Description

Introduction

Peabody is a global, diversified coal company with exposure to both thermal and metallurgical coals and operations in the United States and Australia.

Peabody has been written up several times on VIC, most recently by Motherlode in November 2020 at a share price of $0.85. With the share price now significantly higher and Motherlode closing their recommendation last summer (after a ~25-bagger) I believe it is time for another write-up. Peabody won’t return another 25x over the next 3 years, however the situation is now materially de-risked and I believe the shares offer excellent risk/reward especially in the current market environment.

Despite being up ~25x over the last few years, the stock has lagged other coal companies for reasons that I believe will soon dissipate.

At a current share price of $23.40, the market cap of Peabody is $2.9bn and the Company has $535m of net cash for an EV of $2.4bn. This equates to a ~30% FCF yield based on 2023 FCF of $730m. Go-forward FCF is clearly dependent on coal prices which are somewhat hard to predict in the short-term, however I believe BTU will generate anywhere from ~10% - 30% FCF yields (on an unlevered B/S with excess cash) in a typical year with potential outliers to the upside in the coming years.

Importantly, Peabody is currently in the process of expanding its production footprint by developing the Centurion mine which is expected to produce 4 MT of premium hard coking coal from 2026 onwards which will add an incremental $200m to $400m FCF (or >10% of current market cap) per year and further shift its production profile towards seaborne met away from thermal coal which should drive multiple expansion (though that is not required to do well here). So from 2026/27 onwards, I believe Peabody will generate anywhere from 20 – 40% FCF yield on its current market cap every year, with likely outliers to the upside, for an average through-the-cycle FCF yield of likely north of 30%. I believe the majority of this FCF will be allocated to shareholder returns and hopefully as much as possible to buybacks.

I am constructive on the medium- and long-term price outlook for met coal due to lack of new mine investment with increasing deficits expected from 2026 onwards (just when Peabody’s production should ramp up with Centurion).

While less important from an FCF perspective at current prices, Peabody produces more US domestic thermal coal tonnage than met coal. I do not ascribe significant value to the US domestic thermal coal business, would however note that just a somewhat small increase in thermal coal pricing in the US would have a disproportionate impact on BTU’s earnings power and FCF generation in any given year due to high number of tons involved. I view this akin to an at-the-money call option on US electricity prices and by proxy thermal coal prices. However, this is pure optionality and not required to do well here.

Based on our 2026 onwards view of through-the-cycle FCF of ~$800m ($500m existing footprint + $300m Centurion), and assuming a fair multiple of ~6.5x (or ~15% FCF yield) our view of value in 2026 is $5.2bn. I assume that share count will have reduced by 20% at that point (as most cash flow generation in the interim is allocated towards share buybacks) with net debt broadly unchanged. This implies a share price of ~$54 and an IRR to end of 2026 (~2.5 year hold) of 40% or 2.3x money multiple including a ~1% dividend yield. I would probably be a happy holder at $54 in 2026 and continue to earn my ~15% FCF yield at that time or ~35% on my cost base.

Capital Structure

As Motherlode discussed, the Company’s solvency was at risk in late 2020 amidst covenant breaches and looming maturities in the middle of the COVID downturn. In order to avoid bankruptcy, the Company reached an agreement with its surety providers (which are required by the regulator to cover the cost of asset retirement obligations) and successfully completed a liability management exercise by exchanging existing debt into a structurally senior facility issued by its Australian Wilpinjong mine. The transaction ensured BTU could continue operate as a going concern and extended its runway materially. However, it came with a significant amount of limitations including restrictions on shareholder returns through 2026.

With the Company generating a significant amount of excess cash during the post-COVID boom years especially in 2022 & 2023 post the Russian invasion, BTU was able to renegotiate its agreement with the sureties in April 2023 paving the way for future capital returns.

The Company still has an LC and surety facility, however this is fully cash collateralized (the Company has $856m of unrestricted cash, which is what you see on Bloomberg, but also has $836m of restricted cash). The only drawn debt in the capital structure is a $320m convertible which has a 3.25% coupon and is in the money with a strike price of $19.59 (16.3m of incremental shares on top of the existing 128.4m shares). Pro-forma for the conversion, the company is therefore debt free, with $856m of cash on B/S and a market cap of $3.3bn at the current share price of $23 ($2.5bn EV).

Capital Allocation and Shareholder Returns

I view the coal industry as ‘ground zero’ for the importance of capital returns that David Einhorn discussed on his podcast appearance in March of last year. AMR has the most aggressive buyback policy in place and the share price performance has crushed the rest. There’s other considerations (e.g. met/thermal mix) but overall it’s clear what has been driving coal equity returns.

