Too Early to Bet Big on These Coal Miners

The problems of coal producer Peabody Energy haven't disappeared. Despite the fact that the company recently reported a quarterly profit instead of an expected loss, the future of the company's business continues to be uncertain. Yes, Peabody is outperforming its peers Arch Coal and Alpha Natural Resources , but is it enough to satisfy investors?

Looking at China
In the third quarter of this year, Peabody had a favorable shipment mix. The company delivered 4 million tons of met coal, 3.1 million tons of seaborne thermal coal, and 1.9 million of domestic coal. Why is it beneficial? Because domestic thermal coal is under the biggest pressure. We'll get to this shortly.

Both met coal and export coal are sources of hope for Peabody. Chinese steel production rose 15.6% in August. China is a crucial source of met coal demand, and such data is supportive for met coal prices. There are also possibilities to grow thermal coal sales outside of the U.S. Peabody states that India's domestic thermal coal production lags demand. As a result, coal imports grew 37% year to date.

Although both met coal and export thermal coal could be counted as opportunities, it is too early to place your hopes there. The market is still oversupplied, although Peabody states that both U.S. and China are going through a process of supply rationalization.

Problems at home
The domestic thermal coal market is a big obstacle. The company that suffers the most from this is Arch Coal, which is heavily involved in the production of thermal coal. Cheap natural gas prices in combination with new environmental regulations put coal under significant pressure. Plus, the current administration does not favor coal at all. Arch Coal has already lost 46% of its capitalization this year, and, in my opinion, is on the way to lose more.

At the beginning of this year, Alpha Natural Resources stated that it wanted to grow its met coal exposure. As a result of this effort, 50.5% of its second-quarter revenue came from met coal. In comparison, met coal accounted for 38% of revenue in 2012. While met coal is not a safe heaven, it is surely in a better position than thermal coal. This transition has made Alpha Natural more competitive, but not immune to low coal prices.

Peabody trades just above its book value and at a 33 forward P/E. Given the problems that they face and their inability to operate profitably in current conditions, both Arch Coal and Alpha Natural Resources trade at less than a third of their book value. This valuation might seem cheap, but it's not.

All these companies remain highly leveraged. Peabody had $6 billion of debt at the end of the third quarter. Alpha Natural Resources finished the most recent quarter with $3.3 billion of debt on the balance sheet, while Arch Coal had $5 billion of debt. This is a heavy burden for all these companies, but especially for Arch Coal, which has a debt-to-equity ratio of 1.87.

Peabody recently announced that it has managed to secure a new credit facility. The five-year revolver credit was expanded to $1.65 billion, and a seven-year $1.2 billion loan was secured.

This move strengthens its liquidity position but does not solve the main problem, which is the low-price environment. To Peabody's credit, the company has managed to cut costs on both its U.S. and Australian mines, which resulted in a surprise profit. However, margins are still very thin, and the overall position is vulnerable.

Bottom line
I believe that Peabody Energy is fairly valued at current prices. The business is performing well, but the price environment weighs heavily on profits. Cost-cutting is not an endless process, so Peabody will ultimately need higher prices to improve its performance. Although there are bright spots here and there, the outlook for both met coal and thermal coal prices remains uncertain -- as is Peabody's future.

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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