Peabody Energy Corp (NYSE: BTU)

Key Takeaways:

• Initial forecast calls for 12 million tons to 13 million tons in Australian thermal coal shipments and 14 million to 15 million tons of Australian metallurgical coal sales.
• Expected US thermal coal production already sold under contracts, limiting exposure to price weakness after unseasonably mild winter.
• Has placed Wilkie Creek Mine in southeast Queensland on sales block to reduce debt incurred from acquisition of Macarthur Coal.
• Management warns that 2012 will be a year of transition for Peabody Energy, as operational mines acquired from Macarthur Coal will require significant investment to upgrade equipment and remove waste rock.
• Management’s guidance calls for first-quarter earnings per share of $0.50 to $0.75, well below analysts’ consensus estimate prior to the call.

After surging 42 percent in 2010, shares of Growth Portfolio holding Peabody Energy Corp gave back these gains in 2011, hit by uncertainty surrounding steel production and economic growth in China and other key emerging markets.

Despite these worries, Peabody Energy Corp still managed to report record full-year results, including revenue of $7.97 billion (up 18 percent) and earnings before interest, taxes, depreciation and amortization (EBITDA) of $2.13 billion (up 15.7 percent).

After weather-related disruptions in early 2011 and equipment moves and a roof fall at its North Goonyella mine in the third and fourth quarter, the company’s Australian operations (36 percent of 2011 revenue) shipped 25.3 million tons of coal–down slightly from 27 million tons in 2010. This total included 9.3 million tons of metallurgical (met) coal, the varietal used in steelmaking, and 10.1 million tons of seaborne thermal coal, the varietal burned at power plants.

Nevertheless, strong pricing in 2011 for both met and thermal coal enabled Peabody Energy’s Australian concerns to grow their revenue by 28 percent from a year ago, while a 26 percent improvement in margins led to a 22 percent surge in EBITDA.

The firm’s US operations (55 percent of 2011 revenue), which are located primarily in the low-cost Powder River Basin and the Illinois Basin, enjoyed a 5 percent uptick in coal shipments during the year, largely because of a record 109 million tons of low-sulfur coal output from the North Antelope Rochelle Mine in Wyoming.

During a conference call to discuss fourth-quarter earnings, Peabody Energy CEO Gregory Boyce indicated that the company expects the “two-speed global economy” to continue in 2012, with emerging markets such as China, India and Brazil leading the way and the developed world posting subpar growth.

Outlook for Seaborne Thermal Coal

Peabody Energy expects global demand for seaborne thermal coal to increase by 5 percent to 10 percent in 2012, led by China and India. Accordingly, management estimates that the firm’s shipments of Australian thermal coal will increase to between 12 and 13 million tons, from 10.1 million tons in 2011. About 40 percent to 50 percent of Peabody Energy’s expected 2012 Australian thermal-coal sales are covered by contract, providing ample exposure to any potential upside in prices.

The long-term growth story in seaborne thermal coal also remains attractive.

As the quintessential emerging market, China’s appetite for thermal and metallurgical coal receives a lot of attention from investors and commentators.

The Mainland’s utilities built up their winter inventories of thermal coal ahead of schedule in 2011, amassing a record 81.5 million metric tons (21 days’ worth of consumption) in November. Some of this record inventory stems from an uptick in domestic output–government-mandated consolidation in the industry has improved productivity–but looser credit requirements on the part of domestic suppliers also factor into the equation. Meanwhile, relatively mild weather has suppressed demand relative to previous years.

Nevertheless, the Mainland’s thermal-coal imports are expected to increase consistently over the next several years because of rising electricity demand and insufficient rail capacity to transport output from coal-producing provinces in western China to end markets in eastern and southern China. These logistical bottlenecks, coupled with rising wages and production costs, increase the price competitiveness of imported coal.

In November 2011, the National Development and Reform Commission instituted a ceiling on coal prices in an effort to limit losses related to rising coal prices and regulated electricity prices. Previous efforts of this nature, which addressed the domestic market and failed to account for global supply and demand factors, have failed; we expect this latest attempt to suffer the same fate.

