Cracks in the Foundation

Prior to the apparently sudden realization this week that "hey, it's hot outside!", nobody seemed to want to own coal stocks anymore. Iffy ultra-short-term guidance from Peabody (NYSE: BTU) and Arch Coal (NYSE: ACI) churned the waters a bit and disappointing results from Massey (NYSE: MEE) and Foundation (NYSE: FCL) certainly didn't help. In the case of Foundation, though, perhaps there's enough value to merit some patience and forgiveness.

Results in this second quarter were certainly affected by some factors outside of direct management control. Coal shipments were up 16%, but Powder River shipments were still impaired by rail issues (presumably at Burlington Northern (NYSE: BNI)). And while coal pricing in general is still pretty good on a year-over-year basis, Foundation reported lower average realizations on a combination of a higher percentage of PRB coal (which sells for less) and lower premiums.

All in all, then, total coal revenue rose 11%, and while reported operating income dropped 20%, a major factor in that drop was less benefit from a non-cash amortization of a supply agreement. In other words, reported operating earnings were down, but adjusted earnings were up. You could also argue that earnings quality improved, since cash earnings were higher. For those who track adjusted EBITDA (which is a very common metric for valuing coal stocks), it was up 15%.

Partly because of those lower premiums, Foundation lowered its full-year earnings guidance. Sulfur dioxide emission allowance prices dropped about 40% this quarter from the prior year and have since moved even lower. This is bad for Foundation. In a nutshell, when allowances are expensive, Foundation can reap a higher premium for cleaner-burning coal, but those premiums shrink when allowance prices fall and utilities can simply buy the allowances instead of the more expensive coal.

This second quarter certainly doesn't make it any easier to argue the case for owning Foundation stock. By the same token, they're a small producer whose reserves look rather cheap on an energy-equivalent basis. So though I can certainly understand why an investor might want the security of a stock like Peabody or the higher income of Penn Virginia Resource Partners (NYSE: PVR) or Natural Resource Partners (NYSE: NRP), more aggressive investors may still want to inspect Foundation's foundation and see if there might be value here.

For more Foolish thoughts on the coal sector:

• Massey Energy Takes Its Lumps
• Coal Continues to Creak
• Building on Foundation

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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).