The best opportunities arise when there is a "divergence from
the consensus." This phrase often refers to analysts'
forecasts, and the wide range of estimates spells opportunity if
you know on which side of the fence to land.
Yet there is another type of consensus that can
opportunities -- when most individual investors have concluded that
a particular industry is headed for good or bad times. That's when
it's often smart to go against the crowd.
Indeed, I think I've found that both of these opportunities when it
comes to a particularly "hated"
Increasingly strict environmental regulations coupled with a plunge
in natural gas prices have left many to believe that it has no
future. Yet there are more than a few
price targets for a few key players in this industry.
When I see the two scenarios I mentioned above (varying opinions
among analysts and a feeling among investors that the stocks are
"no good") -- it's time to dig deeper.
And this is exactly what appears to be the case with coal stocks.
Why even bother?
Market Vectors Coal ETF (
, which is an
exchange-traded fund (ETF)
that owns a wide range of global coal-mining firms and the
companies that provide equipment to the industry, has slid sharply
in the past year. Remarkably, this ETF understates the pain, as it
holds a range of China-based coal-mining firms that have held up
well in 2012: U.S.-based coal-mining firms have fallen even more
dramatically in some cases than this ETF implies.
On this instance, I used to with the consensus. I also used to
wonder why investors would even bother with an industry that faces
so many long-term challenges.
Then a funny thing happened...
Several investment professionals I know (and respect) all started
to ask me the same question in my regular one-on-one conversations
"What do you think about coal?"
After my indifferent answer, each explained that they thought this
beaten-down sector now provides a great opportunity, and to various
degrees, they were putting their own money into coal.
Are they crazy? The more I dug into the issue, the more I realized
they were on to something.
After taking a deeper look at coal, I'm now inclined to agree with
my colleagues. It's a risky, and not worthy of a huge investment,
but coal stocks actually now appear to have more upside than
Let me explain...
The pain of C2G
In recent months, the steady and profound drop in natural gas
prices has accelerated a process that some saw as inevitable: Any
power utility that could operate on either coal or gas has switched
to gas, known as the C2G conversion, is now doing so.
Since just the start of the year, industry projections for demand
of coal have fallen by about 8% to about 850 million tons. And the
pain hasn't ended. The process by some estimates is only 85%
complete, meaning another 15% of the nation's power plants that
have yet to make the C2G move will do so during the next few years.
Adding insult, the relatively mild winter in much of the United
States led to weak secular demand for coal, and it would take an
especially hot summer for inventories to be whittled down and
The segment of the industry that was hit the hardest is what is
known as Appalachian Thermal coal, which is used by many
mid-western power plants. That should have an especially hard
Arch Coal (
, according to Goldman Sachs. They rate the stock a "sell," and
earnings per share (EPS)
of $0.51 in 2012, below the $0.60 consensus forecast. Companies
with heavy exposure to the Powder River Basin, located in Montana
and Wyoming, are also likely to suffer from the falling demand for
From thermal to met
Against such a bleak backdrop, some analysts are noting that coal
miners producing metallurgical coal (or "Met coal" which is used in
heat-intensive applications such as steel production), should fare
better in coming quarters, and are still well-positioned to
. Not only will this type of coal see better demand in this country
and in exports markets such as China, but it's not quite as
abundant as thermal coal, so supply is unlikely to overwhelm the
These 3 coal stocks may be worth a small
Merrill Lynch, which recently initiated coverage on the entire
industry, notes that
Walter Energy (
Alpha Natural Resources (
-- both of which have a "buy" rating -- are seen as solid met-coal
Peabody Energy (
, also with a "buy" rating, may be overlooked by the crowd, the
adds. Peabody paid more than $5 billion in late 2011 to acquire
Australia's MacArthur Coal and is now a leading coal provider to
Notably, all three of these "buy"-rated stocks are down more than
50% in the past 12 months. More to the point, each trades for less
than 4.5 times projected 2012
, and subsequent levels of EBITDA should move higher as demand from
the steel industry and China continues to build.
Merrill considers Peabody to be a top pick of these three, with
expected to ramp to $2.85 in 2012, $3.90 in 2013 and $4.60 in 2014.
is nearly 25% above current levels.
Analysts at UBS concur with Merrill Lynch's relatively bullish
outlook for met-coal producers, especially as these companies have
shown a willingness to cut output to help bolster pricing, which
they expect to remain around $210 per thousand tons of coal. And
they say there is still a solid cushion in place if industry
conditions worsen and prices unexpectedly drop further. They figure
Natural and Peabody would all still generate solid
free cash flow
even if pricing fell to $175 per thousand tons.
While Merrill slightly favors Peabody, UBS gives the top nod to
Walter Energy and Alpha Natural. It sees Walter trading up from a
recent $65 to $85, noting it has only limited exposure to thermal
coal. Alpha Natural has nearly 75% upside to UBS' $28 price target,
since the company is cash-rich (fueling a $100 million quarterly
stock buyback) and sports a double-digit free cash-flow yield.
If there is such a thing as a "consensus pick" in an industry where
most investors are steering clear, then it would indeed be Alpha
Natural Resources. Brean Murray also saysshares are quite oversold,
though it carries a more conservative $25 price target. The
analysts note that the company's recent production cuts were at
Alpha's highest cost mines, which weren't very profitable anyway,
so forward profit forecasts have largely stayed intact.
Risks to Consider:
China remains an active buyer of met coal in foreign markets,
while global steel producers are also big users of this energy
source. Continued health among those markets is essential for these
stocks to start moving back higher.
Action to Take -->
Commodity stocks typicallyoffer several entry and exit points
throughout an economic cycle. The sharp sell-off in coal stocks
a solid rebound of 25% or more, even as these stocks are unlikely
to revisit their 2011 highs any time soon.
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-- David Sterman
David Sterman 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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