Published on April 11th, 2019 by Aristofanis Papadatos
Coal is the most burdensome type of energy fuel for the environment. As a result, numerous countries make coordinated efforts to phase out coal in favor of natural gas and renewable energy sources, such as solar and wind power.
While U.S. consumption of coal has steadily decreased since peaking in 2008, coal production has actually grown in the last two years thanks to the impressive growth in U.S. coal exports. Demand continues to rise in emerging markets such as China and India.
In 2018, U.S. coal exports reached 116 million short tons, the highest level in five years and almost twice the level of 2016. The increased exports have resulted from high international prices, which have made it economical for the domestic producers to export coal.
This has allowed several coal companies to return to profitability, and in some cases, pay dividends to shareholders. Dividend-paying coal stocks are included on our list of 427 dividend stocks in the materials sector.
You can access all 427 dividend-paying materials stocks with a downloadable spreadsheet below:
While many investors have concluded that coal stocks will soon become irrelevant, this is far from true. In this article, we will analyze the four best coal stocks today.
#1: Warrior Met Coal (HCC)
Warrior Met Coal is a low-cost producer of metallurgical coal. It has underground mining operations in Alabama.
The company produces high-quality hard coking coal, which is the reason behind the ticker of the stock. Warrior sells all its coal production to steel producers in Europe, South America and Asia.
Warrior exhibited remarkably strong performance in 2018 and exceeded its own guidance. It achieved record production of 7.7 million short tons and record sales of 7.6 million short tons, higher than its guidance of 7.1-7.5 million short tons for both metrics.
The company thus grew its production by 15% and its revenues by 17% over prior year. It also reported free cash flow of $458 million or $8.70 per share, a great achievement for a company that engages in a capital-intensive business.
It is impressive that Warrior returned $400 million to its shareholders last year, which is 25% of its market capitalization. The greatest part of those returns was the special dividend of $6.53, which the company distributed a year ago.
If we add the regular dividend of $0.20 per share, Warrior offered a 21.7% dividend to its shareholders last year.
Even better, it is reasonable to expect additional special dividends in the upcoming years. Warrior has an exceptionally strong balance sheet.
It has net debt of $298 million, which is less than the annual earnings of $459 million, and hence this amount of debt is essentially negligible.
S&P seems to agree on this, as it recently upgraded the bonds of the company that mature in 2024 from “BB-“ to “BB”.
Moreover, Warrior recently announced that it is accumulating cash in order to distribute another special dividend, which will be up to $229.4 million ($4.45 per share), in the near future.
If management delivers its promise, it will offer a 14.7% special dividend and a 0.7% regular dividend for a total 15.4% dividend. In other words, the company intends to offer excessive returns to its shareholders once again this year.
Moreover, Warrior has exciting growth prospects. Blue Creek, one of the few remaining untapped reserves of premium metallurgical coal, has the potential to provide Warrior with meaningful growth for several years.
Source: Investor Presentation
Management believes that Blue Creek can produce up to 3.0 million short tons per year. Such a production rate would increase the current output by 39%.
It appears that this project will be a major growth driver for the company in the upcoming years. Management expects to spend $550-$600 million over the next five years on this project.
To conclude, Warrior has exciting growth prospects and a strong balance sheet. Both of these characteristics are very important in this highly cyclical business.
Moreover, the company distributes exceptionally high special dividends thanks to its extremely shareholder friendly management.
As the stock is trading at a trailing price-to-earnings ratio of only 6.8, it is likely to highly reward its shareholders from its current price.
The cheap valuation of coal stocks is a result of their high cyclicality but Warrior seems capable of withstanding downturns thanks to its high-value asset portfolio and its healthy balance sheet.
#2: Alliance Resource Partners (ARLP)
Alliance Resource Partners is a master limited partnership (MLP) that generates income primarily from coal production. It produces coal from eight mining complexes in various U.S. states and operates a coal loading terminal in Indiana.
It also receives royalty income from its stakes in some oil and gas producing regions in the U.S., in an effort to reduce its exposure to coal prices.
However, this royalty income comprises just about 5% of its total EBITDA and hence Alliance Resource Partners should be viewed as an essentially pure coal producer.
