More Headwinds Ahead for This Coal Miner

Limited ability to cut costs and low coal prices will continue to pressure Peabody's performance.

Feb 2, 2014 at 9:41AM

The coal industry is clearly not out of the woods yet. Even the best performing companies like Peabody Energy (NYSE:BTU) struggle to make meaningful progress in the current environment. However, Peabody managed to stay profitable in the fourth quarter, which distinguishes the company from most coal miners.

Companies like Alpha Natural Resources (NYSE:ANR), Arch Coal (NYSE:ACI) and Walter Energy (NASDAQOTH:WLTGQ) are expected to post losses when they report their fourth quarter results. While Peabody is performing better than its peers, there are obstacles that could prevent Peabody's shares from being a great investment this year.

It will be difficult to cut costs further
Peabody's management has done a good job lowering the cost of production as much as possible. However, this was done mostly by reducing headcount. The company reduced its U.S. workforce by 12%, while the Australian workforce was reduced by as much as 20%.

There is little room for further reduction of personnel. As a result, the company expects that its U.S. costs could drop by 1% to 3% in 2014 compared to 2013, while Australian costs are likely to remain at the existing level. Any further downside on the price front will push the company's earnings back into the negative territory, as Peabody is unlikely to make additional progress in costs.

Disturbing news from China
According to the HSBC China Manufacturing Purchasing Managers' Index, China's manufacturing sector contracted in January. Earlier in January, the release of Chinese GDP showed that economic growth was at a 14-year low.

As China is the largest importer of met coal, such news unnerves shareholders of coal stocks. Walter Energy, which is a pure met-coal play, is already down 30% this year. Continued weakness in met coal prices and massive debt put significant pressure on the company. Shares of Alpha Natural Resources also started the year on a sour note, as met coal brought 40% of revenues in the last quarter.

Despite recent news, Peabody remains optimistic about the situation in China. The company stated that China's thermal coal generation increased 7% in 2013, while domestic supply rose just 1%. Peabody also stated that Chinese coal imports accelerated to a monthly record of 35 million tons in December. Chinese met coal imports increased over 40% in 2013, but this didn't help prices.

Severe weather and rising natural gas prices in U.S. add support to shares of thermal coal-heavy Arch Coal. Natural gas near $5 is clearly bullish for thermal coal. It's worth noticing that longer-term natural gas futures remain below $4.5, signaling that elevated natural gas prices could be a one-time event.

Short-term headwinds persist
In its earnings release, Peabody stated that it thinks that coal demand growth will exceed supply increases. I believe that it is true in the longer term, as uneconomical production will ultimately leave the market. However, this process will take some time.

While the market is flooded with supply, Peabody has little room for maneuver to improve its profitability. During the earnings call, the company stated that it will continue to explore the sale of non-strategic assets.

Australian Wilkie Creek mine's case has shown that it's easier said than done. The company was trying to sell the mine for more than a year, but didn't find sufficient buyer interest. As a result, Peabody decided to close the mine.

All in all, I believe that the limited ability to cut costs further down together with persistently low coal prices will continue to pressure Peabody's performance.

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Vladimir Zernov has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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