Stock Quotes in this Article: ACI, ANR, BTU, CNX

NEW YORK (Stockpickr) -- Roughly a decade ago, gutsy investors were able to profit from the “tobacco trade,” snapping up tobacco stocks even as the long-term picture grew more challenging. These investors knew that the tobacco stocks still posted hefty cash flows -- and sported impressive dividend yields -- despite the social stigma against them.

Well, the “tobacco trade” is back on, though this time around, it’s called “the coal trade.” Coal-mining stocks are being shunned as investors focus more squarely on oil and gas stocks. Yet the sector valuations are stunning. And unlike tobacco, which may one day be legislated out of existence, coal isn’t going anywhere. Case in point: China builds a new coal-fired power plant every week.

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    More to the point, you want to invest in coal stocks when demand exceeds supply, as reflected by coal inventories. As analysts at Sterne Agee recently noted: “Despite tepid electricity generation, very competitive natural gas prices, and a high level of uncertainty regarding the eventual net coal-fired plant retirement, user inventories have been declining. Our supply demand forecast through 2013 suggests further pressures on stockpiles, a continued mix shift in Btu consumptions and cyclical pricing for U.S. thermal and metallurgical coals.”

    The key for investors is to focus on the best values in the group. Here are four names that you should be focusing on, if you have the temerity to pursue “the coal trade.”

     

    Arch Coal

    Arch Coal (ACI) has fallen by half since May, largely due to a pair of weaker-than-expected quarters. Yet the outlook for 2012 remains quite bright, thanks to Arch Coal’s increasing exposure to the low-cost Powder River Basin and to a switch toward metallurgical coal, which is more highly valued for its ability to power high-temperature steel-making furnaces.

    The enhanced exposure to met coal is the result of an acquisition of International Coal earlier in 2011. The PRB exposure should also help, where spot prices have already rebounded from $10 per ton in the summer of 2009 to a recent $14.30.

    On its recent conference call, Arch Coal’s management ran through a series of recently signed contracts for coal delivery in 2012, leading analysts to more clearly analyze 2012 profit forecasts. Right now, analysts think that EPS can more than double in 2012 to around $2.60. Shares trade for just eight times that figure.

    Looked at another way, the entire company (as reflected by enterprise value) is worth less than four times projected 2012 EBITDA. This will never be a high-multiple stock, but it’s fair to expect shares to trade back to five or six times projected 2012 EBITDA (which should exceed $1 billion), highlighting potential 25% to 50% upside.

    As of the most recently reported period, Arch Coal is one of the top holdings at Moore Capital.

    Alpha Natural Resources

    The fact that Alpha Natural Resources (ANR) has moved from $16 to $26 in just a month is surely impressive -- until you realize that it traded for $60 back in the spring. Concerns that a slowing global economy would crimp demand for Alpha, the nation’s leading coal exporter, now appear over-stated, hence the recent stock rebound. Yet shares still have plenty more upside, as Alpha generates steadily improving results after digesting the June 2011 acquisition of Massey Energy.

    That acquisition caps off a series of deals in the last decade that has made Alpha Natural into an industry powerhouse. Sales rose from $444 million in 2004 to $3.9 billion in 2010, and they should top $8 billion next year (thanks in large part to the Massey purchase). The company is now the third-largest producer of metallurgical coal in the world, behind BHP Billiton (BHP) and Teck Resources (TCK).

    Alpha’s increased heft and low cost structure are turning it into a cash cow. The company is on track to generate more than $750 million in free cash flow in 2012 and again in 2013, assuming coal prices stay at current levels. As a result, the company is buying back stock ($600 million remains on the current authorization that expires in 2014). A move to reinstate a dividend, which was suspended in 2006, may come next. Trading at just 3.5 times projected 2012 EBITDA, this stock looks to have 40% to 60% upside.

    Alpha, which as of the end of September was one of the 10 worst-performing S&P 500 stocks of the year, was one of the 10 best-performing stocks during October's rally.

    Peabody Coal

    Peabody Coal (BTU) is a high-risk/high-reward play, thanks to a soon-to-close acquisition of Australia-based MacArthur Coal. Peabody got into a bidding war for MacArthur with steel-maker Arcelor Mittal (MT) -- and ultimately prevailed. The $5 billion purchase price is surely steep, and debt-to-capital is set to soar form the low 30’s into the mid-50’s, but the acquisition could fuel robust profit growth in 2013 and beyond. (2012 results will be a wash).

    Although the acquisition won’t yield a major boost on the company’s total coal output, it brings greater exposure to the Australian market, where coal prices are far higher, thanks to the proximity to the Chinese coal import market. Even prior to the MacArthur deal, Peabody’s Australia operations accounted for just 12% of shipments in 2010 but drove 37% of revenues and 44% of EBITDA.

    If you’re looking for exposure to China’s insatiable demand for coal, then Peabody looks like a great backdoor play, through its burgeoning Australian exposure.

    Consol Energy

    Consol Energy (CNX) is a play for those investors that don’t want to go all in on “the coal trade.” Consol’s Appalachian focus provides it with the some of the highest-quality coal in the world, but also brings considerable exposure to natural gas, as the company owns acreage in the all-important Marcellus and Utica shales. In both the coal and gas segments, Consol has been focused on being a low-cost producer, thanks to heavy investments in technology.

    Although this stock is a bit more richly valued than its coal peers, it’s also undervalued in relation to natural gas peers. Analysts at Sterne Agee crunched the numbers and figure that the company’s coal and gas assets are worth a collective $19 billion. Back out the company’s $3 billion in debt (and apply an additional $2 billion discount for the company’s conglomerate status) and the company should be valued at $14 billion, or $60 a share, well ahead of the recent $44 share price.

    To see these stocks in action, check out the Coal Trade Portfolio on Stockpickr.

    At the time of publication, author had no position in stocks mentioned.

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