As a commodity producer, Alliance Resource Partners is extremely sensitive to the prevailing price of coal. This is clearly reflected in the behavior of its stock, which has been on a roller coaster in the last five years.
Between 2014 and 2016, the price of coal plunged and caused the earnings per share of the company to slump more than 50%. That slump took its toll on the stock price, which plunged 80%, from $50 in 2014 to $10 in early 2016.
However, the strong international demand for coal has greatly increased the amount of U.S. exports in the last three years and thus it has provided a strong boost to the price of coal.
As a result, Alliance Resource Partners has enjoyed a strong recovery in the last three years, with its stock price almost doubling off its bottom three years ago.
In 2018, the company posted strong performance. Thanks to strong export volumes, it reported record sales volumes and grew its revenues by 11.5%, assisted also by higher coal prices. The company also grew its earnings 21%.
Even better, it provided markedly strong guidance for this year, expecting its earnings to jump from $366.6 million to $505.5-$545.5 million. At the mid-point, this guidance implies a 43% increase in earnings this year.
Moreover, Alliance Resource Partners is offering an exceptional 11.0% distribution yield. While such abnormal yields usually indicate the risk of an imminent cut, the payout ratio currently stands at 77.4%. In addition, the company has a markedly strong balance sheet.
Its net debt stands at $788 million, which is less than twice the annual earnings of the company, while interest expense consumes only 11% of the operating income.
Given the reasonable payout ratio, the strong balance sheet and the positive business momentum, the distribution can be considered safe for the foreseeable future.
On the other hand, investors should always remember that commodity producers are very sensitive to the underlying commodity prices. In the downturn of its business, Alliance Resource Partners cut its distribution by 35% in 2016, from $0.675 to $0.4375.
Nevertheless, the company has raised its distribution in most quarters since then and thus it has partly restored its dividend, to $0.53 per quarter. As long as business conditions remain favorable, the coal producer will continue raising its distribution quarter after quarter.
Even if an unexpected downturn occurs in the future, a 35% distribution cut will result in a still attractive 7.15% distribution yield.
Overall, Alliance Resource Partners is likely to continue offering an exceptional distribution yield for the foreseeable future and the stock will still offer an attractive yield even in the event of a major downturn.
It is also important to note that Alliance Resource Partners has a significant competitive advantage, namely the low production cost of its mines.
Source: Investor Presentation
This competitive advantage is of paramount importance, given the high cyclicality of the business. Whenever a downturn shows up and coal prices slump, Alliance Resource Partners should remain profitable while some of its peers will incur losses due to their high cost base.
Finally, investors should focus on the most important feature of the company, its solid balance sheet. Given the high cyclicality of this business, a strong balance sheet is of paramount importance.
A strong balance sheet helps the company navigate successfully during downturns, without causing permanent losses (via dilution) to its shareholders.
A healthy balance sheet is also a testament to the quality of management, which is very important in the cyclical sectors.
To cut a long story short, Alliance Resource Partners enjoys favorable business momentum, offers an exceptional distribution yield and is one of the most defensive coal producers thanks to its solid balance sheet.
#3: BHP Group (BHP)
In November, BHP Billiton changed its name to BHP Group. The company, which is headquartered in Australia, is an exploration and production giant in the metals and mining industry, with a market capitalization of $137 billion.
It generates 41% of its annual EBITDA from iron ore production, 22% from petroleum, 19% from coal and 18% from copper.
Just like all commodity producers, BHG Group is very sensitive to the gyrations of commodity prices. Consequently, its performance record has been highly volatile. In the Great Recession, its earnings per share plunged 62%.
Even worse, in the recent commodities downturn, the company incurred huge losses in 2016 and thus it was forced to slash its dividend by 76% in that year.
Since the bottom of the commodity cycle, in early 2016, BHP Group has enjoyed a strong recovery and hence its stock price has almost tripled.
Moreover, the company enjoys a strong tailwind this year, namely the reduced supply in the iron ore market due to the collapse of a dam in Brazil, which led the country’s mining regulator to close 56 tailing dams.
