Peabody Energy : (BTU)

INVESTMENT THESIS This week's Focus Stock of the Week is Peabody Energy (BTU: $43), which carries Standard&Poor's highest investment recommendation of 5-STARS, or Strong Buy. Following an overall decline in 2009, we believe the coal industry is experiencing a sustained recovery and that Peabody will benefit more than most from this rebound. We view positively the significant reduction in thermal coal inventory levels at utilities in the U.S., presently at about 53 days of consumption versus a long-term average of 50 days. We think this will help lead to sustained higher demand and greater contract pricing leverage for Peabody and the coal mining industry. In addition, we note that steel production, and hence the demand for metallurgical coal has strengthened since bottoming in late 2009, a trend we expect to continue. We view Peabody as one of the strongest competitors in the coal mining industry, largely due to the company's operating scale and direct international growth exposure. Coal mining is a capital-intensive business and we believe that Peabody's size and scale provide it with financial and cost advantages not afforded to competitors. We also view positively the company's international exposure, noting its wholly owned mines in Australia and other operations, such as its joint venture to develop Mongolian coal mines. Using EV/EBITDA valuation analysis, we think that the shares, which recently traded at about 7X our 2010 EBITDA estimate, are undervalued. Our 12-month target price of $53 assumes that BTU stock will trade at 8.6X our 2010 EBITDA estimate, about a 40% premium to the peer average, in line with its historical premium.

INDUSTRY BACKGROUND According to the U.S. Energy Information Administration (EIA), coal is mined in over 50 countries. In 2008 (latest available), the coal mining industry produced more than 7.2 billion short tons of coal, with the top-five producing nations being China, the United States, India, Australia, and Russia. Coal comes in many grades based on energy content, hardness, and impurity levels. In addition, coal can also be classified as to what market it is being sold into - such as thermal coal used in power generation or other industries; or metallurgical coal, which is used in the production of steel. Thermal coal (which constitutes more than 90% of Peabody's 2009 production mix) is used primarily in power generation at utilities but is also used by industrial users such as cement producers. The global market for thermal coal is largely regional, but international trade of thermal coal has increased in recent years. In the U.S., thermal coal inventories at utilities - according to the research firm Genscape - averaged more than 70 days of supply in November and December 2009. However, we have seen a significant reduction in inventory levels over the proceeding seven to eight months due to abnormal weather patterns in the winter of 2009/2010, abnormally hot weather in the summer of 2010, and an improved economic environment. In our opinion, coal demand and pricing will remain durable now that thermal coal inventories are more in line with long-term averages. We also note that historically, thermal coal usage exhibits some resilience during periods of economic weakness. On the other hand, metallurgical coal (also called coking coal or met coal) has a larger international trading market and is largely leveraged to global economic growth, especially growth in China, which is the world's largest steel producer and one of the largest consumers of met coal. Typically, met coal has a higher heating content and rarity value relative to thermal and other coal types. As such, met coal commands higher prices as compared to thermal coal. In the last two years, met coal prices have ranged from a high of about $300 per ton to $140 per ton. We believe that met coal demand rises and falls along with steel production, and note that steel production levels have increased significantly since late 2009. Despite the sequential easing of global steel production in June and July of 2010, as reported by the World Steel Association, we expect production levels to continue to increase year over year - all leading to better demand dynamics for met coal. We also note that weekly steel production appears to have increased through August and the Baltic Dry Index (a measure of dry bulk shipping rates for commodities and, in our opinion, a measure of overall commodity demand) has rebounded significantly since the July 2010 lows. We estimate that about 7% of Peabody's volumes are metallurgical coal.

COMPANY PROFILE&OUTLOOK St. Louis-based Peabody Energy is the largest publicly traded coal miner in the world, and has operations domestically and internationally. The company's domestic operations are focused on what we view as higher-growth regions, including the Powder River Basin and Illinois, while the company's Australian operations provide Peabody with direct exposure to growth in the Asian seaborne markets - including China and India. In addition, Peabody has entered into joint ventures to develop coal fields in Mongolia. In 2009, the company sold nearly 244 million tons of coal, with 192 million from its U.S. operations (mainly thermal coal), 22.5 million tons of both thermal and metallurgical coal from Australia, and the remainder from other operations. In 2010, we project that Peabody will generate sales growth of 17% and EPS growth of 85%. Our projection is based on our estimate that total coal volumes will increase by 2% in 2010, reflecting significantly higher Australian coal volumes and modest growth domestically. Our 2010 sales projection also includes our forecast for a 14% rise in coal pricing, based on our belief that Peabody will benefit from firming coal prices, positive coal contracting, and significantly higher metallurgical coal prices. We estimate EPS of $3.04 in 2010, compared $1.64 in 2009. In our estimation, Peabody's earnings will benefit from vastly improved operating leverage in 2010, due primarily to higher pricing and greater asset utilization. We project that total production costs will increase by about 11% as compared to 2009, and see total production per ton rising nearly 6%.