In short, we remain bullish on China’s long-term demand for seaborne thermal coal. The country’s electricity consumption increased by more than 10 percent in 2011. With China expected to build 250 gigawatts of coal-fired generation capacity between 2011 and 2015, imports should increase in coming years. Coal from Australia will be a big part of this story, and Peabody Energy will be a leading supplier.

Meanwhile, Indian demand for thermal coal will likely outstrip Chinese demand over the next decade. Domestic coal production has lagged the growth targets laid out by India’s Planning Commission in the current five-year economic plan. Much of this shortfall reflects the operational difficulties facing Coal India, which produces 78 percent of the nation’s domestic coal supply, and has struggled to ramp up production. Some of these challenges relate to difficulties obtaining mining permits and acquiring land in the densely populated nation.

All of this adds up to a massive supply shortfall that must be offset by expensive imports, primarily from Australia and Indonesia. In the fiscal year ending March 31, 2012, the gap between domestic supply and demand should reach 142 million metric tons and will only continue to expand. In 2011 India’s imports of thermal coal surged 35 percent from year-ago levels, to about 85 million tons.

With its extensive production platform in Australia, Peabody Energy is well-positioned to supply utilities in India and China with thermal coal. By 2015, the company expects to expand its annual thermal-coal production in Australia to between 15 and 17 million tons.

However, the near-term outlook for the US thermal coal market is less sanguine. The supply-demand balance has deteriorated in recent months, as an unseasonably warm winter has combined with sluggish economic growth to increase utilities’ coal inventories. With power companies seeking to curtail deliveries or sell excess supplies into an already thin market, US thermal coal prices have come under pressure.

Meanwhile, depressed natural gas prices and efforts to reduce carbon dioxide emissions continue to prompt some utilities to switch to gas from coal. Rick Navarre, Peabody Energy’s chief commercial officer, told analysts that the company expects fuel replacement among US power companies to eliminate between 35 and 40 million tons of coal demand in 2012, largely from mines in Central Appalachia.

After spinning off its assets in Central Appalachia, Northern Appalachia and less desirable parts of the Illinois Basin in 2007, Peabody Energy has little exposure to rising production and regulatory costs in these mature mines.

Today, the company operates primarily in Wyoming’s Powder River Basin, which contains thick seams of low-sulfur coal that are relatively easy and inexpensive to mine, and the Illinois Basin, another low-cost region that produces coal with higher sulfur content. With many plants scheduled to have advanced scrubbers installed over the next few years, the addressable market for Illinois Basin coal is growing rapidly.

In addition to its low cost base, management’s prescient decision to sell the firm’s planned 2012 production under contracts will insulate earnings from the recent deterioration in prices. The firm has 45 percent to 55 percent of its planned 2013 production priced under contracts. These moves, coupled with the company’s extensive operations in Australia, give the firm a leg up on US-based competitors.

Outlook for Met Coal

Rising demand for met coal in China, India, Brazil and other emerging markets will drive much of Peabody Energy’s earnings upside in coming years. Management currently expects seaborne volumes of met coal to increase by 10 percent to 15 percent in 2012, spurred by a 5 percent uptick in global steel demand. The company aims to sell between 14 and 15 million tons of metallurgical coal in 2012. Almost all the firm’s expected 2012 output hasn’t been priced under supply contracts; the company could enjoy a lucrative year if met coal prices stabilize and move higher.

The long-term supply and demand picture for met coal is more bullish. Peabody Energy estimates that urbanization in China, India and other emerging markets will increase global demand for met coal at an average annualized rate of 5 percent over the next eight years. With an ambitious slate of organic expansion projects, Peabody Energy expects its Australian operations to produce between 22 million and 25 million tons of met coal annually by 2015.

