Coal Still Isn't Cool, But Don't Count Out These Companies

After another week of bearish natural gas reports, most coal stocks were hit by negative analyst reports. Even though a lot of the news suggests a more bullish environment for coal, the market isn't finding the stocks appealing.

The quarterly coal report from the EIA and the weekly natural gas inventory report should remind investors that not only is coal still alive, but it could have a surprisingly strong future. Domestic focused producers in the Western U.S. and Illinois Basin will benefit the most, providing some upside potential for Cloud Peak Energy Arch Resources , and Alpha Natural Resources .

Industry reports
First, the weekly natural gas inventory report continues to point toward a bullish scenario for coal. The most recent report showed inventories down 157 billion cubic feet, or bcf, to a level 10% below the five-year average. On top of that, the record cold snap in the Midwest has analysts forecasting a near record 300 Bcf drop for the next report. The lower natural gas inventories should push up prices, making the cheaper western coal more appealing.

Second, the EIA reported in the quarterly coal update that the fuel source should remain a primary commodity used in electricity production for the next three decades. Another part of the report identified coal stocks down to lows not seen since 2008.

Pure-play Powder River Basin
Cloud Peak Energy is the only pure-play in the Powder River Basin, or PRB, in the western part of the U.S. The focus on low-cost coal provides the company an advantage over the more costly Appalachia underground mines. For the third quarter, Cloud Peak sold 23.1 million tons at an average production cost of $9.78. The realized price was $13.03, down from 2012 levels, but mostly consistent with 2013 prices.

On a valuation basis, Cloud Peak appears attractive, trading at less than 4x the forecasted 2013 guidance for EBITDA, or earnings before interest, taxes, depreciation, and amortization, of $210 to $230 million. Considering the pricing environment and declines from 2012, the company could see plenty of upside with the PRB inventory levels at utilities declining.

Semi-focused Arch
Arch Coal doesn't provide the pure-play PRB miner, but it sells more tonnage from the region. During the third quarter of 2013, Arch sold 31.5 million tons of PRB coal for an average sales price of $12.26 and a cash cost of $10.20 per ton. The company has seen a substantial decline in pricing from $13.79 a ton last year.

Arch has a small operation in the Appalachia that only sold 3.3 million tons during the third quarter. With a significantly higher average sales price, the sales are meaningful to the company. The current sales price of $73.71 per ton doesn't cover the operating costs of $82. Outside the PRB and Appalachia, Arch sold another 3.5 million tons of thermal coal at a average price of $33.74 for an operating margin of $4.57 per ton.

Arch generated an adjusted EBITDA of nearly $200 million during the third quarter alone. The stock is only valued at $900 million, but part of the issue is the substantial debt, costing $95 million in interest during the last quarter alone.

Diversified Alpha
Alpha Natural Resources is the most diversified of the group with $1.2 billion in quarterly revenue. The coal miner shipped 10.1 million tons of PRB coal during the last quarter. Though the volumes are significant for western coal, the eastern metallurgical and thermal coal prices swamp the PRB when reviewing revenue.

The PRB shipments were priced at $12.58 per ton, while PRB costs were an impressive $9.29 per ton during the third quarter. Unfortunately the average costs of all the coal combined were $44.62 per ton. With average revenue of $47.09 per ton, the company only generated a slight margin.

Alpha will continue to benefit from a more favorable pricing of PRB coal compared to natural gas, but the actual impact on the financials is minimal with the dominant pricing situation of metallurgical coal and eastern thermal coal.

Bottom line
Higher natural gas prices will continue to encourage utilities to switch back to the cheaper PRB coal. On top of that, lower coal inventories will help spur further demand and lift prices. Cloud Peak remains the primary beneficiary of the value proposition of PRB coal, though any stability in the Appalachia coal market would benefit Arch Coal the most. Alpha Natural Resources remains a wild card that benefits from increased PRB demand, but the coal miner is substantially tied to the metallurgical market.

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Mark Holder and Stone Fox Capital Advisors clients own shares in Alpha Natural Resources. 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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