BTU - Peabody Boost Shareholder Rewards As Coal Prices Implode

2023-04-17 15:25:42 ET

Summary

• Thanks to rebounding coal prices, high demand, and rapid debt reduction, Peabody Energy was just able to announce a very ambitious shareholder return program.
• While shares reacted positively, it needs more than this announcement to allow shares to recover, as the industry has shifted from undersupply to oversupply.
• The good news is that the risk/reward has gotten better, as I expect rebounding natural gas prices and bottoming economic growth to turn into tailwinds in 2H23.

Introduction

In November 2022, I wrote my last article covering the American coal giant Peabody Energy ( BTU ) . Since then, the stock price has been unchanged despite a steep slump in coal prices triggered by a mix of macroeconomic and weather-related headwinds. However, the company just revealed a new shareholder return program, which is giving its share price a much-needed boost.

In this article, I will update my thesis in light of new developments and assess the risk/reward after management decided to boost cash flows toward its shareholders.

So, let's get to it!

What's Peabody Energy?

With a market cap of $3.9 billion, Peabody Energy is one of America's largest coal producers. Headquartered in St. Louis, Missouri, the company owns an interest in 17 active coal mining operations in the United States and Australia. Among these mines is North Antelope Rochelle, the world's largest coal mine.

According to the company, that mine alone produced more than 60 million tons of coal in 2022.

The company's sales for the year 2022 totaled 124 million tons of coal, with 101 million tons being US thermal coal, commonly known as steam coal, used primarily for electricity generation. The remaining 7 million tons were metallurgical coal, also known as coking coal, which is used in the production of steel. This indicates that the company's main focus is supplying coal to electricity generators rather than the steel industry.

In other words, BTU is the key supplier of the very commodity the energy transition is trying to eliminate from the picture.

So far, that is working quite well. As I tweeted last month, coal just fell behind renewables when it comes to power generation in the United States.

Estimates are that coal will supply just 17% of electricity in the United States. Last year, it was 20%. When the New York Yankees won their 25th World Series in 2000, that number was above 50%.

In the last year alone, about 11 gigawatts of coal plants have closed, representing 5% of the total coal capacity, according to the Energy Department and reported by Bloomberg .

That said, this does not indicate that coal companies are about to go bankrupt in the next few years.

Peabody's New Plan For Shareholder Distributions

As reported by Seeking Alpha , Peabody approved a new shareholder return framework, which includes a stock buyback plan, a fixed quarterly cash dividend, and a variable quarterly dividend.

The company, which did not pay a dividend prior to this announcement, plans to return at least 65% of its annual available free cash flow to shareholders - retroactive to January 1, 2023.

Peabody expects to launch the shareholder return program in the second quarter of 2023, following the company's announcement of its first-quarter earnings.

According to the company :

"With the achievement of our target to eliminate all senior secured debt and fully pre-fund estimated final reclamation costs , strong execution of operating plans and favorable market conditions for our products, we are pleased to announce our program to return value to shareholders," said Peabody President and Chief Executive Officer Jim Grech. "These actions allow us to return a designated portion of our cash flow to shareholders while reinvesting in our long-term future and maintaining a strong balance sheet , underpinning Peabody's objective to be the coal producer of choice with an unmatched opportunity to return free cash flow to shareholders."

That said, the shareholder return program includes a regular quarterly cash dividend of $0.075 per share (a 1.1% yield) on top of repurchasing shares with 65% of its available cash flow from operations.

The company aims to transition to a more balanced shareholder return program, incorporating fixed quarterly cash dividends, variable dividends, and share repurchases in the second half of 2023, with all shareholder returns subject to the discretion of the Board, which is always the case.

Shareholders liked this proposal, as shares rose by 6% after the announcement.

So far, so good, but how attractive does this make BTU? After all, it needs to make money in order to distribute anything to its shareholders.

The Peabody Energy Risk/Reward

BTU was in a very bad spot in 2020. A mix of structural demand weakness, economic growth slowing (pre-pandemic), and the pandemic in early 2020 annihilated shareholder value.

