Focus Stock

By John Hingher, CFA

Cleaner Coal an Energy Option

CONSOL Energy produces coal for electricity production. S&P sees demand growth and low stockpiles as reasons to look twice at shares

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Demand from electricity generators for a proven, lower-cost fuel continues to climb. And that has given new life to a key fossil fuel: coal. We at Standard & Poor's Equity Research believe CONSOL Energy (CNX; recent price, $72) is well positioned to benefit from the rising demand for, and price of coal over the next several years.

The company produces coal and methane gas mostly from reserves located east of the Mississippi River, selling primarily to the electric power generation industry. Utility customers' coal stockpiles are well below five-year averages, as demand recently outstripped supply, and transportation problems have limited supply even further.

Also contributing to demand growth will likely be planned capacity additions of coal-fueled generators, high natural gas prices (an alternative fuel for electricity generation), and the planned retrofitting of existing power plants with scrubbers to burn high-Btu coal.

MULTI-FUEL.  Following a sell-off in the shares since the beginning of the year, we find them highly attractive for purchase. CONSOL now trades at a meaningful discount to its peers based on p-e and ratios of enterprise value to EBITDA (earnings before taxes, interest, depreciation, and amortization). We have a 5 STARS (strong buy) recommendation on the shares.

Through expansion and acquisitions, CONSOL has grown from a single-fuel mining company formed in 1860 into a multi-energy producer of coal and gas. It produces high-Btu coal and gas, two fuels that collectively generate two-thirds of all U.S. electric power, from reserves located mainly east of the Mississippi River.

The company's coal segment (CNX Coal) has 17 mining complexes in the U.S. and sells steam coal to power generators and metallurgical coal to metal and coke producers. The company had an estimated 4.5 billion tons of proven and probable coal reserves at the end of 2005, nearly all of which was located in underground mines.

UNDER CONTRACT.  About 60% of CNX's reserves are found in northern Appalachia, with 17% in the Midwest, 10% in central Appalachia, 10% in the western U.S., and 3% in western Canada. The company is a major fuel supplier to the electric-power industry in the Northeast quadrant of the U.S., accounting for approximately 6% of total tons produced in the U.S. and approximately 14% of total tons produced east of the Mississippi River in 2005.

Coal produced at CNX's mines is transported to customers via railroad cars, barges, trucks, and conveyor belts, or by a combination of these methods. In 2005, the company sold 68.9 million produced tons of coal, up from 67.3 million tons in 2004. Approximately 91% of coal produced in 2005 was sold under contracts with terms of one year or more. The average sales price per produced ton sold in 2005 was $35.54 vs. $29.84 in 2004.

CONSOL owns 81.5% of CNX Gas Corporation, which is one of the largest U.S. producers of coalbed methane (CBM), with daily gas production of 173 million cubic feet (Mmcf). CBM is pipeline-quality gas that is found in coal seams usually in formations at depths of less than 2,500 feet, as opposed to conventional natural gas fields with depths of up to 15,000 feet. In 2005, the company sold 54.4 billion cubic feet (Bcf) of gas at an average price of $6 per Mmcf against 54.6 Bcf at $5.04 in 2004.

FUEL OF CHOICE.  The company also operates a gas-fired electric generating facility in a joint venture with Allegheny Energy Supply Co. The facility is located in southwest Virginia and was opened in June, 2002. The facility is used for meeting peak load demands and uses coalbed methane gas produced by the company.

Coal is the most popular means of fueling electricity generation for utilities, maintaining a market share of between 49% and 53% over the past 10 years. We believe that coal will likely remain the fuel of choice for some time as oil and natural gas prices remain high and nuclear and hydroelectric power generation is capacity constrained. The U.S. produced 1.1 billion tons of coal in 2005, over 20% of total global production, behind only China.

After stagnating for much of the 1980s and 1990s, primarily due, we think, to overcapacity and improved productivity, coal prices began to rise appreciably in 2003, and continued to increase in 2004 and 2005. Rising prices reflect considerable industry consolidation since 1990, combined with increasing demand, driven by an expanding global economy, in our view.

POSITIVE OUTLOOK.  According to the Energy Information Administration (EIA), coal prices should continue to rise in 2006, primarily in response to growing demand from the electric power sector. Utility customers' coal stockpiles are significantly below five-year averages, as demand recently outstripped supply.

Our longer-term outlook for coal producers is also positive, as the EIA forecasts a 1.9% compounded annual growth rate in total U.S. coal consumption between 2004 and 2030, primarily due to a projected 1.5% compounded annual rise in coal consumption for electricity generation.

However, we also believe the coal industry faces several obstacles, including near-term transportation difficulties -- as U.S. railroads operate near capacity, the potential for increasing environmental regulation on coal production and utility emissions, increasing low-cost supplies from what we see as relatively undeveloped international mines, and difficult geological and mine permitting conditions in the eastern U.S.

CLEANER AIR.  We see CONSOL's revenues growing nearly 11% in 2006, as we expect higher prices and improved volumes due to recent permitting of mines and a reduction in production-related difficulties in northern Appalachia. In light of the high fixed costs and resulting earnings leverage of the coal mining industry, we see coal segment margins widening in 2006, primarily as a result of the volume and price increases. We estimate 2006 income before extraordinary items of $454 million, or $4.85 per share, including projected stock option expensing.

Longer term, we expect solid demand growth for northern Appalachian coal as more scrubber capacity comes on line. Due to clean air regulations, coal from northern Appalachia has been losing share east of the Mississippi River to cleaner burning Powder River Basin coal.

However, the retrofitting of existing plants will eliminate this disadvantage and, we believe, highlight northern Appalachia's transportation advantage. Management expects scrubbed capacity east of the Mississippi to more than double by the end of the decade, such that 50% of the installed coal-fired capacity east of the Mississippi will be scrubbed, up from about 22% in 2005.

DISCOUNT RATE.  We project Standard & Poor's Core Earnings per share of $4.84 in 2006. In 2006, our S&P Core EPS estimate includes costs of about $1 million (one cent per share) related to our estimate of the difference between the company's actual pension and post-retirement benefits expenses and its use of pension accounting.

The company's stock was recently trading at a meaningful discount to its peer group average based on our forward 12-month EPS estimate of $4.85 and at an enterprise value of 6.7 times our estimate of 2006 EBITDA, vs. a peer multiple of 9.1 times. We have a 12-month target price of $85, or nearly 17 times our forward 12-month EPS estimate.

We believe that CONSOL's corporate governance practices are somewhat better than average relative to other companies in the materials group. However, we do have concerns regarding the company's policies that relate to takeover defenses. In particular, the company has a rather onerous poison pill in place that was not approved by shareholders.

SOME CONCERNS.  On the positive side, in our view, is that only one inside director and no affiliated outsiders serve on the board; the chairman and CEO roles are separated and Chairman John Whitmire is an independent outsider. The audit committee is comprised solely of independent outside directors, as is the nominating committee.

Risks to our opinion and target price, in our view, include lower-than-anticipated increases in coal and/or gas prices, transportation problems, lower production volumes from existing mines, and difficulties in hiring and retaining skilled workers. Also, we have concerns regarding CONSOL's corporate governance policies that relate to takeover defenses.

Analyst Hingher follows shares of coal producers for Standard & Poor's Equity Research Services

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