For 2011, we look for total revenue to rise about 13% on a mix of higher coal volumes and better pricing. Our sales growth forecast for next year assumes that total coal volumes will increase about 6%. We believe coal volume growth will be mainly driven by higher volumes in Australia (up 8%) and an 11% increase in the company's Illinois Basin operations, projections partially based on Peabody's estimates and contract positions as stated in the company's second-quarter earnings release. In addition, our forecast assumes that demand in the Asian seaborne markets remains strong. We also think that coal production in the Illinois operations will ramp up as new production is brought online, and that demand for the Illinois coals will increase due to the energy-content advantage the region's coal has over the Powder River Basin and other Western coals. We estimate that Peabody will generate EPS of $4.40 in 2011, on higher sales and a further improvement in operating leverage. We project that total operating costs will advance about 6% in 2011, but that production costs per ton will increase by less than 1%.

We think Peabody's earnings will benefit from a greater volume throughput, no equipment moves in 2011, and higher overall pricing. VALUATION On an enterprise value (EV)-to-earnings before interest, taxes, depreciation, and amortization (EBITDA) basis, BTU shares recently traded at 7.2X our 2010 EBITDA forecast of about $1.8 billion. This EV/EBITDA multiple is below the company's five-year historical median of 8.6X estimated EBITDA, but greater than the peer-average EV/EBITDA multiple of 6.1X 2010 EBITDA estimates. Using recent trading multiples, BTU trades at an 18% premium to the peer average, which is below the average 35%-40% historical premium garnered by the shares over the past five years. We believe the stock's current discount to both its historical median multiple and peer-relative premium valuation is unwarranted. This belief is partially based on our earnings outlook for 2010 and 2011 along with our view that industry fundamentals will remain strong, as thermal coal inventories at utilities continue to firm and metallurgical coal remains in demand. In addition, we believe that BTU shares should trade at a higher premium valuation, relative to peers, due to the company's scale of operations and its direct exposure to expanding markets. Based on our view that the shares should trade more in line with historical valuation levels, we apply an EV/EBITDA multiple of 8.6X, a 40% premium to the peer average and in line with its five-year median multiple, to our 2010 EBITDA estimate, resulting in our 12-month target price of $53 per share.

CORPORATE GOVERNANCE We have an overall favorable view of Peabody's corporate governance practices, and think that positive governance attributes overshadow a few negative characteristics. On the positive side, the board of directors is composed of a majority of outside directors, which we believe enhances the quality of the oversight of management. We also find it a positive that shareholders have voted to declassify the board of directors, as a classified board can serve to entrench management. In addition, we like that the audit and compensation committees are comprised of independent directors. On the negative side, we think that Peabody's takeover defenses, stock ownership guidelines, and some board practices partially detract from the quality of governance. For instance, Peabody has a poison pill provision and can issue blank check preferred stock, which may serve to entrench management and deter acquisitions. Additionally, the company has no stated share ownership guidelines. Lastly, we think that the combined CEO and chairman of the board roles and the lack of individual director performance reviews both detract from governance quality. INVESTMENT RISKS We see a number of primary risks to our recommendation and target price. First, coal demand and pricing is affected by the price of natural gas, as it can be a substitute for coal-based power generation. A sustained decline in natural gas prices can lead to fuel switching and lower coal demand. In addition, coal company share prices exhibit a robust inverse correlation to the U.S. dollar index, meaning any sustained increase in the dollar's value can imply lower stock prices. Also, a higher dollar value can lead to lower coal export activity. Increased regulatory scrutiny is also an issue for Peabody, especially following the April 2010 accident at the Upper Big Branch mine. Increased regulation could lead to both lower production and higher costs. Lastly, coal mining is dangerous and accidents occur, which can lead to higher variability in earnings and increase financial risk.

CONCLUSION We view favorably Peabody's long-term prospects and believe that the company's sales and earnings will improve in 2010 and 2011, on better pricing and volumes. In addition, we view BTU's valuation as compelling, with the stock recently trading at a substantial discount to its historical levels based on EV/EBITDA. Our target price of $53 implies potential capital appreciation of over 20% from current levels. Our recommendation is Strong Buy./Mathew Christy, CFA S&P's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.

30-Aug-2010 10:00:20 (15806537)   Copyright 2010 The McGraw-Hill Companies, Inc, Standard & Poor's, a division of The McGraw-Hill Companies, Inc., and their affiliates (collectively, "S&P"). Reproduction of this content in any form is prohibited except with the prior written permission of S&P.