That said, the past few years were great for coal. Since early 2022, shares have almost tripled. That's after a 21% decline from the stock's 52-week high.

The surge was supported by economic reopening, which caused energy demand to soar. Moreover, because (mainly Western) nations had pushed hard for renewable energy, it was hard to produce affordable energy. This was made worse by the war in Ukraine, which caused Russia to lower natural gas exports to Europe by more than 90%.

That said, some of these tailwinds have eased. API2 coal futures are the benchmark price reference for coal imported to northwest Europe. These prices have fallen from more than $440 per ton in early 2022 to less than $140 while I am writing this.

The same goes for Newcastle coal and a wide range of other coal futures.

One reason is the warm winter in Europe, which allowed natural gas storage levels to remain elevated. This reduced the demand for coal. Moreover, global economic growth has slowed down quite significantly, reducing demand for cyclical commodities like thermal coal.

Hence, the market went from being undersupplied to being oversupplied.

As reported by the Wall Street Journal :

“We went from undersupplied to oversupplied very quickly,” said Andy Blumenfeld, data analytics director at McCloskey by OPIS, a pricing service that is part of Wall Street Journal publisher Dow Jones & Co.

Prices started surging in 2021, when power producers fired up coal-burning generators to keep air conditioners running during some of the hottest temperatures on record. Stockpiles at U.S. power plants shrank to their lowest level since the Nixon administration .

With that said, coal buyers are likely to have more impact on prices. According to the aforementioned WSJ article, coal miners are facing financial challenges as coal-burning capacity decreases, leading to decreased financing for speculative production. Most miners are now selling the majority of their output in advance, leaving them with limited inventory to meet unexpected demand.

Big mining companies have informed investors that they are largely sold out for 2023. However, there is a possibility that power producers may have overbought and may attempt to resell coal in export markets or renegotiate deals with their suppliers, which could further drive down prices.

As a result, some utilities are resorting to burning coal to create space for incoming deliveries, even though it has become economically unfavorable, according to Mr. Blumenfeld of McCloskey.

With that said, the long-term demand for coal is strong. BTU anticipates global coal demand to remain close to 1.3 billion tonnes until at least 2025.

When adding that the industry has seen years of underinvestment, BTU believes that thermal coal prices (Newcastle coal) could remain close to $200 per ton on a prolonged basis.

That's roughly where Newcastle coal is currently trading and twice as high as pre-pandemic prices.

With that said, this year, BTU is expected to generate $1.1 billion in free cash flow. Next year, that number is expected to fall to $430 million, which is $200 million more than the company generated in 2021.

In other words, even if we ignore 2023, the company is in a good spot to maintain a long-term free cash flow yield of more than 10%.

In the first half of this year, the company will likely stick to buybacks. However, according to its new shareholder cash distribution plan, we might be looking at a very juicy special dividend announcement in the second half of this year, on top of an expected hike of its base dividend, which is currently just 1%.

With that said BTU shares are trading at just 1.7x NTM EBITDA. This is very low. Even if we include a potential decline to $430 million in 2024 EBITDA, the stock is undervalued.

The current consensus target price is $33 (current price: $27).

I agree with that.

However, investors need to be aware that in order to continue this rally, we need a few things:

• Higher natural gas prices (I expect this to happen as I wrote in this article ).
• An economic demand rebound, I expect this to happen in the second half of this year.
• Strong emerging market demand, which I believe is supported by recent USD weakness.

Takeaway

Peabody's decision to open the floodgates of cash to shareholders this year is fantastic. It will finally unlock the combined power of high free cash flow and a healthy balance sheet.

However, it does NOT have a major impact on the bull case. After all, it was obvious that the company would eventually start distributing cash.

The drivers of BTU will be seaborne coal prices and related demand factors. So far, these factors have been bearish. However, we could be close to a bottom if we get support from rebounding economic growth and natural gas prices, which I expect to happen.

So, please be aware that the risk/reward is getting better, yet still on shaky ground.

Hence, my rating for the time being is neutral.

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