Peabody, Alpha, Arch: What’s the Best Investment in the Coal Industry?

Arch Coal Inc (ACI)Arch Coal Inc (NYSE:ACI), the U.S.’s second largest coal producer, accounts for 15% of total American coal production. The company was up 10% last week on better than expected 3Q earnings, with EPS up over 200% on the back of lower production costs and better than expected coal prices.

The expected increase in natural gas prices should bode well for coal stocks in the future, as power generation companies switch back to coal, after having switched to lower priced natural gas. The fallout from Hurricane Sandy will also be interesting for potential price movements in natural gas. Additionally, a more normalized winter – colder temperatures – should also boost coal demand. Longer-term demand should be driven by growth internationally, namely from developing countries. Also, earlier this month, coal stocks saw a stock pop after Republican Presidential candidate Mitt Romney spoke favorably of the coal industry during the presidential debate.

Arch Coal’s most notable competitor is the world’s largest publicly traded coal company, Peabody Energy Corporation (NYSE:BTU). The company’s recent earnings announcement put continuing operations EPS at $0.51, beating estimates of $0.28. Peabody also improved its outlook based on positive coal demand in China and Europe, and a decline in U.S. coal stockpiles. Following the announcement, Peabody saw investment firm Brean Murray reiterate its hold rating with an improved outlook on 4Q EPS.

Other notable Arch Coal competitors include Alpha Natural Resources, Inc. (NYSE:ANR), Alliance Resource Partners, L.P. (NASDAQ:ARLP) and Walter Energy, Inc. (NYSE:WLT). Alpha Natural is the third largest coal producer in the U.S. The company’s 2011 purchase of Massey Energy helped drive its 2011 revenue up 81% from 2010, but sales for 2012 are only expected to be up 3%. The company also expects to see tightening margins due to continued integration of Massey. The company also has an overhang from the Massey mining tragedy, where Alpha recently paid $209 million to settle government claims.

Walter Energy reiterated earlier this month that it expects to meet coal production for 3Q, which would be up 14% from 2Q. The company’s 2Q results for EPS came in at $0.51, down drastically from $1.83 the same quarter last year. However, the company plans to reduce 2012 CapEx in an effort to hedge possible coal demand slowdowns. We see this as a negative for the company, given the poor positioning it will be in should coal demand rise faster than expected.

Alliance’s 3Q results showed income at $61 million, versus $104 million for the same quarter last year. However, production was up to 9 million tons, compared to 7.6 million in 2Q 2011. The company cited a $24 million loss on shut down of a Kentucky mine due to equipment failure as a result of the wider-than-expected loss. Alliance pays the highest dividend by far at a 6.7% yield, yet the company also saw some of the weakest interest from fund managers. As well, Walter Energy saw poor fund interest. Alliance called notable investor Jim Simons a shareholder during 2Q, but with only a small number of shares. Meanwhile, Walter Energy had Steven Cohen as an investor, but Cohen reduced his 1Q stake 50% during 2Q.

Some of the most robust interest was in Arch Coal. While Peabody and Alpha Natural saw interest from notables Jim Simons and D.E. Shaw, respectively, Arch Coal saw the former take a new stake during 2Q. Ken Griffin also upped his stake almost 100%; check out all funds that are interested in Arch Coal.

When trying to figure out the best company to play a possible pop in coal demand, our favorite is Arch Coal. The company saw positive liquidity boosts in 3Q, upping its liquidity position to $1 billion, compared to $860 million in 2Q. As well, the company has no significant debt maturities until 2016. Following Arch Coal’s earnings announcement, S&P upped its price target to $9.00, whereas its stock currently trades around the $8.00 mark.

Although both Arch and Alpha have incalculable P/E ratios, each trades well below the other peers on a P/S basis at 0.4x and 0.3x, versus the peer average of 1.1x. We see the Massey overhang as a reason to avoid the Alpha for now. As well, we believe that Peabody being the leading market provider for coal has attracted too much interest and made the valuation unattractive, unlike the underappreciated Arch Coal.