By Michael Tian
Our universe of coal stocks has come down between 10% and 20% since we last discussed these names back in March. Oil and natural gas prices have come off of their rallies induced by the Japan disaster and Arab revolt, a deflation which spilled over into coal prices. Plus, demand in the United States has been weak, a situation that higher export volumes couldn’t overcome. However, this short-term blip hasn’t dented coal companies’ enthusiasm. Uniformly, industry management has been very bullish on the long-term prospects for coal prices, with the term “super cycle” brandished on more than one occasion.
At least one company recently has put its money where its mouth is: Arch Coal (ACI) paid $3.4 billion to acquire International Coal (ICO) in early May. International Coal was one of the last sizable independent Central Appalachian miners, and its former management team previously had worked for Arch. This continues a strong pattern of consolidation in the coal industry. The previous mega-deal was when Alpha Natural Resources (ANR) snapped up Massey Energy (MEE) in late January. Both in the U.S. and internationally, several deals have been consummated in recent months, mostly targeting metallurgical coal. Another example is Walter Energy’s (WLT) $3.3 billion purchase of Western Coal in December 2010.
If there’s one thing these deals have in common, it’s the aggressive prices being paid. Typically, a rash of dealmaking is a bearish indicator for commodity prices. When prices are high, commodity producers generate a lot of profits, and it’s easy to foresee rosy times stretching as far as the eye can see. We saw a similar slate of deals in 2007-08, which put the overstretched acquirers under tremendous stress. Two examples are Teck Resources (TCK) and Rio Tinto (RIO), which bought Fording Coal and Alcan, respectively, for rich price tags. Teck’s stock price cratered from $50 per share to $3, and the company flirted with bankruptcy before recovering back to $50 range today on a metallurgical coal boom.
While we don’t foresee a second Great Financial Crisis, the speed and prices at which deals are being done is certainly a reason to be cautious when investing in coal. For example, Alpha bought Massey for a mighty 17 times 2010 EBITDA. Granted, Massey had a terrible 2010 and was mismanaged, but even assuming better times ahead, the multiples are high considering that Massey operates in a secularly declining basin and extremely cyclical industry.
Arch was actually the runner-up in the heated bidding for Massey. Perhaps to assuage its disappointment, it quickly redeployed its funds into International Coal. Arch paid 11 times International’s stand-alone 2011 EBITDA, which would have been the highest in the firm’s history. International Coal’s history was checkered, having been cobbled together from a few bankrupt coal companies in the early 2000s. In the five years ending in 2010, the firm lost money in three and was chronically starved of capital. Through a combination of skill and luck, it bootstrapped itself into an impressive platform of expanding metallurgical coal output. This fact made the company irresistible to Arch. We were impressed with International’s improving mine portfolio as well, but we think the acquisition is priced optimistically and likely destroyed value for Arch shareholders. The market apparently agrees: Arch is the worst performing stock in our coal universe since the end of April.
Alpha Natural already may be feeling some buyer’s remorse. In early May, with the ink barely dry on the merger agreement, Massey lowered its 2011 guidance materially. Massey dropped its output outlook by about 2.5 million tons and raised its cost guidance by $5 per ton (implying all-time record costs). This was especially alarming because Alpha’s due-diligence team had expressed confidence just a month earlier that Massey would hit its targets. Not surprisingly, Alpha Natural has underperformed our coal coverage universe since the deal was announced in January.
The number of available and digestible coal companies in the U.S is steadily shrinking. In the U.S., James River (JRCC), Patriot Coal (PCX), and Cloud Peak (CLD) are the only smallish, public miners remaining. We believe James River is a poorly positioned coal miner, and an acquisition would destroy value for any suitor. Cloud Peak is a very well-positioned company, and likely would create value in the long run. However, neither company has much (if any) metallurgical coal exposure, which makes them less strategically attractive today. That said, Central Appalachia is still dotted with smallish, private miners and plots of coal reserves. In fact, James River just paid $475 million for a small private-equity-owned miner. Therefore, deals likely will be struck in the next year as coal companies are full of cash and optimism. Unfortunately, if recent history is any guide, investors should be wary. Richly priced acquisitions are more likely to be a cause to sell rather than to celebrate.
