Circling the Coal Carnage

 | May 27, 2012 | 10:30 AM EDT  | Comments
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For value players and investors in distressed industries, a lot of the attention is starting to focus on the coal space. Following Patriot Coal's (PCX) announcement that the company has begun to explore restructuring possibilities, I have gotten several questions per day about coal stocks. In recent weeks I have discussed this sector and, more specifically, the bonds of some of the more leveraged coal companies. The group is an area worth exploring. It seems nobody loves coal these days, as everyone from the Environmental Protection Agency to the utility companies turn their back on this longtime fuel source.

As with any energy subsector, when I have questions I contact fellow Real Money contributor Glenn Williams. Glenn has more knowledge and insight into energy than anyone I have ever met. He is a valuable resource, and if you are not reading him, it is probably costing you money.

In Glenn's view, the coal outlook is not as bad as we'd first feared, yet it's probably not as good as some of the more bullish forecasts. The coal plants that have been closed were older, less efficient ones, and the electricity industry will continue to run plants that are higher-efficiency and with cleaner burning. For utilities and industrials, much of the recent shifting to natural gas has been a result of very low natural gas prices, and the pendulum could easily swing in the other direction as coal supplies pile up amid weak demand.

A recent report from the U.S. Energy Information Administration provides some idea of what is going on in the industry. Although weak demand from electrical utilities led coal consumption in domestic markets to fall by 18%, export demand increased by 32.6% year over year, and more than 6% sequentially.

It seems nobody loves coal right now -- except for the emerging markets. Although these countries may pay lip service to the idea of reducing emissions, the real interest of nations with fast-growing economies is cheap energy to fuel industry and provide cheaper power to the developing middle class. Coal demand in the U.S. will probably decline for a period of time, but it will eventually stabilize, and I expect faster-growing world markets to take up the slack. This industry has its problems, but it is far from dead.

But the same cannot be said for all the coal stocks. In the past few weeks, I have pointed out that some of the more highly leveraged coal companies may face severe distress. I would not touch the equity of companies like James River Coal (JRCC) or Patriot at these levels. Although they are asset-rich, the near-term outlook for the industry may not enable them to support their very high levels of debt service.

Instead, I've become interested in the debt issued by these companies, as these notes are trading below the predicted recovery rates by at least one major rating company. If these companies file for bankruptcy or otherwise reorganize, you should emerge intact and with a profit. If the bonds remain performing, or if these firms are taken over by a better-financed competitor, you'll have a home run investment.

When I run credit scores on the coal companies, I only find one that passes with flying colors: Hallador Energy (HRNG), a small coal miner in the Illinois River basin that I mentioned a few months back as a potential buy. In predictable manner, the stock has gone lower since then, but the company has an Altman Z score of 3.8 and a Piotroski F score of 8. It is the only coal company I could finds that passes both of these tests. Peabody Energy (BTU) has a solid F score of 6, but a Z score of just 1.5. In similar fashion, Consolidate Energy (CNX) has a very strong F score of 7, but a Z score of just 1.5. Fundamentals show some signs of improvement, but these companies carry some financial risk if coal demand and pricing remains weak.

I do not see insiders at the coal companies flocking into the shares yet, either. So far, only Arch Coal (ACI) has what I would call positive insider activity: We have seen some buying in the past few months as this stock price has plummeted. Shares are now cheap on the basis of price to tangible book value -- but the Z score of 0.8 and F score of 4 indicate the company could struggle for some time yet.

The carnage in coal has caught my "vulturistic" eye. However, I have not yet done much in the sector. I had a small, partial order fill on some Arch Coal puts last month, and I expect those will be put to me in June at a small loss. If Hallador's price continues to decline, I would be a buyer below its tangible book value of $5.78. I also have bids in for James River and Patriot well below market value, as I'm hoping to catch a blow-off in upcoming weeks on additional bad news flow.

The well-fed vulture is a patient vulture. The coal industry is close to becoming a solid distressed opportunity – but, judging by credit scores and insider activity, we are not quite there yet.

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