Why I'm Now Bullish On This Hated Commodity

The best opportunities arise when there is a "divergence from the consensus." This phrase often refers to analysts' profit forecasts, and the wide range of estimates spells opportunity if you know on which side of the fence to land.
 
Yet there is another type of consensus that can yield opportunities -- when most individual investors have concluded that a particular industry is headed for good or bad times. That's when it's often smart to go against the crowd.
 
Indeed, I think I've found that both of these opportunities when it comes to a particularly "hated" commodity among investors.
 
Increasingly strict environmental regulations coupled with a plunge in natural gas prices have left many to believe that it has no future. Yet there are more than a few bullish price targets for a few key players in this industry.
 
When I see the two scenarios I mentioned above (varying opinions among analysts and a feeling among investors that the stocks are "no good") -- it's time to dig deeper.
 
And this is exactly what appears to be the case with coal stocks.
 
Why even bother?
The Market Vectors Coal ETF (NYSE: KOL), which is an exchange-traded fund (ETF) that owns a wide range of global coal-mining firms and the companies that provide equipment to the industry, has slid sharply in the past year. Remarkably, this ETF understates the pain, as it holds a range of China-based coal-mining firms that have held up well in 2012: U.S.-based coal-mining firms have fallen even more dramatically in some cases than this ETF implies.


On this instance, I used to with the consensus. I also used to wonder why investors would even bother with an industry that faces so many long-term challenges.
 
Then a funny thing happened...
 
Several investment professionals I know (and respect) all started to ask me the same question in my regular one-on-one conversations with them:
 
"What do you think about coal?"
 
After my indifferent answer, each explained that they thought this beaten-down sector now provides a great opportunity, and to various degrees, they were putting their own money into coal.
 
Are they crazy? The more I dug into the issue, the more I realized they were on to something.
 
After taking a deeper look at coal, I'm now inclined to agree with my colleagues. It's a risky, and not worthy of a huge investment, but coal stocks actually now appear to have more upside than downside.
 
Let me explain...
 
The pain of C2G
In recent months, the steady and profound drop in natural gas prices has accelerated a process that some saw as inevitable: Any power utility that could operate on either coal or gas has switched to gas, known as the C2G conversion, is now doing so.
 
Since just the start of the year, industry projections for demand of coal have fallen by about 8% to about 850 million tons. And the pain hasn't ended. The process by some estimates is only 85% complete, meaning another 15% of the nation's power plants that have yet to make the C2G move will do so during the next few years.

Adding insult, the relatively mild winter in much of the United States led to weak secular demand for coal, and it would take an especially hot summer for inventories to be whittled down and stabilize pricing.
 
The segment of the industry that was hit the hardest is what is known as Appalachian Thermal coal, which is used by many mid-western power plants. That should have an especially hard effect on Arch Coal (NYSE: ACI), according to Goldman Sachs. They rate the stock a "sell," and project earnings per share (EPS) of $0.51 in 2012, below the $0.60 consensus forecast. Companies with heavy exposure to the Powder River Basin, located in Montana and Wyoming, are also likely to suffer from the falling demand for thermal coal.
 
From thermal to met
Against such a bleak backdrop, some analysts are noting that coal miners producing metallurgical coal (or "Met coal" which is used in heat-intensive applications such as steel production), should fare better in coming quarters, and are still well-positioned to generate solid cash flow. Not only will this type of coal see better demand in this country and in exports markets such as China, but it's not quite as abundant as thermal coal, so supply is unlikely to overwhelm the market.
 
These 3 coal stocks may be worth a small investment

Merrill Lynch, which recently initiated coverage on the entire industry, notes that Walter Energy (NYSE: WLT) and Alpha Natural Resources (NYSE: ANR) -- both of which have a "buy" rating -- are seen as solid met-coal plays. Peabody Energy (NYSE: BTU), also with a "buy" rating, may be overlooked by the crowd, the investment bank adds. Peabody paid more than $5 billion in late 2011 to acquire Australia's MacArthur Coal and is now a leading coal provider to China.
 
Notably, all three of these "buy"-rated stocks are down more than 50% in the past 12 months. More to the point, each trades for less than 4.5 times projected 2012 EBITDA, and subsequent levels of EBITDA should move higher as demand from the steel industry and China continues to build.
 
Merrill considers Peabody to be a top pick of these three, with EPS expected to ramp to $2.85 in 2012, $3.90 in 2013 and $4.60 in 2014. Its $38 price target is nearly 25% above current levels.
 
Analysts at UBS concur with Merrill Lynch's relatively bullish outlook for met-coal producers, especially as these companies have shown a willingness to cut output to help bolster pricing, which they expect to remain around $210 per thousand tons of coal. And they say there is still a solid cushion in place if industry conditions worsen and prices unexpectedly drop further. They figure Walter Energy, Alpha Natural and Peabody would all still generate solid free cash flow even if pricing fell to $175 per thousand tons.
 
While Merrill slightly favors Peabody, UBS gives the top nod to Walter Energy and Alpha Natural. It sees Walter trading up from a recent $65 to $85, noting it has only limited exposure to thermal coal. Alpha Natural has nearly 75% upside to UBS' $28 price target, since the company is cash-rich (fueling a $100 million quarterly stock buyback) and sports a double-digit free cash-flow yield.
 
If there is such a thing as a "consensus pick" in an industry where most investors are steering clear, then it would indeed be Alpha Natural Resources. Brean Murray also says shares are quite oversold, though it carries a more conservative $25 price target. The analysts note that the company's recent production cuts were at Alpha's highest cost mines, which weren't very profitable anyway, so forward profit forecasts have largely stayed intact.
 
Risks to Consider:  China remains an active buyer of met coal in foreign markets, while global steel producers are also big users of this energy source. Continued health among those markets is essential for these stocks to start moving back higher.
 
Commodity stocks typically offer several entry and exit points throughout an economic cycle. The sharp sell-off in coal stocks appears to offer a solid rebound of 25% or more, even as these stocks are unlikely to revisit their 2011 highs any time soon.

by David Sterman