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3 Coal Stocks: Buy, Sell or Hold? - 10340 views
MINNEAPOLIS (Stockpickr) -- One of my top-performing picks from last year was Patriot Coal (PCX). This mid-size U.S.-based coal operation gained 25% in 2010. Impressive as that may be, the stock did not really gain any steam until the last three months or so of trading. In fact, shares had been in negative territory when that explosive rally began in September.
The gains for Patriot in recent months mirror the gains for the sector. From September to the end of 2010, Patriot shares approximately doubled in value and kept on going right through the first month of 2011. After peaking at $29 per share, Patriot took a step back on Feb. 3 after it was announced that its largest stakeholder, Arclight Capital, had liquidated its 12% position in the company.
In addition to the action in Patriot Coal, the sector received another piece of news with the announcement that Alpha Natural Resources (ANR) was buying troubled mining operator Massey Energy (MEE). The $7 billion deal allowed Alpha Natural to surpass bidding from other players, possibly including Arch Coal (ACI) and Arcelor Mittal (MT) and represented a 21% premium over current market prices.
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The deal changes the landscape somewhat in the coal industry. Alpha now becomes a bigger player in the industry, including a one-third control over the U.S metallurgical coal business. This may or may not be enough power to attract the attention of antitrust regulators.
At a minimum, the industry is in somewhat of a hyper-state of activity. Stocks are exploding higher, deals are generating premium offers, and the global economy is growing. Add in inflation concerns and you have the recipe for stocks that seem to be moving in only one direction: higher.
Of course, no stock moves higher in perpetuity. These things tend to move in cycles. Depending on your view, we could be at the beginning, middle or end of the current cycle. Ultimately, valuation is what should matter when evaluating coal stocks.
Let’s take a look at three names in the industry .
Given the explosive move at the end of 2010, I chose to not include Patriot Coal in my list of Top Stocks for 2011. That decision does not necessarily mean there will not be further gains for the stock this year. It simply means that I found more compelling value elsewhere.
I clearly made a mistake in the short term, as Patriot Coal jumped some 50% before settling back a bit on Feb. 3. The big gains completely change the valuation picture for the company. Perhaps that is why stakeholder Arclight Capital decided to sell its position.
After a year of heavy losses, Analysts expect Patriot to be profitable in 2011. The current estimate is for the company to make 50 cents per share. More important, the expectation is for profits to jump to $2.31 a share in 2012.
At the current price of about $25.50 per share, Patriot trades for 51 times 2011 estimates but only 11 times 2012 estimates. With such a drastic change in operating performance, investors should not rely too heavily on analyst estimates. They are likely to be wrong.
Typically when earnings are growing, estimates tend to be too conservative. The company would have to do somewhat better than the 50-cents-per-share estimate this year to make the stock compelling at current levels. That may or may not happen.
I would be cautious with Patriot, especially in light of the Arclight sale. Large shareholders usually have a pretty good idea of what is happening on the front lines and the sale may indeed signal a rougher road ahead.
Like Patriot Coal, Arch Coal has been on the same kind of tear. Shares have added more than 50% in market capitalization since last September. The gains for Arch have been more consistent than Patriot and not quite as volatile.
While Arch may have been interested in acquiring Massey Energy, losing out on that opportunity may be a positive for the company. The Massey acquisition was no doubt expensive for Alpha Natural, and it remains to be seen if the deal will be accretive to earnings.
Arch is poised to prosper during the current economic expansion. It's is on track to make a profit of $1.11 a share for the year ended Dec. 31, 2010. Analysts expect the company to more than double that result to $2.56 per share in 2011.
Investors can buy that potential doubling of profits in the current year by paying 30 times 2010 earnings and 13 times 2011 estimates. That seems to be on the low end of where shares should be trading given the growth expectation.
If one assumes that we are still in the early stages of recovery, investors in Arch Coal should do relatively well in the next year or two. The only real risk is that the company may not meet expectations if economic growth stumbles.
At this point, I think those are reasonable risks to take. I would buy Arch Coal.
James River Coal
So far we have looked at two of the bigger coal companies. But what about the smaller players?
Certainly the industry may want to consolidate, but the market instead is focusing on the competitive landscape of the industry given the Alpha transaction. Smaller companies might be getting squeezed by the bigger players selling coal at lower prices. Shares of James River Coal (JRCC) have dropped in the trading days since the Massey deal was announced.
Selling may just be legitimate profit-taking. James River shares have moved in tandem with the rest of the industry since September and are looking a bit expensive given profit estimates. Wall Street expects the company to make $2.17 a share for the year just ended in December but only $2.19 a share in the next year.
At a current stock price of $21.50, James River trades for 10 times 2010 estimates and 10 times 2011 estimates. Given that minimal growth is projected, the current valuation appears fair.
James River is a hold at these prices. The possibility of an acquisition may result in shares trading higher. In addition, a stronger economy may result in current estimates being too low. With a 10 times earnings valuation, investors are protected on the downside.
To see these stocks in action, visit the Coal Stocks: Buy, Sell or Hold? portfolio.
-- Written by Jamie Dlugosch in Minneapolis.
At the time of publication, author had no positions in stocks mentioned.
Jamie Dlugosch is a founder and contributor to MainStreet Investor and MainStreet Accredited Investor. Formerly, he was president and CEO of Al Frank Asset Management. He has contributed editorially to The Rational Investor, The Prudent Speculator, Penny Stock Winners and InvestorPlace Media.