Is This Coal Stock Worth the Risk?
Arch Coal's stock price has appreciated more than 12% over the past month, but some investors will strongly argue that this is nothing more than a dead cat bounce. With no international improvements in thermal coal markets in the second quarter, and all coal exports expected to be lower in 2013 than 2012, finding reasons to be bullish on Arch Coal can be challenging. However, challenging situations sometimes provide exceptional investment opportunities.
Industry trends
If you want to know where the coal industry is going, look at natural gas prices. If natural gas prices are high, then it's good news for coal, as coal is the cheaper alternative. If natural gas prices are low, then it's bad news for coal, as coal is the more expensive option.
Natural gas prices have jumped over the past several days, currently at $3.39, but this is well below historical averages. For example, natural gas traded at $5.50 in the summer of 2010, and it traded above $8 in the summer of 2008. Reduced supply has the potential to drive natural gas prices higher, but coal needs more help than that.
Two big challenges exist. One, President Obama wants to regulate CO2 emissions from coal-fired power plants by the end of his term. This, of course, is a major potential headwind for coal. Two, the global economy is in flux. Europe is in recession, China is slowing, and the United States is an enigma. If the global economy slows, coal will suffer.
Relying on exports
Arch Coal's total coal sales declined 3% in 2012 versus 2011. And metallurgical coal prices plummeted 50% from their 2011 peak. In response to this slowing demand, the company reduced production and closed mines. The goal was to cut costs and free up cash in order to prepare accordingly for an industry turnaround. However, the industry has yet to turn around.
Exports have (or at least had) been the one bright spot. Arch Coal shipped 13.6 million tons of coal (thermal and metallurgical) to Europe, South America, the Middle East, and Asia in 2012. Arch Coal predicts growing demand in Asia, and it has opened operations in Beijing in anticipation of this trend.
However, the company exported just 5.5 million tons of coal in the first half of 2013 versus 7 million tons in the first 6 months of 2012. Metallurgical coal demand has remained stable, but thermal coal demand remains weak. Despite the stable demand for metallurgical coal, an oversupply issue still exists, which negatively impacts pricing.
On the domestic front, Arch Coal has seen improvement in the thermal market, as electric generation facilities have increased coal consumption by 10% through May 2013 compared to the year-ago period.
Fundamentally unsound
Arch Coal might not impress you much on a fundamental basis, and its peers, Alpha Natural Resources and Peabody Energy aren't much to brag about either. That said, one of these companies might present a better investment opportunity than Arch Coal.
Let's first take a look at some important numbers:
ROE | Dividend Yield | Debt-to-Equity Ratio | Short Position | ||
|---|---|---|---|---|---|
Arch Coal | -13.39% | 2.70% | 1.32 | 19.40% | |
Alpha Natural Resources | -9.60% | None | 0.72 | 22.30% | |
Peabody Energy | -14.92% | 1.90% | 1.88 | 6.70% |
A few things stand out here:
One, the companies throughout this industry tend to operate in similar fashion, which is a result of industry weakness. Many of the savviest investors in the world strongly believe that the industry is more important than the individual company when it comes to investing. The coal industry is a prime example.
Two, Alpha Natural Resources is the only one of the three that doesn't pay a dividend. At the same time, it's also the only company that has a debt-to-equity ratio lower than the industry average of 1.0. This kind of fiscal responsibility may lead to Alpha Natural Resources holding up better during difficult times.
Three, Peabody Energy's short position, though high, is much lower than its peers. Peabody Energy is the only company of the three that managed to increase revenue in 2012 despite such a difficult environment. However, just like Arch Coal and Alpha Natural Resources, it reported a loss in 2012. On the other hand, it was the only company that delivered a profit in its last quarter.
Conclusion
The coal industry is at a crossroads, and nobody knows which road it will take next. What we do know is that natural gas prices remain historically low, Arch Coal's exports have slowed in the first half of the year compared to last year, and government policies have the potential to hamper the industry's potential going forward. While an improved domestic thermal market and increased export potential due to infrastructure spending are positives, there are simply too many risks to recommend Arch Coal as an investment at this time. If you're eager to invest in the space, consider Alpha Natural Resources thanks to its stronger debt management, but only as a small speculative play.
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The article Is This Coal Stock Worth the Risk? originally appeared on Fool.com.
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