Coal Stocks (and Bonds): A Cautionary Tale for Value Investors

Coal Stocks (and Bonds): A Cautionary Tale for Value Investors

by George Putnam, III

Introductory Note: Late last week, I wrote this cautionary article on coal stocks. In light of Alpha Natural Resources’ (ANR) $11 billion bankruptcy filing, this perspective now appears all the more relevant. Incidentally, ANR is the 9th mining company and 4th major coal sector provider to seek Chapter 11 protection this year.

For several years now, as the prices of coal stocks have kept declining, many value-oriented investors have been trying to make the case for buying them. The argument went something like this, “While there are environmental concerns, coal is still the largest energy source around the globe; coal is needed to make steel; we will always need coal, and so the stocks have to rebound.”

This argument in favor of coal stocks was not without merit, but it was overwhelmed by several other factors, most notably the following: the abundant supply of natural gas in the U.S. has reduced the price of gas and made it a cheaper (and cleaner) substitute for coal in many applications; China, which has been a huge consumer of coal, is reducing its demand; most coal producers have large liabilities for pensions and environmental clean-up costs and many educational institutions and environmentally-oriented organizations are choosing to divest their holdings of coal stocks. All of these factors are putting significant downward pressure on the stocks of the major coal producers.

Not only are some or all of these trends likely to continue for a protracted period, but there is no law of nature that says that beaten down stocks “have” to rebound. This is particularly true when the companies involved have significant amounts of debt (or other liabilities such as pension and environmental obligations). What is much closer to an immutable law of nature is the rule under the U.S. Bankruptcy Code that says that when a company files for Chapter 11, all loans, bonds and other liabilities must get paid off in full before stockholders get anything.

Therefore, to all those frustrated value investors who say things like “Peabody Energy (symbol BTU) is a big company whose stock price has gone from 70 to 1 over the last five years–it must be cheap” we will point out that Peabody has bonds that are now trading for about 20 cents on the dollar. And if the Peabody bondholders don’t get paid off pretty much in full (there is usually a little wiggle room in bankruptcy cases) the stockholders will likely get nothing.

I could say the same thing about Arch Coal (symbol ACI, five-year stock range 360 – 2, after a proposed reverse split, and bonds trading in the teens) or Alpha Natural Resources (symbol ANR, five-year stock range 61 – 0.20, bonds trading below ten). [Editorial Note: Just days after this article was published, ANR filed for Chapter 11 protection with the U.S. Bankruptcy Court. With $11 billion in pre-petition assets, this is the second-largest bankruptcy of 2015 thus far.]

Then there is Walter Energy (WLT), which recently filed for Chapter 11. Its stock, which traded above 140 in 2011, now trades for about 0.10, and its bonds are changing hands for about two cents on the dollar.

Enough with the examples. I don’t deny that coal is not going to disappear as a valuable energy source any time soon, and it could provide good returns to brave investors. But until the sector settles down, I recommend proceeding very cautiously. One approach would be to invest in some of these beaten-up bonds rather than the stocks. But even there I would be cautious. Several of the coal companies have first lien (meaning they have a first priority claim on the company’s assets) bonds that are trading around 60 cents on the dollar or lower. This means that investors are uncertain that even these highest priority bonds will get paid off in full. Anything below the first lien debt must be viewed as quite speculative.

For stock buyers, I suggest sticking to the “safest” names in the coal sector–and “safe coal stocks” may remain an oxymoron for some time to come. The most recent issue of my distressed investing newsletter names six stock picks that offer a better alternative to playing any potential coal industry rebound.

You can see this comment on the site here.