Some Thoughts on Coal Companies and Railroads

Posted on Posted in Industry-Railroads, Investment Ideas & Company Research

Stock prices have finally entered the much anticipated correction, and so I’ve spent more time lately looking at my watchlist of great businesses that I’d like to own at some point. My portfolio has been largely made up of special situation investments for some time, and although I don’t really have a preference when it comes to value (I’m just looking for the most mispriced investments relative to risk), I’ve always liked the compounders. These types of businesses do a lot of the work for you, and at the right price they can be sized very large as often their quality provides a margin of safety.

That said, I only think great businesses make great investments at great prices, and at least by the looks of my watchlist, it doesn’t appear that we are generally to a market level where great prices can be had yet. Although prices have come down, they could certainly fall much further (and will have to before there are numerous quality businesses at prices that I would really get excited about). So for now, I continue to look under the rocks and in the nooks and crannies for the special situation investments and bargains that are usually present in any market environment. But I have dusted off the “great business” watchlist and may become more interested if (hopefully) stock prices continue their descent.

Coal

“A diamond is a piece of coal that stuck to the job” – Thomas Edison

One business I have spent some time on recently is the coal industry (I’ve been reading about coal for a few different reasons, but not because I’m interested in owning coal stocks—if anything the opposite would be the case).

Despite Thomas Edison’s enthusiastic view of the potential of a diligent, hard-working piece of coal, I’m not sure he would have felt the same way about coal stocks. After spending some time researching the industry and a few specific companies, I’ve come to the conclusion that the aggregate equity across the entire US coal industry could be close to being worthless (so no coal stock is on my great business watchlist). Maybe that’s a bit harsh—a few low cost producers in the lower cost basins will probably see their equity survive, but most will have to restructure. There have been numerous bankruptcy filings already, and I think that trend will continue. Like many commodity businesses, these companies borrowed heavily to expand their plants right as the price of their product was reaching all time highs:

Metallurgical Coal

The coal companies leveraged up hugely in 2011 when demand from China—the world’s largest coal consumer—was at an all-time high and metallurgical coal prices were soaring (met coal is a key ingredient in the production of steel). Companies were making huge capital investments to expand capacity in order to meet this growing demand from Chinese steel mills, and since pulling coal out of the ground is a business that often consumes more cash than it throws off, these capital expenditures and expansion projects were financed with massive amounts of new debt.

I’ve found that a simple axiom has helped keep me out of trouble when evaluating companies or investment opportunities:

  • Rising Debt + Shrinking Revenues = Bad News for Stockholders

Debt-fueled Acquisitions at the Top of the Market

Not only did companies take on debt to finance “growth” capex, but some began acquiring other businesses based on overly optimistic outlooks for met coal prices and Chinese demand.

In 2011, Walter Energy paid $3.3 billion to buy a large Canadian met coal producer, Alpha Natural Resources spent $6.7 billion for Massey Energy group, and Arch Coal spent $3.4 billion for International Coal Group. Just 4 years later, Walter and Alpha have gone bankrupt, and Arch has found itself in the midst of an interesting bit of game theory between management and the senior and junior bondholders that may result in a “kicking of the can” down the road a year or two, but will almost certainly at some point see the equity wiped out.

So this cycle rhymes with most of the other boom/bust commodity cycles we’ve seen in the past. But with coal, it could be particularly more painful since coal is a commodity—unlike oil, gas or base metals—that likely has already seen its peak demand and could be in a long (but very slow) secular decline. According to the US Energy Information Administration, in April, natural gas topped coal for the first time as the number one source of electrical power generation in the US. This trend might accelerate or slow down based on the price of nat gas, but it does appear to be a trend. 5 years ago, coal-fired power generation was twice the level of nat gas-fired power generation, and now both coal and nat gas have roughly equal share of US power generation.

Adding to the cyclical woes are the regulatory hurdles that the industry currently faces, and will likely continue to face going forward. The US Supreme Court remanded the EPA’s Mercury and Air Toxic Standards on June 29th, which would have cost power plants upwards of $10 billion annually. This was perceived as a victory for the coal industry, but many power plants have already been converting from thermal coal to natural gas in anticipation of regulatory requirements. Who knows what lower courts will decide regarding mercury emissions, but once a plant switches to gas, it’s not going back to coal regardless of price.

But the bankruptcies we’ve seen so far (and likely will continue to see in the next couple years) have more to do with mismanaged balance sheets than regulatory policies or even pricing issues.

Is Trouble Opportunity Here? 

Is the pessimism surrounding the coal industry overblown? My own feeling is the pessimism surrounding coal as an energy source might be overblown, as coal is still used to produce nearly a third of the country’s electricity. This might be in terminal decline, but it will decline slowly over decades, not anytime soon. It takes a lot of time and money to convert a power plant from coal to natural gas or some other energy source. That said, many debt-laden coal stocks will go to $0, so while the industry will survive for a long time to come, current stockholders might not.

