Coal Bankruptcy Fears Stoked, but China Risk Is Bigger (Update 1)
By Antoine Gara - 07/20/12 - 12:41 PM EDT
Updated to include additional analyst comments, sector data
NEW YORK (TheStreet
) -- As coal giants limp into the second half of the year, there's still the prospect that things could get worse for the sector. However, a weak revenue outlook and debt-laden balance sheets won't prove to be the death knell for an industry whose troubles were highlighted by the recent Patriot Coal
"I think the second half of the year is not going to be a heck of a lot better than the first half," says Davenport & Co.
analyst Christopher Haberlin of his outlook for the coal sector. However, the reasons for caution are shifting.
Instead of an existential crisis, coal players head into second quarter earnings with a potential reversal of demand indicators. Met coal, which was the primary source of health for coal companies in the first half of the year thanks to Asian demand, and in particular, China, which uses the coking product to produce steel, is at risk of slacking. Thermal coal, mostly used in power generation, slumped in early 2012 as natural gas hit decade low prices, but a rebound in natural gas prices amid a late June and July heat wave has driven prices above $3, making coal an economic alternative for utilities in some markets.
Indeed, as investors brace for an outlook shift in which met coal becomes the bigger industry risk and the prospect of stronger economics for thermal coal signal an upside opportunity, there may be little reason to move away from the beaten up shares of Peabody Energy
, Cloud Peak Energy
and Teck Resources
, which have outperformed peers including Alpha Natural Resources
and Arch Coal
. (In 2012, coal outperformance means a 25% drop or less, compared to 50%-plus declines for many industry giants.)
The likes of Peabody Energy and Cloud Peak may continue to outperform because of their operational efficiency and exposure to more economic coal basins, notes Haberlin.
Bankruptcy risk hasn't left the coal landscape. After Patriot Coal's recent bankruptcy, Haberlin highlights James River
as possibly the most at-risk company in the sector because of its high cost structure. However, the company also has nearly $200 million in cash and thermal coal contracts through 2013 that may outreturn extraction costs.
"Aside from JRCC, the remaining companies in our coverage universe are not faced with significant bankruptcy risks over the next several quarters," wrote Haberlin in a note to clients.
The prospect of slowing growth in China and lower steel demand removing the largest marginal buyer of met coal has Haberlin more concerned. Haberlin and other coal analysts recently cut earnings expectations throughout the sector. Nevertheless, investors may still focus on whether companies revise met coal guidance -- of if earnings will slump faster than expectations.
"Into earnings we think estimates are too generous for more met-focused Alpha Natural Resources and Walter Energy and too tough for Consol Energy
, given its restart of higher profit low-vol met coal production at Buchanan," wrote Bank of America Merrill Lynch analyst Timna Tanners in a July 17 earnings outlook.
"Despite near-term met concerns, we remain convinced that the market remains robust longer term given limited supply globally and high production costs," adds Tanners.
Benchmark met coal prices rebounded from $210/metric ton in the second quarter to $225/mt in the third quarter, according to Haberlin's report. However, prices are now likely headed lower due to increased supply, declining global steel production, and a slower global macro environment, the Davenport analyst wrote in his July 18 earnings outlook. Haberlin recommends buying Peabody Energy shares after he cut its 2012 earnings per share estimate and noted the prospect of a $150 million Patriot Coal-related loss.
Met coal exports within UBS analysts' coverage increased roughly 12% in June and thermal exports were up 287%. Year-to-date, UBS analysts also note that thermal exports are up 16%, with shipments to China and India up 97% and 63%, respectively. Interestingly, it was now-bankrupt Patriot Coal which has led the way with an 86% increase in coal exports, the UBS analysts noted.
In spite of Patriot's July 9 bankruptcy, Raymond James
analyst Jim Rollyson has a view of coal stocks that implies bankruptcy is not a legitimate near-term risk for most of the major players and may unduly scare investors off opportunity.
"I think the stocks are factoring in quite a bit lower outlook than we are expecting," Rollyson said. He expects Cloud Peak to come out of earnings relatively unscathed and sees the prospect for optimistic commentary from James River and Alpha Natural Resources that could drive shares higher.
"A lot of balance sheets are more stressed," concedes Rollyson, especially since Alpha Natural Resources and Arch Coal made recent large acquisitions. However, in spite of a weak earnings outlook and high leverage ratios, Rollyson notes that many struggling players have pushed debt maturities past 2012 and 2013 through refinancing. "If you look at the group as a whole, most of these guys don't have meaningful debt due until 2015," says Rollyson.
Rollyson even sees a silver lining for James River -- the company he too highlights as the one with the most bankruptcy risk in the sector: "I suspect they have more staying power than people think."
Following Patriot Coal's July 9 bankruptcy filing, BMO Capital Markets analyst Meredith Bandy cut the ratings of many coal sector players, while highlighting that not all operators and basins can't be judged equally.
In fact, as analysts expect thermal coal to rebound, stock performance will be dependent on the basins to which thermal coal players are exposed.
"The Powder River Basin, with some of the largest surface mines in the world, has economies of scale to compete with natural gas below US$3.00/mmBtu," noted Bandy in a July 16 note that highlighted Cloud Peak, Peabody Energy and Teck Resources as thermal coal-exposed players with the balance sheets, margins and valuations to withstand sector headwinds.
"The Appalachian basin is an aging basin facing rising strip ratios, deeper and thinner seam mines and a rising cost structure. Appalachia needs above US$4.00/mmBtu natural gas prices to compete," wrote Bandy, who downgraded regional giants like Arch Coal and Alpha Natural Resources to underperform on falling margins and stretched balance sheets. "Expected closures in Appalachia may also make servicing debt increasingly difficult," Bandy cautioned.
In addition to natural gas switching by utilities, thermal coal miners are struggling with new emissions-based regulations, which alongside better economics for natural gas led to the lowest use of coal-based energy since 1988, according to first quarter Energy Information Administration
data. It was this factor, in addition to a concentration to uneconomic coal basins in Appalachia, which drove Patriot Coal into bankruptcy.
In announcing its bankruptcy, Patriot Coal CEO Irl Engelhardt characterized those challenges as part of an industry-wide transformation. "The coal industry is undergoing a major transformation and Patriot's existing capital structure prevents it from making the necessary adjustments to achieve long-term success," said Engelhardt in a statement explaining the bankruptcy filing.
The expected outperformance of Peabody, a St. Louis-based company with a history that traces back to the late 19th century, should be taken as a context of the wider woes of the coal sector and some potential bright spots if commodity prices continue to recover.
For instance, in spinning off its longstanding operations in West Virginia and Kentucky into Patriot Coal
, Peabody has continued to tilt its asset base to Australian met coal and the Powder River Basin.
In a late May reappraisal of the coal industry, Goldman Sachs
raised its outlook for the sector to attractive from neutral, and highlighted Peabody as its only new buy-rated coal company.
"We have a less favorable view of the most CAPP thermal- and US metcoal-focused producers within our coverage," wrote Andre Benjamin in the May 28 note that cited valuations, regulatory pressures and leveraged balance sheets as concerns for U.S. centric players.
For more on the sector's troubles, see why old king coal is headed to the retirement home. See 8 ways to play stocks in risky global markets for more on energy investment ideas.
-- Written by Antoine Gara in New York
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