Peabody (New York stock market :BTUs) released third quarter results and the market was decidedly muted. First. But then investors started to come to their senses. And despite this stock being so long, it’s finally starting to make headway.
I thought this stock was going to be a home run in 2022. And guess what? He went absolutely nowhere for the better part of 6 months!
I am told that investing in energy was the only winning trade of the year. And I ended up with an egg on my face for most of 2022.
But now, as we come weeks away from calling 2022 an end, is it possible I was just too soon?
I’m inclined to believe that if 2023 is as good as 2022, Peabody will sizzle higher.
The redemption problem
In my previous article, I pointed out the problem. Peabody does not have a clear capital allocation strategy because its debt comes with covenants. Here’s what Peabody’s filings with the SEC say:
the Company has entered into a transaction support agreement with its surety providers which prohibits the payment of dividends until December 31, 2025 or until the expiry of the credit agreement (currently March 31, 2025).
That’s part of the reason Peabody’s valuation is so compressed. Because investors who want to invest in other coal companies will likely opt for those that can buy back their shares or return capital to shareholders through dividends.
So until Peabody tackles its debt, there will be no return of capital to shareholders.
With that in mind, consider Peabody’s liabilities for the second quarter of 2022:
And now consider Peabody’s liabilities for Q3 2022 and see if you spot a difference?
The difference is that Peabody made approximately $545 million of its senior debt current.
During the Q&A section of the earnings call, Peabody management declared,
With the [accounting] classification, the current liabilities of all of our secured debt, this is a clear signal that we will eliminate the remaining $550 million over the next 12 months.
Management is therefore seeking to deleverage its balance sheet.
However, in later parts of the call, Peabody management then discussed other organic opportunities to expand its portfolio alongside shareholder returns.
[In a few months we] regain this financial flexibility, we can reinvest in organic projects like North Genial.
[…] That’s a 25% yield, and it only uses 28% of the existing reserves in this project. So while we have great organic portfolio opportunities, we’re also looking to do that alongside shareholder returns and eliminating that debt.
For shareholders all too accustomed to fossil fuel companies wasting valuable capital on lofty acquisitions, investors weren’t too happy with the lack of shareholder-friendly initiatives from management.
BTU Stock Valuation – Cheap, So What?
In my previous post, before Peabody Earnings, I said Peabody was on track to generate over $1 billion in free cash flow in 2022.
Given what we saw in the third quarter, I think that number is now easily achievable. In fact, it will probably be outdated to some degree. Can Peabody generate $1.3 billion in free cash flow in 2022?
This is probably going to be overkill. But it is more likely that it will not end in this stage.
The big question here is what will 2023 look like? And this is where things get complicated quickly.
But before we over-complicate and intellectualize what metallurgical coal will be like in 2023, and speculate on thermal coal prices, I think the question investors need to form an opinion on is whether management will prioritize organic projects or returns on capital?
Because very few investors will seriously reward a rapidly growing coal company. Investors would much rather earn strong capital returns than embrace growth investments.
There are two downside considerations that Peabody faces.
First, we are talking about investing in a coal business. Yes, 2022 has been very strong. But can we expect 2023 to live up to 2022?
The bears would argue that one way or another, natural gas prices will fall in 2023, which will alter the supply-demand equation for thermal coal. And by extension, that would see the free cash flow of this capital-intensive business shrink.
Second, can we trust management to put shareholders before empire building?
For my part, I strongly believe that these bearish considerations are already largely factored into Peabody’s valuation.
In fact, I suspect that in less than 12 months I will be discussing, and not whether Peabody will return capital to investors. But rather, how much of its free cash flow will shareholders get through share buybacks?