Arch Coal Inc (ACI), Alpha Natural Resources, Inc. (ANR): Finding the Right Company To Invest in This Industry

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Can a good management team turn things around?

Alpha Natural Resources, Inc. (NYSE:ANR)’ management deserves credit for controlling what they can (costs, production, and its selling, general, and administrative expenses). These company specific benefits are offset by current weak metallurgical coal prices that continue to be the main EBITDA driver for Alpha Natural Resources, Inc. (NYSE:ANR).

The company’s management deserves credit for improving the company-specific cost structure and aggressively closing higher-cost unprofitable assets. The remaining volumes and EBITDA remain significantly levered to metallurgical coal prices (i.e., an approximately $20/mt swing in met prices off of a $170/mt base translates to a nearly $400 million swing in EBITDA), which in turn will normalize at higher-than-current levels over time (due to industry-wide cost pressures.)

Accordingly, 2013 should mark the trough in earnings for Alpha Natural Resources, Inc. (NYSE:ANR), and the pricing level required to reach EBITDA that is necessary to justify buying the shares is more attainable than it is for some of the company’s closest coal peers. Barclays has set a price target of $11 based on the 6.0 times 2015 EBITDA estimate of $800 million. This translates to an upside of 55% from current levels!

Another well-run company that is not recommended as a buy

Cloud Peak Energy Inc. (NYSE:CLD) is another good, well-run company. Interestingly, this coal company hasn’t shed its market cap as fiercely as its peers that were mentioned above:

Contrary to popular belief, however, this does not make Cloud Energy immune to poor coal market conditions.

Cloud Peak Energy Inc. (NYSE:CLD)’s export thermal coal business, which generated outsized EBITDA contributions in 2012, is essentially unprofitable (currently) due to weak global coal prices. Meanwhile, even though natural gas prices are higher, excess capacity and limited “discipline” in the Powder River Basin will limit sustainable pricing power for at least the next two years. To this end, Cloud Peak Energy Inc. (NYSE:CLD) and other coal companies continue to lock in 2014 volumes before the expected recovery in price materializes. Currently, Cloud Peak Energy Inc. (NYSE:CLD) has sold approximately 6 million tons of 2014 PRB coal at an implied price of around $11/ton, which is not far from current cash costs of $10.37/ton.

The bottom line is that the “normalized” EBITDA for Cloud Peak Energy Inc. (NYSE:CLD) is meaningfully lower than the consensus expectations (i.e., approximately $250 million, vs. approximately $300 million based on 2014/2015 consensus.)

Final word

A secular decline in coal demand has been a nightmare for coal investors. To add fuel to the fire, met coal demand has also been declining which has made the outlook on stocks like Arch Coal Inc (NYSE:ACI) bearish. Some companies have been neutralizing the impact of declining prices by locking coal futures into 2014, however. Though this might help companies like Cloud Peak Energy Inc. (NYSE:CLD) to cover their operating costs, they will not add significantly to their EBITDA (and will hinder profitability if the coal markets improve before 2014.) In case of a revival, only well-managed companies like Alpha Natural Resources, Inc. (NYSE:ANR) will be able to benefit from rising met coal prices.

The article Finding the Right Company To Invest in This Industry originally appeared on Fool.com is written by Zain Abbas.

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