As stated in a recent Fool article, the decline in shares of Alpha Natural Resources in the past year has left its market value significantly below its book value. Another coal producer, Arch Coal, faces a similar situation. This puts into question whether investors should consider holding on, or whether they should stay clear of these companies.
Why hold?
The main advantage these companies have is the huge discount on their valuation: Alpha Natural Resources has a market cap of $734 million, while its book value is over $4 billion -- this comes to an 82% discount; the market cap of Arch Coal is $636 million, which is a 70% discount from its book value. But the book value doesn't take into account these companies' debt burdens and earnings.
The other side is the potential short-term rise in coal market in the coming months, which may provide some backwind for local coal producers in the near term. But this backwind isn't likely to last long as more utility companies, the prime users of coal in the U.S, steer away from coal to other resources such as natural gas.
Why not?
Let's start with these companies' current valuations. Based on their enterprise value to EBITDA ratios, these companies are priced high even in the coal industry. The table below summarizes these figures.
Source: Yahoo! Finance and Aswath Damodaran.
The other factor to consider is their lack of production growth. This year, Arch Coal's production is expected to fall by 3.4%, and Alpha Natural Resources' by 4.5%.
Source: Arch Coal and AlphaNatural Resources.
Looking forward, the expected cool-down in the coal market by 2015, based on the recent outlook of the Energy Information Administration, suggests these coal companies won't benefit for long, if at all, from any modest recovery the coal market experienced in the past year.
The drop in coal sales is not only due to lower output, but also to falling coal prices. Arch Coal, as an example, estimates its margin on coal sold per ton will decline from 14.8% in 2013 to 14.2% in 2014. This is after the margin was over 20% back in 2012. Moreover, even after the company expects its cash cost to fall by 7% in 2014, year over year, this decline won't be enough to offset the average annual realized price of coal.
Source: Arch Coal
Alpha Natural Resources faces similar problems and is likely to move in a similar path.
The final nail in the coffin is the high debt level these companies carry on their balance sheets. Arch Coal's debt-to-equity ratio is 2.4, and Alpha Natural Resources' ratio is 0.83. Since these companies aren't showing any profits, this is likely only to get worse in the coming quarters, which will raise their financial risk.
What is the bottom line?
I think investors should consider assets that offer a good bargain for their given level of risk and have a good chance of appreciating over time. Investing in coal companies, even at such a discount, might not prove to be profitable. These companies face shrinking sales, lower profit margins, expected growing debt, and a contracting industry. These factors put together suggest investors should steer clear of coal companies.
