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Reevaluating Coal

by: Hard Assets Investor August 21, 2008 | about stocks: ACI / KOL    
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By Julian Murdoch

A while ago, energy and energy stocks were the hottest thing since Google. But that bubble may have burst - or has it?

We've been harping enough about the downturn in oil prices recently; instead, let's take a look at the other black gold, coal, and in particular, one U.S. company - Arch Coal (ACI).

Step into my time machine...

A year ago, Arch Coal's stock price was sitting around $30. The company was plugging along, doing its thing, mining coal and making money. Energy prices (aka our friend crude oil) started rising and coal headed along for the ride. It didn't hurt that global coal demand was increasing (thanks China!) while supply was tightening. Supply, demand ... not surprisingly, coal got a bit more expensive, with the priciest Northern Appalachian coal running from under $50/ton to over $150/ton in less than a year.

 

Chart: Coal supply & demand by date

Source: DOE Coal News and Markets

 

The stock market noticed, and by June 9, ACI's stock hit its high of $75.44.

Since then, however, things haven't been as rosy.

Chart: Arch Coal

 The pullback that began in July has continued into August, wiping out most of this year's gains. Even the second-quarter report of tripled earnings wasn't enough to do more than briefly bump the price up. (Granted the bump was 10% - nice if you got the timing right. But it didn't erase the summer tumble in the share price.)

It's Tough All Over

Van Eck launched their Market Vectors Coal ETF (KOL) on Jan. 10, 2008. Since it tracks the Stowe Coal Index - an index of coal miners and related companies - it's as good a barometer for the industry as any.

Chart: KOL activity

During the time period covered by the ETF, Arch Coal's stock is up 19%, while KOL is up less than 1%. In other words, Arch has been a bit of a golden child in the industry. But since Arch Coal hit its high on June 9, KOL has dropped 27% and ACI is down 37%. That's quite a slide in just a couple of months.

Given that I wrote about coal last month, when the bloom was just coming off the rose, I thought it worth taking a deeper look at Arch and seeing what the deal is here. Here's a little "what the heck" checklist for dealing with a big drop.

 

Has there been a drastic change in management?

No, though the CFO announced his retirement in April and two new VPs were promoted in August

Has there been a catastrophic event?

Nope

Poor earnings?

Hah!

Has the company screwed up somehow?

Not that I can see, but I'm never one to claim I have all the facts.

Has there been a change in how the market views the company?

Possibly. Analysts have been pushing their ratings around as the price changes.

Has there been a change in how the market views the sector?

Admittedly this is the big final bucket, but all signs point to yes.

 

Back at the turn of the millennium, that ugly time when so much of the tech market got cut in half, pundits were fond of talking about "rationality." The premise was that there is a "right" price for a stock: one that represents not just the market price, but the company's core business and its growth prospects. The shorthand most often used for this is P/E - after all, it's the best way we have of gauging a company's business performance relative to its price. It's Investing 101: A high P/E means the market thinks growth prospects are relatively high compared to recent earnings, and a low P/E means growth prospects are relatively stagnant. That's what gave tech stocks ridiculous P/Es and what keeps slow-growth, old-economy so low.

So what's happened with Arch? The chart below shows the stock price on top and the P/E ratio on the bottom.

 

Chart: Arch Coal stock prices & P/E

 

Obviously the P/E of the company has reverted back to a "normal" expectation in the 20s. Note that this is still pretty high-flying for something as boring as a coal miner. There's no industry segment that has an average P/E over 30, and the P/E for Materials in general is about 18. So how sustainable was a P/E of 50 anyway?

It's not that the market is looking at ACI and saying it is a bad company - it isn't. Arch Coal is doing exactly what it should be doing, expanding capacity with relatively cheap debt, delivering on its promises, negotiating well. But the market has been signaling that it doesn't think Arch, or the sector, can continue to sustain the same earnings growth that we've seen in the past year.

It's saying this was a (let's say it quietly) bubble.

Does the market have it right?

It depends on your read of the sector. High oil prices have supported numerous plans to reduce the U.S.' dependence on oil (Pickens, Gore, Grove). And though environmentalists shudder to think of it, electricity (which ends up meaning coal in the short term at least) remains part of the equation, at least for now.

Global demand for coal for electrical generation and industrial use continues to look favorable. Supply is still tight and many countries are switching from being self-sufficient in coal to becoming net importers, or just upping their imports. Coal prices are still at record highs.

The question is: Do you believe there is still room for coal prices to go higher?

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This article has 9 comments:

  •  
    Aug 21 01:30 PM
    Well written. These things are definitely due for a bounce.
    Reply
  •  
    Aug 21 02:00 PM
    Given GS's reaffirmance of $149.00 oil by year end, I very much believe ACI will be flying high once again. GS knows what they are doing and ALWAYS walks the walk.
    Reply
  •  
    Aug 21 02:14 PM
    Good points. While it will be a waste of time to make yet another prediction about where oil and coal prices are headed I am willing to assume that the recent selloff was over-correction for the industry. While the dollar is falling and demand from developing countries is up coal is king
    Reply
  •  
    Aug 21 02:17 PM
    Just wanted to point out that most coal is sold under contracts for future delivery and that prices (and earnings) are probably locked in through at least 2009. I agree that a P/E of 50 is not sustainable, but future earnings should continue to be high even if the supply and demand balance eases this year.
    Reply
  •  
    Aug 21 03:07 PM
    the average estimate for next year is over $6 so when ACI hits 60 bucks the forward p/e will be 10...right now its 57 so the forward P/E is under 10.

    whats all the talk about 20 and 50 P/E's ?
    Reply
  •  
    Aug 21 07:26 PM
    P/E's and fair value should be spoken about with respect to their growth....

    and as stvcomment or a look at their PEG ratio...a measly .44 means this sucker is underpriced and going higher.

    I don't see coal prices drastically decreasing anytime soon (next few yrs) in fact, peak exports of oil and the introduction of electric cars by 2010 could have robust pricing for a very long time.
    Reply
  •  
    Aug 22 08:07 AM
    Looking at the chart of ACI there appears to a short term trend breakdown at around the $70 level late June/July, the rest is stories or what you want to believe
    Reply
  •  
    Aug 22 09:53 AM
    globally coal is in short supply: high demand. that would be both metallurgical and thermal coal. in asia many countries are putting high export tariffs on coal to discourage 'in-house' miners from selling abroad where prices are sky high. the shortages of thermal coal in china are nearly desperate now but i see that changing post olympics. by the way how about those swell womens' volley ball togs. anyway coal is booming and despite predicted bric slowdowns it'll continue to do so. but will the revenues and earnings justify high p/e? a great company can still be over valued by the market can't it? or maybe it's a sector swing with money flowing into one and out of another and back again.
    Reply
  •  
    Aug 22 10:07 AM
    Coal production may have peaked in New Mexico in 2005 ... UNLESS Desert Rock is brought on-line.

    www.prosefights.org/co...


    Reply
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