Peabody Energy Corporation (BTU), BHP Billiton Limited (ADR) (BHP): The Best Way to Play the Coal Rebound

Those who thought that coal was a fuel of the past are gravely mistaken. Natural gas may have replaced coal in the U.S, but rising energy demand in Asia is forcing countries like India, Japan and China to shift toward coal gasification technology. As a result, global coal demand is expected to grow at a rate of 17% over the next four years, which has revived hope for coal-mining companies like Peabody Energy Corporation (NYSE:BTU).

Why Peabody?

Due to the massive urbanization in China, power demand in the region has skyrocketed, which led to a 30% hike in the country’s quarterly coal imports. India also reported a 25% increase in quarterly coal imports amid its crippled domestic productions (and mining bans). India and China collectively account for 10.9% of Peabody Energy Corporation (NYSE:BTU)’s overall revenue, and their rapid shift toward coal gasification and rising steel production bodes well for the company.

Peabody Energy Corporation (NYSE:BTU)Peabody’s management expects annual steel production in the region to increase by 20% (CAGR) by 2017, which should significantly increase its share of revenue derived from Asia. However, the company is currently operating at a 55% utilization rate in the U.S, which allows it to meet rising coal demand without expanding its existing facilities.

Peabody Energy Corporation (NYSE:BTU) has been improving its balance sheet.  Last month, management announced that Peabody had reduced its operating costs in Australia by 10% due to greater productivity and increased efficiency at its PCI mines; it reported strong volumes from Wilpinjong and Millennium mines. Furthermore, its quarterly capital spending was down by 70% year-over-year, which, coupled with cost savings, allowed the company to report a quarterly EBITDA of $280 million, which was on the higher end of management’s estimates.

Moreover, Peabody Energy Corporation (NYSE:BTU) repaid $100 million of its debt in the previous quarter, and plans to repay an additional $100 million by the end of May, which brings its annual debt elimination to $600 million.

The company currently has total long-term debt amounting to $6.1 billion, with cash and cash equivalents of $558 million. Although Peabody Energy Corporation (NYSE:BTU) has done a fine job by reducing its overall debt by 8% this year, management remains focused on debt reduction.

A cautionary tale

But that doesn’t mean that all coal producers stand to benefit here. BHP Billiton Limited (ADR) (NYSE:BHP) is the world’s third-largest coal producer, but has been hammered lately due to its towering debt and poor financials. The company had around $200 million in net cash by the end of 2010, which turned into a net debt of $30.4 billion by the end of 2012. As of now, BHP Billiton has total long-term debt of $25.1 billion, which gobbles up $0.9 billion in annual interest expenses.

To repay its towering debt, the company plans to sell some assets, which could raise up to $25 billion. Its management hasn’t commented on the particulars of the sale, but it would be safe to assume that a divestiture could wipe off up to $2 billion of its annual earnings ($25 billion ÷ forward P/E of 13x).

Of course, this generalized model assumes an equal distribution (and valuation) of all its assets and businesses and their earnings. But even a 20% error rate on the model could reduce BHP Billiton Limited (ADR) (NYSE:BHP)’s net income by $1.4 billion, which accounts for 14.6% of its annual net income.

Another debt-ridden company is Arch Coal Inc (NYSE:ACI). Its long-term debt stands at $5.1 billion with a high debt/equity ratio of 185%. The company generates just $321 million in annual operating cash flow out of which $95 million must be paid in annual interest expenses. For comparative purposes, Peabody Energy Corporation (NYSE:BTU) generates around $1.5 billion in annual operating cash flow, while its annual interest expense equates to just $101.3 million.