The Eye of the Storm

When the S&P 500 hit 1,266 on June 4, the index had pulled back roughly 11 percent from its 2012 highs. International equity markets have fared far worse during the recent selloff, particularly stocks in the weakest EU economies.

Equity markets rebounded earlier today, bolstered by Saturday’s news that Spain had secured a EUR100 billion (USD125 billion) bailout for its troubled banking system. Spain is the fourth euro nation to seek a rescue, after Greece, Portugal and Ireland.

A major concern in recent weeks has been the solvency of Spain-based financial institutions, which have faced substantial losses from troubled real estate loans. Word of the bank bailout also lowered yields on 10-year bonds issued by Spain’s government.

Don’t be fooled. We expect more downside to come for equities. The recent rally has all the markings of an oversold bounce that’s a prelude to further downside.

Short-term action in stocks tends to be dominated by technical indicators such as key areas of support and resistance on a price chart, particularly in the absence of major market-moving news.

Traders closely watch the S&P 500’s 200-day moving average, which serves as a gauge of the long-term trend in US equities. When the S&P 500 is above a rising 200-day moving average, stocks are in an uptrend. Stocks are in a downtrend when the index value is less than its 200-day moving average.

The S&P 500’s 200-day average has hovered around 1,280. When the stock market tumbled in early June, the index breached its 200-day moving average but failed to close significantly below that level. This pattern should be familiar. In each of the past two years, the market has found at least temporary support at its 200-day moving average and subsequently rebounded. In June and July of 2011, for example, the S&P 500 retested its early 2011 high before selling off again.

Oversold bounces are part and parcel of every correction in the broader market. However, investors shouldn’t confuse these encouraging blips with the beginning of a new uptrend. The stock market faces plenty of headwinds.

First and foremost, the bailout of Spain’s banking systems does not solve the EU sovereign-debt crisis. If Spain only required EUR100 billion to nurse its financial system and economy back to health, the EU would have addressed that problem two years ago.

Meanwhile, Greece will hold a pivotal election on June 17 that could determine whether the nation remains a member of the EU. The center-right New Democracy party holds only a slim margin over the anti-bailout Coalition for the Radical Left.

Even if New Democracy wins, the party will have a tough time forming a coalition government. If Greece proves unwilling to take its medicine and exits the euro zone, equity markets could sell off dramatically. What’s more, some analysts fear it is only a matter of time before Italy becomes the next country to request rescue money.

At home, the potential expiration of the tax cuts implemented by George W. Bush and planned reductions to government spending could sap US economic growth. This uncertainty, coupled with a tight race in the presidential election, should ensure that the S&P 500 suffers another summer swoon.

The index faces formidable resistance at 1,340 and 1,400, which should constrain any near-term rally. Over the past several months, we’ve advocated reducing exposure to cyclical sectors and taking profits on any big winners. With further downside in store, investors should avoid deploying all their dry powder in one shot.

Bargain in the Coal Bin

Shares of US-based coal producers have sold off considerably this year after an unseasonably warm winter reduced demand for this feedstock and ultra-depressed natural gas prices prompted utilities to switch fuels. In March, coal accounted for only 34 percent of US electricity generation, down roughly 10 percent from year-ago levels.

This selloff offers investors an opportunity to pick up shares of Peabody Energy Corp (NYSE: BTU) at a substantial discount.

Among US-based coal producers, Peabody Energy is best positioned to navigate the current environment. The company in October 2007 spun off its coal mining assets in Central Appalachia (CAPP), a region where rising costs remain a permanent headwind, with the initial public offering of Patriot Coal (NYSE: PCX). Not only did Peabody Energy monetize these mature assets in a bull market for coal, but the move also enabled the firm to focus on building its exposure to growing its production in Australia.

This move was prescient: Shares of Patriot Coal recently plummeted to less than $2, and the company appears to be on the brink of bankruptcy.

In 2007, Peabody Energy generated about 83 percent of its operating earnings before interest, taxation, depreciation and amortization (EBITDA) in its domestic market, while its Australian operations accounted for the remaining 17 percent. In 2011, Peabody Energy’s operating EBITDA was roughly evenly split between the US and Australia.

