Attractive Assets and Cost Control Make Cloud Peak a Winner
Its position in the Powder River Basin gives the firm a narrow moat.
Even after reduced production at one mine resulted in a slight decrease in our fair value estimate, Cloud Peak Energy (CLD) still looks undervalued to us, trading at enough of a discount to merit a 5-star rating.
Cloud Peak is the lowest-cost player in the lowest-cost coal mining region in the world: the Powder River Basin. We think PRB coal prices will increase significantly from current levels over the next few years as PRB coal is a much more cost-effective option than natural gas for generating electricity. Also, current PRB coal prices lie well below the operating costs of marginal PRB operators. We believe above-average coal inventories at power plants are keeping the lid on coal prices, but also believe inventories will be slowly worked down.
Before its initial public offering in November 2009, Cloud Peak operated as part of Rio Tinto's North American energy division. After selling the Jacobs Ranch mine to Arch Coal in 2009, Cloud Peak is now left with three surface coal mines: Antelope, Cordero Rojo, and Spring Creek. All are located within the PRB and exhibit cumulative production capacity just shy of 100 million tons of coal per year. From a cost perspective, the PRB is one of the world's most advantageous coal mining regions, as its thick, uniform coal beds allow miners to utilize massive trucks and draglines for easy and efficient access and transport. While shipping costs for PRB coal can be more than 2-3 times its extraction cost on a per-ton basis, the majority of the U.S. coal power plants still find it more economical to burn PRB coal relative to other types of coal, given the PRB coal's abundance, minimal sulfur content, and ultralow production costs.
In addition to its attractive low-cost coal assets in the PRB, we like Cloud Peak's keen focus on cost control. Furthermore, Cloud Peak's relatively modest debt load reflects its above-average fiscal conservatism, and the company has historically locked in prices for much of its coal production two to three years out. While its affinity for fixed-price contracts has prevented Cloud Peak from enjoying the full benefits of coal price spikes, the strategy is looking smart in the current environment of depressed domestic coal prices.
Large, Low-Cost PRB Position Results in a Moat
We believe Cloud Peak enjoys a narrow economic moat, due primarily to its large, established position in the low-cost Powder River Basin in the U.S. We're big fans of the company's PRB operations, where Cloud Peak is the third-largest among four miners that control the basin, including Peabody Energy, Arch Coal, and Alpha Natural Resources. Compared with other U.S. coal basins (and across the world), cash extraction costs are extremely low, at well under $10 per ton, excluding cash royalty payments. This cost advantage has allowed the basin to grow quickly over the past three decades and steadily take share from the other U.S. production centers, especially central Appalachia.
In addition, PRB producers have shown production restraint in the face of weak demand in the past (such as during the downturn in coal prices during 2009 and 2012), which is supportive of healthy profit margins for the existing PRB operators, including Cloud Peak. The PRB's low costs will always be its biggest strength. As central Appalachian production continues to decline and costs rise in the East thanks to stricter regulation, geological challenges, and a chronic labor shortage, the PRB should gain some market share, benefiting Cloud Peak, in our opinion. Furthermore, we believe existing large PRB operators such as Cloud Peak are relatively protected from new entrants, given the sizable infrastructure investments they have already made within the basin, which allow them to mine adjacent coal deposits using much lower incremental capital than a new miner without any existing operations in the basin could.
Cyclical Nature of Coal Mining Brings High Uncertainty
Coal mining is a highly cyclical industry, and producers have high fixed costs. Poor economic growth or unfavorable weather patterns (such as a warm winter or a cool summer) would reduce domestic coal demand and prices. In the PRB, the government and railroads extract large amounts of rent from the coal producers, and higher government lease rates for coal reserves in particular could lead to significant cost inflation for PRB operators such as Cloud Peak. Furthermore, low natural gas prices and more stringent environmental regulations on power plants are factors that would encourage utilities to switch from coal to gas in generating electricity, which in turn would crimp domestic coal demand. On the other hand, periods of strong demand and supply disruptions can result in exorbitant profits for coal miners. Given the wide range of possible valuation outcomes, we give Cloud Peak a high uncertainty rating. We don't put it in the very high category, however, because its low-cost position and relatively strong financial health mitigate its leverage to coal industry fundamentals.
Management Has Focused on Controlling Costs
We think Cloud Peak's management team has generally done a good job of allocating shareholder capital during its brief tenure. Most members of the current team, including CEO Colin Marshall, CFO Michael Barrett, and COO Gary Rivenes, are Rio Tinto veterans, with plenty of experience in the coal mining business. Since Cloud Peak's 2009 IPO, management has focused on controlling operating and overhead costs. As a result, the company is one of the lowest-cost major producers in the PRB. Thus far, the company has employed the majority of its free cash flows to greatly increase mine life through successfully bidding for federal coal reserve tracts, as well as purchasing private coal reserves. We like management's $300 million purchase of Youngs Creek in July 2012, which added high-quality undeveloped coal reserves, located just miles away from the firm's Spring Creek mine, at a market-competitive price. We also like the constraint that Cloud Peak has exhibited with its mid-2013 announcement that it would curtail production from the Cordero Rojo miner starting in 2015 because coal price levels weren't high enough to justify the capital expenditures necessary to run the mine at full capacity. However, we shy away from awarding Cloud Peak an exemplary stewardship rating, because its investment choices haven't always been ideally timed.
Fair Value Estimate Is $27 per Share
Our long-term forecast for sales volume levels is roughly 90 million tons--in line with expected levels in 2013. We believe higher PRB coal prices going forward will allow Cloud Peak to operate its mines at higher utilization rates, benefiting production figures, but this is offset by the Cordero Rojo reduction. We project Cloud Peak to experience stagnant to falling average selling prices for its coal in 2013 and 2014 before recovering PRB spot coal prices elevate its average selling price to $16 per ton in 2017. Our valuation assumes a cost of equity of 12%, as well as an implied terminal multiple of roughly 6.5 times enterprise value/EBITDA.
Elizabeth Collins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.