|Coal rolls off a conveyor belt at metallurgical coal producer Ramaco Resources Inc.'s Berwind mine in West Virginia. A new analyst note suggests investors may be overly concerned with international pricing and undervaluing some large public coal companies reporting high levels of free cash flow. |
Source: Ramaco Resources Inc.
Several large, publicly traded coal companies boast high free cash flow and little to no debt but still struggle to attract investors, a Seaport Global Securities analyst noted in his call for more mergers and acquisitions in the space.
Attracting new investors to coal equities is challenging even though most publicly traded coal miners are in the "best financial shape they've been in a very long time" amid a healthy international pricing environment, Seaport analyst Mark Levin wrote July 3. Investors can no longer expect metallurgical coal stocks to trade in lock-step with metallurgical coal prices, according to a regressional analysis Seaport performed on stocks such as Arch Coal Inc., Peabody Energy Corp., Teck Resources Ltd. and Warrior Met Coal Inc.
"There are too many U.S. coal companies producing met coal that are not investable for large institutions," Levin wrote. "We hear this time and time again from investors."
The problem is that the market capitalization and liquidity of many coal companies are insufficient for most institutions to buy a meaningful stake or to be capable of getting in and out of an equity position in a short period of time. Coal companies should take advantage of the strong pricing environment to consolidate before a lack of new incremental investors becomes a bigger problem, Levin wrote.
Most coal companies have free cash flow yields in the range of 17% to 34%, and even at coal prices near marginal costs they boast yields equivalent to the S&P 500, Levin wrote. Investors are likely sitting on the sidelines over concerns about the uncertainty created by trade wars, unpredictable Chinese coal policy, currency fluctuations and other economic factors.
Coal company executives are still also likely trying to win back investor trust after some of the largest coal companies were swept up by a debt-fueled wave of bankruptcies.
"With increased size and scale, we also think the opportunity to access the capital markets will increase, which may not seem like a big deal now, but could be later," Levin wrote. "The key, of course, is not to use debt as a primary currency for any transaction. For reasons obvious to any coal equity investor, we don't think that would be well-received by that segment of the market."
Many of the largest companies recently reorganized in bankruptcy court and are careful with their cash. Arch Coal CEO John Eaves said at a May conference that while the sector may be overly fragmented, he does not think Arch necessarily needs to be the one acting as the consolidator.
"When we look around, we don't see anything that appeals to us relative to what we have organically," Eaves said. "We're not opposed to M&A, but we're not anxious to do anything either."
Metallurgical coal prices are expected to remain high in China in the second half, which should support international prices, Wood Mackenzie wrote in its recent metallurgical coal forecast. A lack of metallurgical coal supply additions is supportive of healthy industry fundamentals as long as there are no major supply disruptions, B. Riley FBR analyst Lucas Pipes wrote in a June 12 note.
Noting the high levels of free cash flow yield among metallurgical coal names, Pipes wrote that he was "structurally constructive" on the sector.
"In short, the group continues to be attractively valued and the sector continues to discount much lower prices compared to spot," Pipes wrote. "We believe this dynamic contributes to a lack of growth projects as most producers can earn higher near-term returns by buying back their shares rather than risking capital over multiple years."
Most coal companies have said they are focused on returning cash to shareholders, but Levin said he expects reserve and production replacement to eventually become a priority again. The best way to achieve that would be through mergers and acquisitions, he added. Potential small producers that would make sense for consolidation include Corsa Coal Corp., Ramaco Resources Inc., United Coal Co. LLC, White Forest Resources Inc. and some of the entities controlled by the family of West Virginia Gov. Jim Justice.
Recently, Alpha Natural Resources Inc. and Contura Energy Inc. announced a merger of the two companies, which were split during Alpha's bankruptcy reorganization. Contura recently divested itself of large Powder River Basin thermal coal mines. Levin noted the merger created the largest metallurgical coal producer in the U.S.
"If and when Contura up-lists to a major exchange, we believe investors will give it a much longer look than if these companies traded separately, in no small part because of its size, [free cash flow] and balance sheet," Levin wrote.