Morningstar
submits:
By Michael Tian
Our universe of coal stocks has come down between 10% and 20%
since we last discussed these names back in March. Oil and natural
gas prices have come off of their rallies induced by the Japan
disaster and Arab revolt, a deflation which spilled over into coal
prices. Plus, demand in the United States has been weak, a
situation that higher export volumes couldn't overcome. However,
this short-term blip hasn't dented coal companies' enthusiasm.
Uniformly, industry management has been very bullish on the
long-term prospects for coal prices, with the term "super cycle"
brandished on more than one occasion.
At least one company recently has put its money where its mouth
is:
Arch Coal (
ACI
)
paid $3.4 billion to acquire
International Coal (
ICO
)
in early May. International Coal was one of the last sizable
independent Central Appalachian miners, and its former management
team previously had worked for Arch. This continues a strong
pattern of consolidation in the coal industry. The previous
mega-deal was when
Alpha Natural Resources (
ANR
)
snapped up
Massey Energy (MEE)
in late January. Both in the U.S. and internationally, several
deals have been consummated in recent months, mostly targeting
metallurgical coal. Another example is
Walter Energy's (
WLT
)
$3.3 billion purchase of Western Coal in December 2010.
If there's one thing these deals have in common, it's the
aggressive prices being paid. Typically, a rash of dealmaking is a
bearish indicator for commodity prices. When prices are high,
commodity producers generate a lot of profits, and it's easy to
foresee rosy times stretching as far as the eye can see. We saw a
similar slate of deals in 2007-08, which put the overstretched
acquirers under tremendous stress. Two examples are Teck Resources
(TCK) and Rio Tinto (RIO), which bought Fording Coal and Alcan,
respectively, for rich price tags. Teck's stock price cratered from
$50 per share to $3, and the company flirted with bankruptcy before
recovering back to $50 range today on a metallurgical coal
boom.
Buyer's Remorse?
While we don't foresee a second Great Financial Crisis, the
speed and prices at which deals are being done is certainly a
reason to be cautious when investing in coal. For example, Alpha
bought Massey for a mighty 17 times 2010 EBITDA. Granted, Massey
had a terrible 2010 and was mismanaged, but even assuming better
times ahead, the multiples are high considering that Massey
operates in a secularly declining basin and extremely cyclical
industry.
Arch was actually the runner-up in the heated bidding for
Massey. Perhaps to assuage its disappointment, it quickly
redeployed its funds into International Coal. Arch paid 11 times
International's stand-alone 2011 EBITDA, which would have been the
highest in the firm's history. International Coal's history was
checkered, having been cobbled together from a few bankrupt coal
companies in the early 2000s. In the five years ending in 2010, the
firm lost money in three and was chronically starved of capital.
Through a combination of skill and luck, it bootstrapped itself
into an impressive platform of expanding metallurgical coal output.
This fact made the company irresistible to Arch. We were impressed
with International's improving mine portfolio as well, but we think
the acquisition is priced optimistically and likely destroyed value
for Arch shareholders. The market apparently agrees: Arch is the
worst performing stock in our coal universe since the end of
April.
Alpha Natural already may be feeling some buyer's remorse. In
early May, with the ink barely dry on the merger agreement, Massey
lowered its 2011 guidance materially. Massey dropped its output
outlook by about 2.5 million tons and raised its cost guidance by
$5 per ton (implying all-time record costs). This was especially
alarming because Alpha's due-diligence team had expressed
confidence just a month earlier that Massey would hit its targets.
Not surprisingly, Alpha Natural has underperformed our coal
coverage universe since the deal was announced in January.
The number of available and digestible coal companies in the U.S
is steadily shrinking. In the U.S.,
James River (
JRCC
)
,
Patriot Coal (PCX)
, and
Cloud Peak (CLD)
are the only smallish, public miners remaining. We believe James
River is a poorly positioned coal miner, and an acquisition would
destroy value for any suitor. Cloud Peak is a very well-positioned
company, and likely would create value in the long run. However,
neither company has much (if any) metallurgical coal exposure,
which makes them less strategically attractive today. That said,
Central Appalachia is still dotted with smallish, private miners
and plots of coal reserves. In fact, James River just paid $475
million for a small private-equity-owned miner. Therefore, deals
likely will be struck in the next year as coal companies are full
of cash and optimism. Unfortunately, if recent history is any
guide, investors should be wary. Richly priced acquisitions are
more likely to be a cause to sell rather than to celebrate.
See also
Greek Crisis and Cheap Retailers
on seekingalpha.com