We also like the company’s focus on metallurgical coals that tend to command a premium price: Management estimates that hard coking coal will account for 40 percent to 50 percent of the firm’s 2015 Australian met coal production, while low-volatility pulverized coal injections (LV PCI) are expected to account for 30 percent to 35 percent. This type of coal is crushed into a fine powder and injected into blast furnaces as a partial replacement for met coal in the production of pig iron.

Macarthur Mayhem

Although a slowdown in key emerging economies and China’s steel production would weigh on pricing and demand, the biggest headwind Peabody Energy faces in 2012 is the successful integration of Macarthur Coal, which the company acquired for almost $5 billion toward the end of 2011.

Investors criticized management for overpaying for Macarthur Coal after ArcelorMittal (Amsterdam: MT, NYSE: MT), the world’s largest steelmaker, bowed out of a joint bid for the company. Although the deal makes Peabody Energy the world’s leading producer of LV PCI, the additional leverage the firm assumed to finance the acquisition boosted its debt-to-capital ratio to 55 percent from 37 percent.

We like management’s plan to reduce the firm’s debt burden by putting its Wilkie Creek operation on the sales block. During a conference call to discuss fourth-quarter results, management noted that the mine has few synergies with its main operations in the Bowen Basin and emphasized that recent mergers and acquisitions in the Surat Basin suggest that the asset should fetch a reasonable price.

However, already skeptical investors were likely chagrined to hear about the substantial investments required to bring Macarthur Coal’s operations up to speed and extract the planned 4 to 5 million tons of coal from the Coppabella Mine and Moorvale Mine in 2012.

Management emphasized that although the resource base acquired in the deal lived up to expectations, the prior owner’s financial difficulties during the 2008-09 credit crunch and subsequent weather-related disruptions in late 2010 and early 2011 led to an accumulation of waste material in the Coppabella Mine.

CEO Gregory Boyce estimates that the firm must strip about 12 million cubic meters of overburden (layers of rock and soil that cover the coal seam) to bring the mine up to Peabody Energy’s standards and maximize production. Boyce indicated that the company would remove more than 90 percent of this extraneous material by the end of 2012.

Management also revealed that Macarthur Coal had deferred equipment upgrades and maintenance in the six months prior to the deal; the new owner plans replace inferior equipment with more-efficient models and repair existing machinery.

All told, Macarthur Coal’s assets are expected to contribute only $100 million to Peabody Energy’s EBITDA in 2012. Meanwhile, the rehabilitation of the Coppabella Mine will increase the average cost per ton at its Australian operations to the highs USD70s.

Despite these near-term challenges, Peabody Energy’s acquisition of Macarthur Coal should pay off. Management expects its Australian production costs to decline to normalized levels in 2013, once Coppabella Mine is running at peak efficiency. Management also estimates that the successful integration of Macarthur Coal’s assets will produce USD60 million to USD80 million in annual cost synergies, beginning in 2013. These investments will also lead to meaningful production growth in the following year.

The addition of Macarthur Coal’s assets also diversifies the company’s output base and provides exposure to a varietal of coal that supplements hard coking coal and lowers steelmakers’ costs.

Besides the Coppabella Mine and the Moorvale Mine, Peabody Energy’s acquisition of Macarthur Coal also includes a 50 percent stake in the Middlemont project, which is expected to yield 4.4 million tons of coal (2.2 million tons attributable to Peabody Energy). Hard coking coal will account for about 70 percent of the mine’s output, with LV PCI making up the remaining 30 percent.

Management also approved an accelerated development plan for the Codrilla Mine, which is expected to yield commercial quantities of coal in late 2013 and grow output to 3.5 million tons, about 2.6 million of which would accrue to Peabody Energy. LV PCI will account for 90 percent of the mine’s output.

The Verdict

Peabody Energy is the world’s largest pure-play coal producer with operations in Australia and the western US and remains our top long-term bet on rising coal demand in China, India and other emerging economies. For investors with a longer horizon, the stock trades at an attractive valuation.

