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The Scoop On Coal

With the nuclear disaster in Japan and nuclear projects worldwide now being put on a shelf, many have looked to Coal to gain favor going forward when it comes to power generation.  Therefore when I came across this interview, I thought it prudent to post the transcripts here for future reference.  They discuss not only the two types of coal and their uses, but excavation and transportation costs.  To view the original video click HERE.  Readers should note that there are conflicting reports on coal lately.  One stating China recently *turned away* coal shipments here with other promoters saying it was merely b/c they have been accepting Japan's imports while their ports are expected to be down for at least six months.  Then another predicting U.S. coal exports could jump 70% in 2011 thanks to the cheap U.S. dollar here and Bloomberg paining a rosey demand picture here so perform your own due diligence before investing.  This is not a recommendation to buy or sell but informational purposes only.

 

Jason Stipp: I'm Jason Stipp for Morningstar.

Paul Larson, equity strategist and the editor of the Morningstar StockInvestor newsletter, recently made a purchase for his Hare Portfolio in that newsletter in the energy sector.

He's here to tell us a little bit about why he was attracted to that name. Thanks for joining me, Paul.

Paul Larson: Thanks for having me.

Stipp: So, before we get started, I think it's interesting to note that there aren't a lot of opportunities out there today. When we look across the market, things look, on average, fairly valued. Would you say that that's a pretty good assessment of the situation?

Larson: I would agree that when you roll up our price-to-value ratios across our coverage universe, the average stock is looking roughly fairly valued. Of course, there are individual opportunities out there that still look cheap, but they are much fewer in number than they were just a couple of months ago, especially when you look at the wide-moat universe, which is really where I do most of my hunting for ideas. Wide-moat, 5-star stocks--we had roughly three dozen of them as late as last August, and now we're down to less than 10, and frankly, I own just about all of them.

Stipp: So, this is not to say that the market hasn't hit a few bumps and turmoil recently. The most recent of which, of course, is the Japan crisis, and that's somewhat related to the stock pick that you have, which is in the coal industry. Can you talk about the crisis and how that affected what you see as the future for this pick?

Larson: Sure. Well, the company that I recently bought is certainly an enterprising pick, and it is only a narrow-moat stock, but I think that the catalysts here are real and the valuation is really attractive.

The company name is a Cloud Peak, ticker CLD. How this is being impacted by Japan: Cloud Peak is a coal miner. Their mines are in the Powder River Basin in Wyoming, and this is a low-cost area of mining coal.

But the way that Japan is impacting the coal industry is that with the situation at the nuclear plant in Japan, I think this is going to stop the so-called "nuclear renaissance" in its tracks, and that means that 10 years from now, nuclear power is going to be a much smaller portion of the worldwide energy supply than otherwise would have been had this nuclear renaissance continued.

So, with nuclear being a much smaller portion of the pie, that means that all other energy sources, including coal, are going to have to pick up the slack.

Stipp: So to follow-up on that, coal also, as far as environmental impact, it also faces some headwinds. How do you factor that into the extra share of the energy pie that coal might have in the future?

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Larson: Well, we do have increasing regulation here in the United States. You are correct that the EPA is clamping down on air pollution. We are expecting a number of older coal plants to close because of these regulations, but this is going to be more than offset by growth in Asia. Asian countries have much more lax regulations when it comes to pollution.

So, I think that whatever we lose here in the United States is going to be more than offset by increased demand in Asia, especially since GDP growth and electricity usage are directly correlated, and of course, GDP growth in the emerging markets of Asia is very, very high.

Stipp: So, speaking of the demand in Asia, I think that also plays in a little bit to this particular pick and where it's located. It's in Wyoming, you said. There's different types of coal, that coal is used in different places. Can you talk a little bit about this company and why it's uniquely positioned, do you think, or at least distinctively positioned to benefit from some of that growth overseas?

Larson: Sure. Well, there is two types of coal. There is a met coal, which is used primarily for steel production. Then there's thermal coal, which is used for electricity production. This company produces primarily thermal coal.

The Powder River Basin is a very low cost place to mine. These are basically strip mines where the coal is very near the surface. They just have to take off the top layer of soil, and then it's near the surface and they can use basically dump trucks to just pick it up. This is compared to the Appalachian area, where you have to send people underground. It's much more dangerous, much more costly.

Just to give you an idea of the difference in cost. In the Powder River Basin, it might cost $9 or $10 per ton to produce the coal, where in the Appalachians, it might cost you anywhere from $40 to $60 a ton. So, we're talking of 4-6x multiple in terms of just cost per ton in the Appalachians. So, this gives Cloud Peak certainly a low-cost position.

Stipp: So, given that kind of advantage, why haven't more people invested in some of the Powder River Basin coal companies? Why did [the share price] look attractive to you if it had such a head start and a lag up on the Appalachians, at least on the production cost side?

Larson: Well, the reason is transport cost, because coal is a relatively low value-to-weight product, and it's very expensive to transport, and the railroads certainly have the coal companies over a barrel to a certain degree, and I think this is one of the reasons Buffett was attracted to BNSF, frankly.

So, the transport cost is very meaningful, and a lot of the large coal consumers, the utilities, are in the Midwest and along the East Coast. So, the Appalachian coals are much more proximal--that coal doesn't have to travel nearly as far as the PRB coal does.

Stipp: So, is there anything on the horizon that might alleviate some of those transport costs, or is it going to continue to be a headwind for the Powder River Basin coal?

Larson: Well, there is a very meaningful difference in prices between the average coal price in Asia and again, what you can produce coal for in the PRB. Asian coals are trading for anywhere between a $120 to $130 a ton right now. Again, we contrast this with the PRB coals that cost $9 or $10 a ton to produce. Given that large spread you might ask, well why hasn't that been arbitraged away?

Well, there is very little rail capacity going from the PRB to the West Coast and then even, if you could get significant amounts through the rails, there is also no export infrastructure in terms of ports and such. But that's changing. Peabody is building a port that will allow all the PRB players to actually export to Asia, and I think that's going to mean higher net-back prices to companies like Cloud Peak.

Stipp: So the future for Cloud Peak could look good. Can you talk a little bit about the valuation and how you found that compelling, and why you think it might be priced where it is right now versus what its potential could be?

Larson: Well, I think the valuation is exceptionally attractive on this name today and is a primary reason I bought the stock. The stock is trading at about 10 times expected earnings for 2011 and a little bit over five times EBITDA on an enterprise value basis. That might be an appropriate multiple, you say, for a cyclical company, a coal company that is at peak cyclical earnings that's about to go down the side of the roller coaster.

But given the situation in Asia and what we've seen in the nuclear or what we expect in the nuclear industry, we think that earnings growth is actually going to accelerate and accelerate quite meaningfully from this point forward. So, paying 10 times earnings for a company that has what we think is a very good earnings growth potential, it seems like a compelling idea to me.

Stipp: So, last question for you Paul, you did buy this in the Hare Portfolio. The stock does have a higher uncertainty rating. Can you talk about what some of the risks are that you would keep on your radar with this name?

Larson: Well, I think that this is a coal company at the end of the day, and coal can be incredibly cyclical. Commodity prices are very hard to predict both over the short term and over the long term. If these expected catalysts with the Asian export story, if that doesn't materialize that would obviously poke a hole in our thesis.

So, there are certainly some risks here, but again paying 10 times earnings, I'd like to think that there is a sufficient margin of safety.

Stipp: All right, Paul, a very interesting and timely idea at a time when there aren't a lot of ideas out there. Thanks for sharing it us with today

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