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Wednesday, June 25, 2014 - 14:45

The Top Stock To Own In The 'War On Coal'

Wednesday, June 25, 2014 - 2:45pm

It looks like Barack Obama is crafting a legacy as the Climate Change President.

He has granted the Environmental Protection Agency new powers, and his administration has delayed TransCanada's (NYSE: TRP) Keystone XL pipeline project longer than most anyone expected.

The president rolled out his most sweeping policy yet this month, proposing that the EPA mandate a 30% reduction in carbon emissions from power plants by 2030. The EPA puts the cost of the new proposal as high as $8.8 billion but contends that savings to people's health would more than offset that expense.

This week, the U.S. Supreme Court upheld the EPA's power to regulate greenhouse gases. Applying the law would increase the number of emitters covered by the rules to more than 80,000 from fewer than 280 and could subject businesses to an average of up to $60,000 in increased costs. As Justice Antonin Scalia said, "The EPA is getting almost everything it wanted in this case."

The Death Of 'King Coal'?
According to the U.S. Energy Information Administration, coal was used to generate more than half the country's electricity as recently as 2005. The boom in natural gas production and regulations on emissions drove that percentage down to 37% in 2012 before rebounding to 39% over the past year.

The slide in coal usage has sent prices tumbling, which is painfully evident in a chart of publicly traded companies:

Yet despite the poor performance of coal producers recently and increased regulatory pressure, the death of coal may be greatly exaggerated.

Globally, the use of coal is growing faster than any other fuel, and the EIA projects that coal usage in U.S. electricity generation will stabilize around 40% over the long term. (My colleague Dave Goodboy examined these trends in a recent look at the industry.) Amid all the hype around the natural gas revolution, only 4.5% of America's coal-fired generating capacity has been shuttered or converted since 2009.

U.S. exports of coal to Europe jumped 26% in 2012 on a phase-out of nuclear power and more than 300 GW of coal-fired capacity is expected to be built by 2017, 90% of it in developing Asia. The IEA forecasts global coal demand will grow 65% over the next two decades.

I wouldn't advise rushing in to buy the whole industry on a potential rebound -- but one company has been able to weather the storm and has strong upside from here.

A Low-Cost Producer With Emerging-Market Upside
Electricity producers buy nearly 90% of U.S. coal, and price competition with natural gas has already stabilized as gas comes off historic lows.

Appalachian coal is still relatively expensive but coal from the Powder River Basin (PRB) and the Illinois Basin (ILB), where Peabody Energy (NYSE: BTU) has all of its U.S. operations, is profitable with natural gas above $3.25 per million BTU. The company's peers, Arch Coal (NYSE: ACI) and Alpha Natural Resources (NYSE: ANR), still have 20% and 46% of their reserves exposed to expensive Appalachian coal.

Approximately 70% of Peabody's operating profit comes from its U.S. operations, but the company has a strong position to take advantage of Asian growth. Its 2011 acquisition of Australian producer Macarthur Coal increased reserves in the region to 1.2 billion tons. Peabody has invested heavily in the region and extracted 35 million tons last year. Even with prices for metallurgical coal coming down across Asia, the Australian assets still generate significant profits for the company and provide exposure to long-term growth.

Shares of BTU trade for 0.7 times sales, in line with the industry average but well below the 1.5 times average multiple over the past five years. The company is expected to lose $0.70 a share this year but to turn a profit of $0.27 per share in 2015 on sales growth of 9.8%, to $7.4 billion.

Risks to Consider: Coal prices and shares of BTU will likely remain volatile through most of this year but have strong long-term potential from growth in energy demand.

Action to Take --> A new administration in 2016 could help improve sentiment for coal producers. Even with a stronger EPA, Peabody Energy is a "best of breed" company that represents a strong value play on rising coal demand. My price target of $22.27 a share is based on conservative sales growth of 5.3% to $7.1 billion and a price-to-sales ratio of 0.85 times. Even with that conservative estimate, shares offer 34% upside on top of the 2% dividend yield.

My colleague Dave Forest, the Chief Investment Strategist behind StreetAuthority's Junior Resource Advisory newsletter, has a plan to profit from the "War on Coal." To learn more about Dave's favorite picks in this industry -- including one little-known side play with nearly 80% upside -- follow this link.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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