Rating Peabody: A coal giant on the ropes

The world’s largest private pure play coal miner is an increasing financial risk following net losses in the US and Australia. Management would be prudent to consider the new climate 'normal'.

US-based Peabody Energy Corp, the world’s largest private pure play coal mining company by volume, reported a net loss of $US151 million in the last three months, taking year-to-date net loss to $US272 million. This follows a net loss of $US955 million in 2013 and a net loss of $US432 million in 2012.

The loss demonstrates Peabody is a company with increasing financial risk.

Despite spurious claims that coal is good for humanity, coal mining is proving disastrous for its shareholders. Peabody shares are down 62 per cent over the last two years relative to the S&P500, which is up more than 30 per cent in this same period.

The equity markets are suggesting this is not a healthy company: on a five year time frame, Peabody shares are down 75 per cent, while the S&P500 index is up 80 per cent. These losses are partly due to falling revenue from Peabody’s Australian coal business, reflecting stalling global demand and an increasingly dim investment outlook for thermal coal, one might even suggest structural decline.

Peabody is carrying major financial liabilities. With the stock down another 5 per cent post result, Peabody has a current equity market capitalisation of US$2.7 billion. Against this, Peabody entered 2014 with $US3.7 billion of take or pay liabilities, $US5.5 billion of net debt, plus $US700 million of less than fully funded mine rehabilitation provisions and a further $US700 million of accrued but unfunded post retirement pension liabilities. Investors viewing the company’s commercially minable reserve levels have legitimate concerns as revenues plummet, cost pressures squeeze margins and the company continues to reduce capex.

Despite a production rate of 36-38Mtpa providing huge scale, Peabody’s Australian business has seen gross earnings year-to-date down 89 per cent year-on-year to only $US31 million. This gives Peabody an Australian gross profit margin of less than 2 per cent, a fraction of the 13 per cent reported in the previous corresponding period. This reflects average realised selling prices down 15 per cent year-on-year to $US71/t (and down to average only $US67/t in the latest quarter) while operating costs have only been reduced by 4 per cent to $US70/t.

We note that Peabody’s definition of gross profits is before selling and administration costs, before depreciation, depletion and amortisation charges, before asset retirement obligations and other costs relating to post mining activities. Net of the non-deducted cash costs, Peabody on average is losing cash with every tonne of coal mined in Australia in 2014, before considering the $US400 million of annual interest expenses being incurred.

Peabody massively overinvested at the peak of the coal cycle in buying Macarthur Coal in late 2011 in what was foolishly called “Deal of the Century” at the time but is in hindsight proving to be a financially crippling $4.9 billion acquisition price. As a result, Peabody is now focused on preserving cash and has cut all discretionary capital expenditure. Beyond completing existing commitments, all new growth initiatives have been shelved and maintenance expenditure has been reduced to only a third of the annual $US650 million depreciation and depletion charge.

However, despite the mounting losses over the last three years and the zero funded state of its pension plan for retired workers, Peabody continues to rather optimistically pay $US92 million annually in dividends to shareholders. Absent a sustained and rapid improvement in the coal market, IEEFA would view the curtailment of dividends a prudent and likely step near term.

We also note the inconsistency of the zero funding of the post-retirement pension plan, in contrast to the 90 per cent funding of the $US947 million defined benefits plan. US union officials are sounding the alarm about threats to the pension and health plan risks to retired workers should their past employer go bankrupt. US workers do not have as much protection as now predominantly exists in Australia of full funding and external custodians for pension liabilities.

Despite management commentary referring to strong underlying demand, the Energy Information Administration reports US domestic coal consumption is down year-on-year to date in 2014, and down 21 per cent from its peak in 2007. Likewise through the first eight months of this year, US coal exports are down 16 per cent compared to the year-ago period to 61Mt.

Further, China has reported that year to date domestic coal consumption in 2014 is down, the first time in a decade. This follows subdued growth in the prior two years, in stark contrast to the double digit annual coal volume growth seen for the preceding decade. The fact that Chinese coal demand is down in another year of 7.4 per cent real gross domestic product growth highlights the growing divergence in the historically reliable correlation in Chinese electricity demand growth and GDP growth.

These two data points from the world’s two largest consumers of thermal coal showing a decline in demand contrast with the continually optimistic picture of strong demand portrayed by Peabody.

Peabody’s historically high margin Australian holdings traditionally balanced out the company’s high volume, low margin US holdings. Neither part of the portfolio is currently working well. The company, like many other US coal producers, faces days of reckoning as it caps off another year where company and industry turnaround promises have failed to materialise and losses mount. Going forward the company faces a number of escalating issues in the US. In addition, Washington officials appear to be poised to increase royalties on US coal exports to correct for previous undervaluations.

One other major deal continues to dog Peabody, that being the Prairie State Energy Campus.

Peabody Energy Company transferred almost all the financial risk of building and operating this massively expensive mine mouth coal-fired power plant in Southern Illinois to municipal ratepayers in the Midwest. Having promised a low-risk, steady source of electric power at below market rates of $US41/MWh, the plant has instead charged more than double, and sometimes triple, that price since inception.

The original 2004 cost estimate was $US1.8 billion. The final construction cost has not been disclosed to ratepayers, but is north of the last disclosed figure in 2010 of $US4.9 billion. The plant has also failed to operate at designed capacity due to constant mishaps, with the average at 60 per cent versus the promised 85 per cent.Why was the power plant built? To give Peabody an end-market for its thermal coal mine that was otherwise a stranded asset.

If operating losses continue at the current rate, Peabody will increasingly find debt refinancing harder to complete, and pension and mine remediation liabilities are underfunded and hence exposed. IEEFA considers it financially prudent to stop relying on historical growth rates and to consider the increasing risk profile should seaborne thermal coal have entered structural decline and/or should global policy action to address climate change risks step up into 2015.

Tom Sanzillo is the director of finance studies for the Institute for Energy Economics and Financial Analysis.

*Note: IEEFA provides commentary of the outlook for the global thermal coal and electricity markets entirely for educational and energy policy purposes. In no way should this be considered financial advice on the investment merits or otherwise for any particular company discussed.