Will These Coal Companies Recover?

Leading coal producers Peabody Energy  (NYSE: BTU  ) and Arch Coal  (NYSE: ACI  )  recently released their fourth quarter earnings reports and updated their 2014 guidance. These reports didn't impress investors, and shares of both have tumbled over the past several weeks. Looking forward, can these coal companies recover? 

Fourth quarter results
The recent earnings reports of Peabody Energy and Arch Coal showed another dip in revenues and higher losses. Arch Coal's revenue plummeted by 17% during the fourth quarter, year over year; Peabody Energy's by 41%. Both companies' operating earnings were in the red. A big chunk of these losses, however, came from goodwill provisions and other non-cash impairment costs recorded in the fourth quarter. After controlling for these provisions, Peabody Energy's operating loss falls from $552 million to $17.5 million, nearly eliminating the company's entire quarterly loss. Arch Coal's operating earnings declines to $75 million. This means that while the companies are still losing money, the situation isn't as dire as the earnings reports suggest.  

In terms of output, Peabody Energy's production rose by 2% during the last quarter of 2013, mostly in the U.S. In Australia, the company's production inched down. The main reason for the drop in revenue was the sharp fall in prices in the U.S. and especially in Australia.   

On the other hand, Arch Coal cut down its production by over 10% in the last quarter of 2013. The average price of coal also tumbled by 17.8% during the fourth quarter. As a result of the plunge in coal prices, the company's operating margin turned from a $1.33 per ton profit in the last quarter of 2012 to a $1.19 per ton loss in the fourth quarter of 2013. This shift doesn't bode well for the company's operations and reduces its valuation.  

The ongoing fall in margins led coal producers to downsize their coal operations: During 2013, CONSOL Energy  (NYSE: CNX  ) sold its five West Virginia Longwall coal mines. Such steps are projected to reduce the company's coal sales by 47% in 2014. Further, the company expects to increase its natural gas operations by 30% in 2014, year over year. But unlike CONSOL Energy, Arch Coal and Peabody Energy remain heavily entrenched in the coal business. 

Looking to the remainder of 2014, Arch Coal plans to inch down its annual production by 1.9% to reach 137 million tons of coal. It also plans to slash its capital expenditure by 36% to roughly $190 million. Peabody Energy's outlook is a little less grim: It plans to slightly increase its production by 1.3%, and its capital expenditure is set to fall by less than 8% to $300 million. So even though Peabody Energy plans to slightly increase its production, both companies are expected to reduce their capital spending. 

The main uncertainty will remain the price of coal, which will determine not only their revenues but also their profit margins. So what's next for coal? 

Coal in 2014
According to the U.S. Energy Information Administration's recent outlook, during 2014 U.S. coal production is projected to rise by 3.9% to reach 1,035 million short tons. The rise in production is expected mainly due to the 3.5% rise in local demand. The rise in demand for coal could also facilitate higher volumes of coal sold by Arch Coal and Peabody Energy. Despite the projected rise in demand for coal, the price of coal is expected to be around $2.36 per million Btu -- nearly a 1% drop from 2013. This won't help Arch Coal and Peabody Energy improve their earnings. 

But in the first quarter of 2014, the price of coal might have a short-term recovery if the price of natural gas remains at its current high levels. 

Natural gas and coal
In recent weeks the price of natural gas spiked above the $5 mark. The colder than normal weather has increased the demand for natural gas. As a result, utility companies are forced to pay high prices for natural gas. These developments could shift demand back toward coal. In such a case, coal companies might see a modest rise in their operating earnings in the first quarter of 2014. But these high prices are likely to come down in the coming months, having only a short-term positive effect on the price of coal. 

Bottom line
The coal industry is projected to rally in 2014, which will benefit several coal companies. The recent colder-than-normal weather in the U.S. boosted the price of natural gas, which in turn might have also positively affected the price of coal in the first quarter of 2014. Despite the potential rise in demand for coal, its price is still expected to fall in 2014. Peabody Energy and Arch Coal continue to face narrower profit margins and tougher competition. Therefore, while coal might still offer some viable investments opportunities in 2014, Peabody Energy and Arch Coal might not offer enough to make them an investment worth considering. 

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