Peabody and Patriot Coal: Not All Breakups Are Ugly

By Paul Baiocchi | February 28, 2008 | 3:27 PM | 0 Comments

While Patriot Coal (PCX) has only been on its own for little more than 4 months, the company has the pieces in place to sustain what has been a strong move in the company's stock since its spinoff from Peabody (BTU) in October (56.59% as of close on Feb. 27). Of course, this coincides nicely with a healthy coal market which has seen high grade Coal prices on tightening due to global supply constraints and demand growth. On the surface, it may seem like Peabody and Patriot are therefore just the short term beneficiaries of supply constraints in the coal market, but look a little deeper and you will see two companies specializing in two different areas with some of the best human and physical capital in the industry.

While it may be a stretch to say that Patriot's assets were neglected by Peabody, it is not unfair to say that they had been undercapitalized.  Fortunately for Patriot shareholders, these properties will now be fully utilized.  The most important asset may not even be in the ground, it is likely in St. Louis headquarters, where the executives hang their hats along with their 140 plus years of coal industry experience. This executive team, combined with a world class board of directors, is now able to focus on getting the most out of the 1.2 billion tons of coal reserves in the Illinois Basin and the Appalachians.

Where Peabody was moving to grow internationally, Patriot can now focus its growth domestically. The central Appalachian mines with 446 million tons in reserves alone represent some of the lowest sulfur reserves in the market. Meanwhile, low-sulfur metallurgical and steam coal markets are as hot as any commodity market on the planet.  Based on the strong historical investment in the area by its predecessors, Patriot is able to make use of a vast infrastructure network enabling product transportation to be drawn to contracts to be shipped by rail, barge, and truck. Patriot is now situated to take advantage of rising market prices, as 80% of metallurgical production for 2008 is unpriced and 71% of the domestic coal fired plant capacity resides within Patriot's immediate transportation network.

Now, after a company bewtows a dividend as valuable as Patriot to its shareholders, the company is question will have little value left. In the case of Peabody, however, it may be clear that some of its assets may now be more valuable. This may sound counter-intuitive based on my glowing comments about Patriot, but when you consider the fact that Peabody has been expanding internationally for two decades while at the same time diversifying its clientele, it is clear the company is best left to focus on its global ambitions.

Peabody is still the dominant coal name in a market rich with quality producers. Its 9 billion ton reserve base still dwarfs that of its competitors, but it is where those reserves are located and what they may be used for that is the most compelling story here. For it is Peabody who is at the forefront of the coal-to-gas (CTG) movement on three continents and it is Peabody who is bringing clean coal to the markets with the greatest appetite for it in India and China. While Peabody's North American properties are still substantial,  they represent only part of what is now a global network with operations and customers on 6 continents.

While being small has its advantages to Patriot, being big has its many distinct advantages to Peabody. Based on its presence in China and its international prestige, Peabody was named the only non-Chinese enterprise involved in the GreenGen CTG project. Meanwhile in Australia, where Peabody's presence has tripled, the company's access to six ports insulated them from the effects of the recent floods and ongoing port congestion there. It is this large capital commitment and therefore strong market presence which gives Peabody the flexibility to react to dynamic changes in each of the individual markets it serves worldwide. This is the reason the company is #1 in the PRB, the Illinois Basin, and the number one exporter of U.S. based products.  It is also the reason why Peabody will be able to extend its standing as the number one global coal player, able to take full advantage of an environment where prices per ton are up 152% in Australia, 115% in the metallurgical market, and 71% in China in the past year.

Both Patriot and Peabody are not only a great example of a company creating shareholder value by allowing assets to be properly utilized , but they are evidence of why coal is a market that deserves allocation in your portfolio. When compared to petroleum producers, coal miners carry lower valuations which present an opportunity in a world in which 4.2 billion tons of coal will be demanded from the U.S. and Asia alone in the next 12 years.  This opportunity exists in those companies which are closest to the raw material itself. Peabody and Patriot both represent these types of companies, yet both offer access to different markets.