Peabody Q2 Earnings: Vital Role Of Coal In The Energy Transition

Investment Thesis

Peabody Energy Corporation’s (NYSE:BTU) Q2 results delivered a very strong free cash flow (“FCF”) figure that allowed Peabody to repurchase just over 8% of its market cap during Q2.

There are still some Asset Retirement Obligations (”ARO”) plus long-term debt obligations on Peabody’s balance sheet. But there’s also more than enough cash, which leaves Peabody able to return substantial capital to shareholders.

Indeed, the cash on its balance sheet at $1 billion easily covers the bulk of Peabody’s liabilities. Meaning that whatever free cash flow Peabody produces, at least 65% can continue to be returned to shareholders.

Here I provide insights into Peabody’s recent results and why I’m bullish on Peabody.

Rapid Recap

Peabody makes about 50% of its EBITDA from thermal coal and 50% from met coal. I’m an Arch Resources (ARCH) shareholder, which makes the bulk of its revenues from met coal; therefore, I may be biased in my interpretation of Peabody’s prospects. However, I’ve attempted to provide a balanced analysis and allow you to make up your own minds. A take-what-you-want approach.

Thermal Coal’s Prospects

Thermal coal is used interchangeably with natural gas at about $3.50 MMBtu. Meaning that, when natural gas prices fall below $3.50, there’s a preference for using natural gas. And when natural gas prices rise beyond $3.50, thermal coal is given preference.

In other words, there’s a price where thermal coal is the preferred energy source. And with natural gas prices below $2.8 MMBtu right now, there’s very little incentive to use dirty coal.

This has led to many Western countries shunning coal and embracing natural gas, since it’s not only cheap but also emits about 35% to 40% less carbon into the atmosphere.

Next, an overabundance of thermal coal inventory available in the market, led to thermal coal prices dropping in the most recent quarter.

Here’s a quote from Peabody echoing that statement:

Seaborne thermal coal markets remain volatile with prices declining during the second quarter driven by high coal and natural gas inventories in the northern hemisphere following an unseasonably warm winter.

Also, Peabody voiced during their earnings call:

In the United States, overall electricity demand decreased nearly 4% year-over-year negatively impacted by weather. Through the six months ended June 30, 2023, electricity generation from thermal coal has declined year-over-year due to low gas prices and nearly level renewable generation.

Next, steel prospects have not made a strong comeback thus far in 2023. Even though in the past couple of days, steel does appear to be gaining some vitality, ultimately steel prices weren’t strong enough during Q2 to ignite demand for met coal, which is a feedstock for steel production.

All that being said, it’s difficult not to hear the constant chirping about the energy transition and not think about the massive demand for windmills and rebuilding of the electrical grid.

Both of which will require massive amounts of steel if the energy transition is to gain traction in the near term. And by extension, this will lead to further met coal demand.

Peabody’s Capital Return Program

During Q2 2023, Peabody’s shareholder returns of $262 million were made in the form of a cash dividend of $11 million and share repurchases of $251 million, reducing the share count by 8.3% in one quarter.

We shouldn’t annualize this figure, because it’s practically impossible to know how Peabody’s prospects will be over the next quarter, let alone over the next 4 quarters. But annualizing this figure provides further insightful context. Returning $262 to shareholders over 90 days is the same as providing investors with a combined buyback and dividend yield of 30%. Evidently, that’s a super capital return.

After all, Peabody has made the case that it will return to shareholders around 65% of its available free cash flow. And given that Peabody has about $700 million of net cash on its balance sheet, this further supports management’s plans to return at least 65% of its free cash flow back to shareholders.

And if Peabody can continue to return to shareholders these sorts of combined yields, it won’t take too much longer before the market returns to getting interested in Peabody.

BTU Stock Valuation — Priced As If It Will Stop Operations In 3 Years

According to my estimates, Peabody will make about $1 billion of free cash flow this year. It could be more or less, but that’s a reasonable ballpark to inform our discussion.

And how much free cash flow will Peabody make in 2024? I don’t know. But I don’t think we need to know the answer to that question to be able to form a view on my bull investment case.

Allow me to provide further context. Presently, an investor buying into Peabody’s stock is paying roughly $3 billion market cap.

And the investor is essentially making the case that over the next 3 years, Peabody will make on a cumulative basis enough free cash flows that an investment in Peabody pays for itself. Or put another way, any free cash flows that Peabody makes after year 3, or after 2026, ”free upside.”

The Bottom Line

Peabody Energy Corporation reported strong Q2 results with substantial free cash flow, allowing them to repurchase over 8% of their market cap during the quarter.

The company maintains a diversified portfolio with equal earnings from thermal coal and met coal.

Thermal coal faces challenges due to low natural gas prices and a preference for cleaner energy sources in Western countries. Steel prospects have been moderate, impacting met coal demand.

Peabody’s capital return program is impressive, with $262 million returned to shareholders in dividends and share repurchases, reducing the share count by 8.3%. The company aims to return around 65% of available free cash flow to shareholders.

The market’s current valuation suggests investors anticipate Peabody to generate sufficient free cash flow over the next three years, but to stop being a going concern thereafter — something that is nonsensical.

The energy transition and potential met coal demand for windmills and electrical grid rebuilding are likely to positively stimulate Peabody’s future prospects. I’m hopeful about Peabody Energy Corporation’s medium-term prospects.