The coal producer’s US operations focus primarily on the Powder River Basin (PRB) in the western US and on the Illinois Basin in the Midwest.

Almost three-quarters of the company’s US coal shipments originate from the PRB, where the firm operates surface mines and produces thermal coal. Although PRB coal contains less energy than coal from CAPP, surface mining involves fewer production costs and safety regulations are less onerous. Coal mined in this region contains less sulfur than production from other regions in the US, an important consideration for utilities looking to cut their sulfur dioxide emissions to meet environmental regulations.

The remainder of Peabody Energy’s US coal volumes comes predominantly from the Illinois Basin, an area that yields coal with higher levels of sulfur. For this reason, coal deposits in the Illinois Basin haven’t been mined as aggressively as formations in CAPP. In addition to lower production costs, the Illinois Basin has also benefited from growing demand for high-sulfur coal as utilities install advanced scrubbers that eliminate much of the sulfur dioxide emitted from power plants.

As mine seams thin and output from CAPP declines, expect utilities to increasingly turn to the PRB and Illinois Basin for coal supplies.

Peabody Energy also sells the majority of its US coal production under fixed-rate contracts. All of the firm’s expected 2012 output is covered by contracts. In a conference call to discuss first-quarter results, management noted that some utility customers have asked to renegotiate contracts after an unseasonably warm winter led to a supply overhang. This process often involves rescheduling shipments originally slated for 2012 into 2013 or 2014. Management also indicated that it’s making every effort to maintain the original value of the contract when rescheduling deliveries.

Peabody Energy’s management team has also been slightly more sanguine about the US thermal coal markets than its competitors, likely because of its limited exposure to CAPP and substantial position in the PRB. As coal-to-gas switching has been most prominent in regions that burn CAPP coal, inventories are slightly less glutted among utilities that burn PRB coal.

Management has also pointed out that the industry is responding to excess coal stockpiles by slashing mine output. In April, annualized US coal shipments came in at 932 million tons, more than 150 million tons less than a year ago and the lowest volume in 15 years. This data doesn’t include additional curtailments slated for May and June.

Peabody Energy has pushed back contract negotiations with utilities on 2013 shipments until the third and fourth quarter, suggesting that management expects at least some modest upside to US coal prices in the second half of the year.

That said, Peabody Energy isn’t immune to the industry’s woes. Given the current price environment and inventory levels, the company may need to curtail production in coming years to match demand.

Peabody Energy’s extensive operations in Australia distinguish the company from its US peers.

Management expects the company to produce between 33 million and 36 million tons from its Australian mines: 7 million to 8 million tons of thermal coal destined for the domestic market, 12 million to 13 million tons earmarked for the seaborne market, and 14 million to 15 million tons of metallurgical (met) coal. In other words, met coal will account for about 45 percent of Peabody Energy’s Australian output, a favorable production mix in the near term and over the long haul.

Management emphasized said that Peabody Energy hasn’t received any requests to defer met coal deliveries; this market remains appears healthy, even though prices have retreated as production normalizes.

Peabody Energy has allocated about two-thirds of its 2012 capital expenditures to projects in Australia and plans to grow its production to between 45 million and 50 million tons per annum by the end of 2015. Met coal will account for much of this 35 percent upsurge in output.

In late 2011, Peabody Energy completed the USD3.8 billion acquisition of MacArthur Coal, a massive deal that pushed the company’s total debt to almost USD6.7 billion for about USD2.5 billion in the third quarter of 2011. Some analysts complain that the firm overpaid for MacArthur Coal, but the deal will immediately increase Peabody Energy’s production and expands its slate of potential growth projects.

Peabody Energy continues to pay down the debt used to finance this transaction, with the goal of restoring its leverage ratio to pre-deal levels. Management has also instituted a cost-cutting campaign to improve efficiency and profit margins at the acquired mines.

Although the US market for thermal coal faces undeniable challenges, investors haven’t given Peabody Energy enough credit for its domestic asset base and substantial operations in Australia. Trading at only 0.8 times revenue, the stock has more than priced in any additional bad news. In fact, the shares command a lower valuation than they did at the height of the 2008-09 financial crisis.

The key upside catalyst for the stock will be a turn in sentiment regarding Chinese steel demand, which we expect to occur in the back half of the year.