Peabody Energy (BTU) is the world’s largest private sector coal company, and they have expanded operations quite a bit recently. Starting two weeks ago, with the announcement that Peabody signed a pact to start production from an Indiana mine in the second half of 2010. The Bear Run mine is the largest surface mine in the eastern U.S. and is expected to produce 8 million tons of coal per year. Peabody has contracts with two Midwestern electricity generators in place for up to 17 years, which should net the company $6 billion in revenue. Peabody already supplies about 10% of the electricity for the United States, and with this operation in place, barring legislative interference, the company will continue to produce a hefty portion of U.S. energy for some time.
Today, Peabody announced a 50/50 joint venture with Polo Resources (PRL) to develop coal in Mongolia. For its share of the operation Peabody will contribute $25.8 million in cash, but the potential reward could be great, as some estimates claim 1 billion tons of potential resources are present. Of course, there will be continued exploratory drilling and exploration to get a handle on what is indeed there. This deal with Polo was first released in January but terms of the deal are just now being made public. Clearly, these mines are in a strategically critical location so near to China its Asian neighbors. China in particular is energy hungry and will become more so when the economy resumes its breakneck growth.
At Ockham, we have placed a Undervalued valuation on Peabody Energy because the shares are selling well below established valuation ranges for this stock. For example, Peabody has normally traded between 6.7x and 16.1x of price to cash flow, but the current metric is only 5.1x. Similarly, price to sales is also trading 10% below the low end of its historically normal range.
Peabody shares have been hit pretty hard, down more than 70% from their 52-week high last summer. It is not hard to understand why, as worldwide demand for electricity and thus coal has slumped so have coal prices. Furthermore, analysts have feared, perhaps correctly that the coal industry will face some adverse legislation from the new administration. If cap and trade legislation or some other tax against the coal industry would certainly hurt Peabody, being the largest coal producer. We cannot model possible legislation into our evaluation, so we understand that there is some risk to Peabody shares even though the fundamentals look pretty solid. The potential of the venture in Mongolia could be enticing to some because of its huge potential reserves and it is largely outside the legislative reach of the U.S.