That being said, the stock lacks near-term catalysts and could pull back if economic growth and steel production in China disappoint. Pricing trends on met coal volumes should become clearer during the second quarter. Buy Peabody Energy Corp up to 45.

Macmahon Holdings (ASX: MAH, OTC: MCHHF)

Key Takeaways:

• Strong earnings in the first half of Macmahon Holdings’ fiscal year prompted management to reinstate the company’s dividend of AUD0.015 per share. The company is targeting a payout ratio of less than 50 percent.
• AUD2.2 billion in new work and contract extensions pushed the firm’s order book to a record AUD3.4 billion.
• The pipeline also remains strong, with about AUD3 billion in “serious” tenders.

Aggressive Portfolio holding Macmahon Holdings operates two business lines: contract mining (about 54 percent of the company’s revenue during its 2011 fiscal year) and construction (46 percent of revenue). In addition to Australia, the firm also boasts operations in New Zealand, Southeast Asia and Africa.

The firm’s contract mining services include drilling, blasting, waste management and ongoing maintenance of mines. The company focuses primarily on coal and iron-ore mining.

For example, Macmahon has a contract with Peabody Energy to provide services for the company’s Eaglefield, an open-pit mine that produces both high-quality metallurgical coal and steam coal. The deal is worth AUD500 million, and the contract runs from October 2003 to September 2013. As part of the deal, Macmahon handles all drilling and blasting services, provides an on-site equipment maintenance depot and removes the dirt, rocks and other waste materials around the coal deposit.

Although 2011 marked a difficult year for Macmahon’s contract drilling business–largely because of disruptions related to massive flooding–conditions improved in the back half of the year as operations came back online. This business segment grew its fiscal 2011 revenue by 45 percent from year-ago levels, but the wet weather cost the firm another AUD8.5 million in profits.

This strength continued into the first half of the Macmahon’s 2012 fiscal year, with revenue surging 38 percent from year-ago levels, to AUD829 million. Net profit likewise soared to AUD23.2 million, compared to an AUD13.2 million loss in the first half of its fiscal 2011. These strong results enabled the firm to reinstate its semiannual dividend of AUD0.015 cents per share.

In the first half of its 2011 fiscal year, massive cost overruns on the RGP5 rail project for BHP Billiton (ASX: BHP, NYSE: BHP) forced the construction division to suffer a substantial writedown. Even when you factor out this debacle, Macmahon’s net income was still up 27 percent in the first half of its 2012 fiscal year.

This strength should continue into the second half of its fiscal year and into 2013. Management noted that the company has about AUD903 million worth of work slated for the final six months of the fiscal year and expects full-year revenue to exceed AUD1.8 billion. Meanwhile, Macmahon’s order book swelled to a record AUD3.4 billion after the firm secured AUD2.2 billion in new contracts and extensions.

Major contract wins over these six months include a 10-year contract worth AUD900 million to provide surface-mining services for the Tropicana Gold Project, a joint venture between AngloGold Ashanti (Johannesburg: ANG, NYSE: AU) and Independence Group (ASX: IGO). Macmahon will begin work on this massive project in early 2013. Management expects built-in inflation escalators and likely expansions to further increase the value of this contract in coming years.

The firm also inked a 50-50 joint venture with German outfit Operta to manage open-cut mining operations in Mongolia’s promising Tuvan Tolgoi Coal Mine. The deal is worth about USD500 million. Along with a recently signed contract in Nigeria, this marks one of the company’s first forays into international markets, a key to future growth.

And the pipeline of new projects remains strong. Macmahon has identified about AUD3 billion worth of “serious” tenders, including AUD500 million worth of contracts that the company expects to win within the next few months. Management also announced that the firm had ordered the world’s largest raise drill, a piece of equipment that sinks vertical holes for mining projects. With mines becoming deeper and requiring longer ventilation shafts, this raise drill should give Macmahon a leg up on the competition and enhance its ability to win business.

A solid bet on rising demand for mine expansions and development in Australia, Macmahon Holdings rates a buy under AUD0.85 for aggressive investors.