I therefore viewed the April 2023 announcement by BTU with excitement. The Company announced a $1bn buyback program and more importantly a policy to return at least 65% of annual Available FCF to shareholders. While I wish it’d be all buybacks, BTU will instead pay a regular $0.075 dividend / share on a quarterly basis with the remainder to be used for share purchases. The dividend equates to ~$40m per year. Surprisingly, the stock is actually flat/slightly down since that announcement. Partially this has to do with weaker thermal coal fundamentals however I think a large chunk of it is technical with their largest holder Elliott dumping at least 15 million shares (>10% of float) since then. As of Q1’24, they were down to 4 million shares and are now below the threshold where they need to notify the market about trades. We therefore have to wait for the next 13-F but I expect Elliott to have further sold shares and may even be fully out at this point (and if not, they likely will be soon). This will remove a major overhang for the stock.

Free Cash Flow:

BTU generated Levered FCF of $730m in 2023 or call it ~22% FCF yield on the FD market cap at current prices (which doesn’t take into account that the company has 25% of its market in unrestricted cash on B/S). Coal prices are hard to predict so I think trying to come up with cash flow forecasts and implied go-forward FCF yields is a bit of a fool’s errand and creates an artificial sense of precision.

I don’t expect the met coal prices achieved in recent years to repeat themselves anytime soon, however even at much more conservative assumptions, it is hard to see how BTU won’t generate ~10-20% of its current market cap in cash flow in the coming years in average/below average year with some hard-to-quantify but nevertheless valuable optionality for this FCF to go up massively on short notice:

• Met coal prices experience periodic spikes as a result of a steep cost curve and a relatively concentrated production footprint in flood-prone areas
  • BTU is the only miner of scale with assets in both N. American and Australia and is therefore most likely to benefit from such an event / least likely to suffer disproportionally from lower volumes vs. higher prices
• Implicit at-the-money call option on Henry Hub
  • Domestic thermal coal prices for BTU are very low and as a result despite the high tonnage, the domestic thermal coal segment is a relatively small contributor to earnings and cash flows
  • I’m not saying gas prices in the US will roof tomorrow, but a lot of things have happened over the last few years that I did not necessarily expect so I view having this option is better than not having it. Possible reasons that could get us there:
    • declining gas production from US shale
    • significantly higher power demand (including from data centers which is a theme that’s been documented ad nauseam at this point)
    • Large pull on gas demand from increased LNG export capacity

Conclusion:

People who have been in the coal industry for a while will usually tell you this is an industry where every 5 years or so you make more money than the prior 5 years together. That generally is not a great business model however, when current valuations still give you 10-15% FCF in a bad year, on an unlevered balance sheet, I think this is a highly compelling situation to be involved in.

I believe this opportunity exists as coal (including met coal) is shunned by most institutional  investors. Many people have lost money in prior boom/bust cycles and so not getting involved (in the name of misguided environmental objectives) is an easy way to virtue signal. Given the lack of exploration capex, the unlevered balance sheets and the continued high demand for met coal (especially from developing countries) I believe the met coal industry as a whole will continue to generate attractive returns for its investors.

BTU has historically been the most liquid, “go to” name for generalists looking to get coal exposure. They’ve been severely disappointed given continued management missteps and probably not understanding the capital structure issues going into the trade. Coupled with a large seller pressuring the stock I believe this now creates a very attractive entry point. Few people own coal stocks for the long-run and historically these commodity companies have indeed been ‘names to rent, not own.’ I would argue that this time is different given the chronic lack of mining investment given ESG reasons providing attractive fundamentals as well as the lack of institutional ownership given ESG reasons offering low entry valuations. The combination of strong fundamentals, growing FCF with Centurion, a shareholder friendly capital allocation policy AND low purchase price provides a set-up that lends itself to an asymmetric return profile.

The recent rally in the stock is due to a ~1% of global hard coking coal supply having gone offline following an accident at Anglo’s Grosvenor mine. However, BTU’s rally has lagged significantly those of pure-play met coal names like AMR and HCC as well as the thermal/met hybrids and as such despite the higher share price I believe the relative value remains extremely compelling.

Catalyst

- coal price shoulder season ending

- higher for longer HCC prices following Grosvenor fire

- Elliott fully exits position

- continued share buybacks

- Centurion FCF from 2026 onwards