Is Walter Energy Destined for Greatness?

Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let's take a look at what Walter Energy's (WLTGQ) recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you're about to see tell Walter's story, and we'll be grading the quality of that story in several ways.

Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company's become more efficient over time. Since profits may not always reported at a steady rate, we'll also look at how much Walter's free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Walter's share price has kept pace with its earnings growth, that's another good sign that its stock can move higher.

Is Walter managing its resources well? A company's return on equity should be improving, and its debt to equity ratio declining, if it's to earn our approval.

Healthy dividends are always welcome, so we'll also make sure that Walter's dividend payouts are increasing, but at a level that can be sustained by its free cash flow.

By the numbers
Now, let's take a look at Walter's key statistics:

WLT Total Return Price data by YCharts.

Source: YCharts.
*Period begins at end of Q3 2009.

WLT Return on Equity data by YCharts.

Source: YCharts.
*Period begins at end of Q3 2009.

How we got here and where we're going
Walter's weak showing, with only three of nine possible passing grades, shouldn't be too surprising for anyone who's been watching the wretched performance of coal stocks in recent years. Walter's net income was in decline even before its $1.1 billion writedown in the third quarter. However, materials stocks can be cyclical, and if you examine Walter's performance from the third quarter of 2009 to the second quarter of 2012, its net income and free cash flow both take a rollercoaster ride -- into decline, rising toward gains, and then crashing into decline again. Will 2013 be the year Walter rides back to the top, or is the global economy too anti-coal for Walter to recapture its former glory?

Walter's focus on metallurgical coal has only slightly insulated it from the opposition to coal-fired power plants, but the steel industry is in its own doldrums, waiting for global demand to perk up. Met-coal competitor (and major iron ore supplier) Cliffs Natural Resources (CLF -11.03%) is doing slightly better than Walter, but its decline is starting to look steeper, and it's wound up in a worse free cash flow position as both sides of its business come under extreme pressure. The two steel industry bellwethers, ArcelorMittal (MT -2.40%) and United States Steel (X -2.32%), have actually underperformed Walter in this time frame, with weaker revenue growth and steeper stock-price declines:

WLT Total Return Price data by YCharts.

The other side of the coin, coal-fired power, is in a bit of a bind. On the one hand, American coal consumption is dramatically lower than it was a decade ago, and hundreds of coal plants face an impending retirement. On the other hand, coal is projected to become a huge growth product in emerging markets, particularly in India and China, where it's already become the preferred energy source for much of each nation's power plants. Keep in mind that this is a long-term projection -- but long-term investors should feel comfortable with the wait, if a $30 trillion annual consumption rate is in the cards.

Since Walter's more of a met-coal miner, it hasn't dropped as much as thermal-coal miners Arch Coal and Alpha Natural Resources (NYSE: ANR), both of which have lost nearly twice as much off their share prices  as Walter in the past three years. On the other hand, that means Walter's upside may be more limited, particularly if construction demands taper off as emerging-market populations stabilize. A truly long-term time horizon may not be as favorable to this miner as it might be to more focused peers.

Putting the pieces together
Today, Walter has few of the qualities that make up a great stock, but no stock is truly perfect. Digging deeper can help you uncover the answers you need to make a great buy -- or to stay away from a stock that's going nowhere.