denizbayram
investment thesis
Peabody Energy (NYSE:BTU) is a very attractive investment in terms of valuation. That being said, since I wrote about Peabody last month, a lot has changed. And frustratingly not for the better.
Here I address the recent impact of natural gas prices in the coal industry.
And so I think that although this is unpleasant news, the case of the bull is still intact.
What is happening right now?
Natural gas has tumbled in recent days. More specifically, at one point last month, natural gas prices fell 40%.
Remember, about 50% of Peabody’s prospects are tied to thermal coal. With the rest tied up in metallurgical coal. That is the coal that is used in the production of steel.
However, the problem for Peabody is that thermal coal had been extremely profitable for Peabody in 2022. In fact, Australian thermal coal has allegedly benefited from a very strong thermal market in 2022.
But now that US natural gas prices have fallen so substantially, US natural gas prices will compete with offshore thermal coal.
To be clear, there’s a bit more to the story than this. After all, it’s not just that natural gas prices are cheap and, in many cases, an alternative to thermal coal.
But companies also need to convert natural gas into Liquefied Natural Gas (“LNG“) and export it to desired locations, adding to the final price of natural gas. Not to mention the cost of producing and transporting the coal, as well as the cost of extracting and delivering the natural gas.
Simply put, it’s not always a straightforward formula. On the other hand, very roughly, when natural gas prices fall below $4 mmbtu, it can sometimes be advantageous to rely on natural gas instead of coal for power use.
This comes at a high cost, particularly at this time, as the tankers are already very busy. And this again reinforces my point that it is not a simple story. There are many nuances affecting Peabody’s ultimate prospects in 2023.
With that being said, this is my opinion, the outlook for 2023 for Peabody is not as bright as it seemed when we came out of 2022.
But does Peabody’s valuation already take more than this into account?
Stock Valuation in BTU — Free Cash Flow 3x 2023
This is where the story gets even more complicated. For one thing, Peabody is expected to generate around $1.5 billion of free cash flow in 2023. This puts its stock at about 3 times its free cash flow.
And of course, that’s dirt cheap compared to just about everything else on the broad stock market. In fact, to my knowledge, there is no other sector in the market that is as low in price as coal.
On the other hand, if natural gas prices were to remain low for a considerable period of time, many power plants that were forced to use thermal coal as their primary energy source in 2022 might be in a position to reconsider their stance.
What other catalyst is Peabody up against?
Peabody’s balance sheet has a restrictive liability of $550 million. This has meant that while many other coal companies have been able to return capital to shareholders in 2022, Peabody has not.
The thesis here is that coal is supposed to be a “dead” industry. That means many coal companies are intent on returning capital to shareholders.
Or put another way, there is a general view that I disagree with, but there is a view that the use of coal will vanish substantially by 2030. With the prerogative of the UK being more aggressive and seeking to reduce its reliance on coal . by 50% from 2025.
Even if I think these goals are more ambitious than set in stone, the fact remains that there is a huge amount of energy and capital resources going into reducing power plants’ reliance on coal.
The bottom line
Here’s the rundown, the Peabody prospect has developed some problems in the last month. However, I maintain that paying 3 times this year’s free cash flows is still very attractive.
Also, I suspect that at some point in 2023, Peabody’s restrictive debt covenant could be addressed, which means Peabody will be able to increase its return of capital program.