Since that disaster, which killed about 300 people in January, the price of iron ore has posted a breathless rally and hence it has resulted in a 22% rally of the stock price of BHP Group.
It is remarkable that the stock enjoyed such a strong rally despite the impact of tropical cyclones on its infrastructure in the same period.
Those cyclones are likely to somewhat reduce the output of the company this year but this effect will be minimal compared to the tailwind from the rally of the price of iron ore.
It is also worth noting that management is doing its best to protect the company from its heavy reliance on commodity prices.
Source: Investor Presentation
The company is trying to reduce its operating costs while it also has a healthy balance sheet, with interest expense consuming only 7% of the operating income.
With that said, BHP Group remains a highly cyclical stock, which is highly vulnerable to downturns in the prices of commodities.
Moreover, investors should be aware that the supply shortage in the iron ore market will be eliminated at some point in the future, when the iron ore mines in Brazil return to production mode.
Therefore, the strong rally of the stock this year is more likely a profit-taking opportunity than an investing opportunity.
BHP Group is prudently managed in order to navigate successfully through the boom and bust cycles of commodities. However, it is impossible to avoid the high cyclicality of business performance and the dramatic swings of the stock price.
As a result, while the stock may maintain its positive momentum thanks to the supply shortage in the iron ore market, the stock will have significant downside whenever this market reverts to a healthy equilibrium.
#4: Natural Resource Partners (NRP)
Natural Resource Partners is a master limited partnership headquartered in Texas. The company has a portfolio of properties related to coal, industrial minerals and other natural resources and has a market capitalization of only $513 million.
The company claims to be a safer investment than coal producers thanks to its specific characteristics. It receives royalties from coal producers and thus it does not incur the costs and risks related to the coal mining business.
In addition, it receives about two-thirds of its royalties from metallurgical coal, which does not face the threats from environmental policies.
Source: Investor Presentation
At the end of last year, Natural Resource Partners sold its construction aggregates segment, VantaCore Partners, for $205 million. That transaction was a game changer for the stock, as the value of the transaction was approximately 40% of the current market capitalization of the stock.
The company used the proceeds to reduce its debt load and thus it reduced its leverage. More precisely, its debt-to-adjusted EBITDA ratio has decreased 14% since the end of 2017, from 3.5 to 3.0 at the end of 2018.
This development and the favorable demand for both metallurgical and thermal coal have led the stock to post an impressive rally. To be sure, the stock has rallied 40% since it bottomed, in September.
As the company currently enjoys strong demand for its products and its stock has great momentum, many investors will be tempted to initiate a position in the stock, particularly given its low forward price-to-earnings ratio (8.7).
However, it is important to note that the company still has a significant debt load, with its interest expense consuming one-third of its operating income.
Moreover, Natural Resource Partners has proved remarkably vulnerable to downturns. In 2015, when the price of coal plunged, the company posted a loss of $572 million.
That loss offset all the earnings that the company had accumulated in the preceding four years. In addition, the stock plunged 95% in less than two years. Even worse, despite its rally off its bottom, the stock is still 82% lower than its 5-year high.
Natural Resource Partners is an example of the excessive risk of cyclical stocks. A rough year can erase the profits of several years and can cause devastating losses to the shareholders, who may not be able to retrieve their losses for more than a decade.
Due to the excessive vulnerability of Natural Resource Partners to downturns, we advise investors to stay away from the stock and ignore its strong momentum and its seemingly cheap valuation.
Coal stocks are highly cyclical and hence they should be avoided in principle by income-oriented investors. With that said, Warrior Met Coal has a cheap valuation, promising growth prospects and offers extremely generous dividends to its shareholders.
This year, management is likely to offer an approximate 15.4% dividend while maintaining a strong balance sheet. Therefore, the stock is likely to highly reward investors from its current stock price.
Alliance Resource Partners also has a cheap valuation and an exceptional double-digit distribution yield, with its distribution seeming safe for the foreseeable future.
Overall, while risk-averse and income oriented investors should avoid coal stocks in general, they may consider purchasing the above two stocks thanks to the remarkably attractive features they have right now.