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Tuesday, June 05, 2012

Coal Carnage

A lot of the attention of value and distressed investors is starting to focus on the coal industry. As Patriot Coal (PCX) announced that they have begun to explore restructuring possibilities I have gotten several questions a day about coal stocks. I have talked about coal stocks and more specifically the bonds of some of the more leveraged coal companies in recent weeks and it is an area that that is worth exploring. It seems that nobody loves coal these days as everyone from the EPA to the utility companies are turning their back on this long time fuel source.

As with any energy sector when I have questions I call upon 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 costing you money. In his words the coal outlook is not as bad as we first feared and probably not as good as some of the more bullish forecasts. The cola plants that have been closed were older less efficient plants and the electricity industry will continue to run the higher efficiency cleaner burning plants. Much of the recent switching to natural gas by utilities and industry 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 amidst weak demand.

A recent report by the US Energy Information Administration gives some idea of what is going on in the industry. Although weak demand form electrical utilities lead coal consumption in domestic markets to fall by 18%, export demand increased by 32.6% on a year over year basis and more than 6% sequentially. Nobody loves coal right now except the emerging markets. Although they 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 US will probably decline for a period of time it will eventually stabilize and I expect faster growing world markets to take up the slack in demand. The industry has problems but it is far from dead.

The same cannot be said for all the coal stocks however. I have pointed out in the past few weeks 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 bear term outlook for the industry may not enable them to support their very high levels of debt service. I am becoming interested in the debt issued by these companies as they are trading below the predicted recovery rates by at least one major rating company. If they file for bankruptcy or otherwise reorganize you should emerge intact and with a profit. If the bonds remain performing or these companies are taken over by a better financed competitor you 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 (HNRG) is a small coal miner in the Illinois River basin that I mentioned a few months back as a potential buy. Predictably the stock has gone lower since then but they 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 passed both tests. Peabody Energy (BTU) has a solid F score of 6 but a Z score of just 1.5. Consolidate Energy (CNX) has a very strong F-Score of 7 but a Z score of just 1.5 as well. Fundamentals show some signs of improving but there is some financial risk for these companies 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 has seen its price plummet. The stock is cheap on a price to tangible book basis but the Z score of.8 and F-score of just 4 indicate the company could struggle for some time yet.

The carnage in coal has caught my vulturistic eye. However I have done much in the sector yet. I had a small partial fill on some Arch Coal puts last month and I expect those will be put to me in June at a small loss. I will be a buyer of Hallador below tangible book value of $5.78 if the price should continue to decline. I have bids in for James River and Patriot well below market 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 a solid distressed opportunity but judging by credit scores and insider activity we are not quite there.

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