas is unsustainable, as it jeopardizes their business economics and, therefore, make a concerted effort to cut back capital spending and production to reduce the supply of gas;
3) Demand for natural gas improves, as weather normalizes and as industrial use takes root from expansion among chemical and fertilizer producers and LNG export facilities, pushing gas prices higher and reducing the attraction of switching from coal;
4) Utility customers act rationally and continue to maintain a diversified basket of generation assets that includes coal, gas, nuclear, hydro and alternatives (i.e., coal does not get completely abandoned in the next five to 10 years);
5) Low sulfur PRB coal gains favor with utilities at the expense of higher cost, Appalachian coal where the competitors, as noted, may be financially and strategically constrained;
6) Foreign markets remain open to U.S. producers and port capacity expands to create even more room for U.S. production.
While the U.S. thermal coal business may not embody a wonderful growth story, we do not believe it will share the same fate as newspapers, paging devices and VHS tapes. Given its abundance and low cost, we certainly believe coal has a future as an energy source over our three-to-five-year investment horizon, particularly if natural gas prices rise and export opportunities increase. Our experience suggests owning mispriced assets in an industry that is prone to surprises can be rewarding. At current levels, the shares trade in what we think of as a desirable ratio of upside to downside – around 3:17.
In a beleaguered industry, Cloud Peak (CLD, Financial) seems to stand apart from its peers on several fronts. Its three non-unionized surface mining operations, which produce low sulfur coal, are located in the Powder River Basin of Wyoming and Montana and boast one of the lowest cost positions in the industry. Additionally, Cloud Peak's Spring Creek mine enjoys Canadian port access that connects it to growing Asian markets5, where coal consumption is expected to grow rapidly. Admirably, Cloud Peak's management team has maintained a strong financial position and has not followed its competitors by expanding through large acquisitions, moves that have saddled a number of the largest players with weakened balance sheets (implicitly strengthening Cloud Peak's hand). Its attractive valuation, equating to less than four times estimated 2012 EBITDA or $0.90 per ton of reserves, is well below private market values we estimate to be in excess of $1.50 to $2.00 per ton. Customer contracts equate to almost all of 2012 production and the majority of that for 2013, ensuring some cash flow stability and affording a comfortable degree of downside protection. While the contracts may become negotiable, they do provide a reasonable enough runway and timeframe for energy markets to balance. Additionally, though the company carries a net debt position, it faces no debt maturities until 2017.
A few more pieces to the puzzle, not all of which are necessary for a successful outcome, would make this an even more enticing investment. These include:
1) Cloud Peak management avoids a large, valuedestroying acquisition and watches closely its controllable costs, including labor, fuel, tires, and maintenance;
2) Natural gas producers recognize that $2 gas is unsustainable, as it jeopardizes their business economics and, therefore, make a concerted effort to cut back capital spending and production to reduce the supply of gas;
3) Demand for natural gas improves, as weather normalizes and as industrial use takes root from expansion among chemical and fertilizer producers and LNG export facilities, pushing gas prices higher and reducing the attraction of switching from coal;
4) Utility customers act rationally and continue to maintain a diversified basket of generation assets that includes coal, gas, nuclear, hydro and alternatives (i.e., coal does not get completely abandoned in the next five to 10 years);
5) Low sulfur PRB coal gains favor with utilities at the expense of higher cost, Appalachian coal where the competitors, as noted, may be financially and strategically constrained;
6) Foreign markets remain open to U.S. producers and port capacity expands to create even more room for U.S. production.
While the U.S. thermal coal business may not embody a wonderful growth story, we do not believe it will share the same fate as newspapers, paging devices and VHS tapes. Given its abundance and low cost, we certainly believe coal has a future as an energy source over our three-to-five-year investment horizon, particularly if natural gas prices rise and export opportunities increase. Our experience suggests owning mispriced assets in an industry that is prone to surprises can be rewarding. At current levels, the shares trade in what we think of as a desirable ratio of upside to downside – around 3:17.
