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Mine This Firm's Stock and Bonds for Value

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Commodities have been on the top of a lot of investors' minds recently, and our analyst staff has discovered an intriguing bond pick in the coal space.

I'm here today with Dan Rohr and Mike Tian to take a closer look at Cloud Peak Energy.

Gentlemen, thanks for talking with me today.

Mike Tian: Thanks for having us.

Daniel Rohr: Thanks, Jeremy.

Glaser: So, Mike, let's just take a first step and just look at what's happening with the coal industry in general? How does demand look, how is supply? What's happening in that sector?

Tian: Coal is definitely booming right now. I mean, the basic story, as with a lot of other commodities is that, China, India are importing more and more of this stuff, and we can barely make enough to keep pace. And on top of that, we have torrential rains in Australia and Indonesia thanks to El Niño, and that's flooded a lot of mines and forced closure of a lot production out there.

And accordingly perhaps, no surprise, coal prices are something like 40% higher since last fall for Asian thermal prices, and metallurgical prices are near their all-time peak of almost $300 per metric ton.

Glaser: So, has Cloud Peak been able to benefit from this rise in prices yet?

Tian: Well, actually for Cloud Peak, they have not been able to directly benefit from the rising prices because all their mines are in the region of the world known as the Powder River Basin, which is in Wyoming. So, this place does not have great transportation links with rest of the world. So, they have not been able to export directly to China and India and places like that and get immediate benefit from rising margins.

More importantly, their management has also been rather prudent, and they've contracted out 2011 prices, pretty much committed at lower levels and current levels. However, over the next year, we think the rising prices will definitely be a big tailwind because not only are the higher Asian prices going to ripple through the rest of the world markets and drag U.S. pricing up with it, but also as lower-price contracts roll off and they commit next year's production to higher levels, you should see a natural margin accretion without them having to do anything.

Glaser: So, Dan, when we look at Cloud Peak's balance sheet, when we look at the bonds that you're finding attractive right now, why Could Peak versus any of the other coal miners that might be seeing immediate benefits from this price increase?

Rohr: Well, we regard Cloud Peak as one of the highest-quality credits in coal mining. One of the things about the Powder River Basin where Cloud Peak's assets are is it's a very low cost place to operate, to dig the black stuff out of the ground.

So, that cash flow volatility dampening mechanism is favorable, in our opinion, from a credit perspective. Second reason we like Cloud Peak is, there is not a lot of leverage on the books. I think 12 trailing months to end of 3Q, you're looking at maybe 1.7, 1.8 debt-to-EBITDA, and that's gross debt. In addition the company has got about $300 million in cash, so net debt-to-EBITDA is quite a bit more favorable.

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Finally, as Mike mentioned, this company tends to be rather conservative with respect to its contracting. So, that's another thing we like from a credit perspective that an equity investor may not necessarily like in a period of rising prices.

But based on the prevailing bond prices, we like both of the company's bonds. They've got two outstanding 2017s and 2019s. And we like them in terms of both absolute value and relative value. So, starting with absolute value, the question is, are we getting more yield than we would expect for a given amount of credit risk? And with Cloud Peak, we think the answer is yes.

We rate the company BB-plus, and these bonds currently trade around 450 basis points above Treasuries give or take 25 basis points or so depending on the day. That compares to an average BB bond that trades around 390 basis points over Treasuries.

So, you're looking at about 60 give or take basis points of additional bang for your buck and one notch higher credit quality. Now, the question you asked, why do we like Cloud Peak more than, say, some of the other coal names is really a question about relative value instead of absolute value.

So, here we think you're getting a pretty good deal compared to some other coal mining bonds that are out there. So, if we take Cloud Peak's competitor Arch Coal for instance: We rate Arch BB-minus, so a couple of notches below Cloud Peak's BB-plus, and there are a variety of reasons, but one of the biggest ones is Arch has quite a bit more leverage on its balance sheet. I think 12-trailing months debt-to-EBITDA on a gross basis might be in the neighborhood of 2.7, 2.8, so almost a full turn of leverage greater than Cloud Peak.

So, if we take at look at Arch's 2020 notes: Those are trading about 350 basis points above Treasuries, so that's 100 basis points inside of Cloud Peak despite, in our opinion, those Arch bonds representing greater credit risk. So, there is good relative value in the Cloud Peak bonds as well.

Glaser: Mike, if the bonds look like they are pretty attractively valued, what about the stock right now?

Tian: We like the stock a lot as well. I guess I first should talk about the history of the company. Cloud Peak is sort of a weird company because until late 2009, it was actually a unit of Rio Tinto and sort of lost in the shuffle of this gigantic company, and they IPO-ed themselves, but even after that, Rio Tinto still owned 49% of the company. So, they had a very complicated ownership structure and a relatively small float and a small market cap.

So, investors really did not pay a lot attention to it until very recently when Rio Tinto sold its remaining stake, and that simplified the structure of the company a lot, increased the amount of stock floating out there, and we think just from a technical standpoint, there will be more investor interest. But more importantly, Cloud Peak is actually a very good company, probably of one of the highest-quality companies in the coal space, trading for a relatively low valuation.

Dan already talked about the low-cost advantage at Cloud Peak, and we think that's a gist of the story, and we think over the next few years, there is going to be a natural accretion to margins both as contracts roll-off and are reset at higher levels, and as the low-cost advantage makes itself felt more and more apparently each year as the rest of world experiences higher and higher mining costs.

So, we think margins are going to expand pretty steadily over the next five years and just based on 2011 valuation metrics, the stock is only trading for about 11 times forward earnings, our earnings estimates, and maybe 5.5 times EBITDA, which is lower than the rest of the universe.

Our fair value estimate is $31, so with the stock at a little less than $23, it's probably one of the most attractive names in the commodity space today.

Rohr: Jeremy, I'd have to disclose that I also own Cloud Peak stock, so I like the story as well.

Tian: A vote of confidence.

Glaser: That's great. Mike, Dan, thanks so much for joining me today.

Rohr: Thanks, Jeremy.

Tian: Thanks.

Glaser: For Morningstar, I am Jeremy Glaser.