So has the carnage in coal brought down other businesses with it?

Railroads

One place to look is railroads. The rail stocks have been clobbered over the past couple months (partly due to the recent stock market decline, but mostly due to the market suddenly worrying about lower coal volumes). Coal could be a legitimate concern for the railroads. In 2014 coal accounted for 39% of tonnage shipped and 19% of rail revenues, the single largest driver of revenue for the rails:

Rail Tonnage and Revenue Breakdown

I have just started thinking about this and reading about railroads. I don’t have any opinion on the value of rail stocks yet, and maybe this price decline is justified, or maybe it’s simply that rail stocks have been in a huge bull market over the past four years and this pullback is warranted simply from a valuation standpoint.

I’m not sure, but it’s a business that has some qualities that are attractive such as high operating margins, pricing power, and significant barriers to entry. It would be virtually impossible to replicate the rail network that Union Pacific or BNSF have cobbled together over the past century.

It also has certain things that are generally not viewed as positives such as unionized work force and significant capital requirements. The US rail industry will spend an estimated $29 billion in 2015 on maintaining and improving their network, and since deregulation in 1980, the railroads have spent over half a trillion in capex:

Rail Capex

Not exactly the “capital light” business than many investors look for… Of course, businesses that soak up sizable chunks of capital can still create significant value if there is an attractive return associated with that capital investment.

Another data point that could be considered positive or negative is the dramatic increase in crude by rail that coincided with the US energy production boom of the past 7 years—specifically the rise of hydraulic fracturing in the Bakken field of North Dakota. In large part thanks to the frackers, crude by rail has nearly tripled since 2008:

Crude by Rail

This is obviously good for the railroads if it can continue, but this could also be a point of concern if US production begins slowing down due to much lower energy prices. Crude is much less a factor than coal however, at only around 4% of revenue, but when combined with sand and gravel tonnage that is also used in fracking, it becomes a more meaningful revenue contributor.

Of course Buffett famously surprised many people when he bought BNSF back in 2009, a purchase that–despite what he said on Charlie Rose’s show–has provided Berkshire with spectacular returns. One of BNSF’s competitors is Union Pacific, which Buffett said took market share from Berkshire in 2014.

UNP has been clobbered along with the other rail stocks.

Here is a good article on the rail business—UNP specifically—that is worth a read.

It’s been a great decade to be a Union Pacific shareholder as pricing power and operating leverage have combined to triple operating margins from 13% to 37%:

UNP Margins

Operating income has increased to $8.7 billion from $1.8 billion in 2004, and the stock price is up 5x, even when factoring in the recent 30% decline.

I think it’s a good business. But I’m not yet sure what to think about some of the fundamental drivers (namely how will declining coal volumes affect the business, and where will margins be in the coming years).

This post is more of just jotting down some notes/thoughts on these businesses. I may begin writing more shorter-form posts on companies I’m researching as a way to share my notes and also get feedback from readers who may have also done some work on things I’m interested in.

So I have no real conclusion other than to say that UNP is one business on my “companies to read about list” that maybe will set up for an opportunity via a double whammy of a pessimistic coal outlook and an increasingly bearish stock market sentiment. We’ll see… Until then, I may begin parlaying some reading on coal into some work on the railroads.

Have a great weekend.

11 thoughts on “Some Thoughts on Coal Companies and Railroads

  1. Interesting article, I agree with most of you points, but still found stocks interesting even in these depressed times, like ARLP, etc.
    Probably won´t be star performer, but with current price could be interesting opportunity, well only time will tell.

  2. My firm had a meeting with BNSF management maybe six months before Berkshire bought them and they laid out some simple facts about rails’ advantages. For forty or fifty years the alternative to rails, trucks, had received a subsidy via the Interstate Highways. We aren’t going to build any more of those, other than connectors. The average speed of a truck on the interstate today is x, forty years ago it was x-y (I forget the numbers). Rails’ cost is q per ton per mile versus q + r for trucks. Rails are vastly better at managing their capital than they had been so that cars don’t sit idle in the yard like they used to and shippers’ goods don’t take so long to get from where they are to where the shipper wants them to be. Costs for rails have been cut dramatically (most engines had a fireman for forty or fifty years after the last steam engine was retired). Look at the operating ratios of rails now versus twenty years ago. Today’s ratios would have seemed like science fiction back then.

    All of these advantages will grow with time. If you’re in a commodity business you want to be the low cost producer; for long haul, bulk shipping that’s the rails.

    The western rails’ (UNP) coal is low-sulpher steam coal, met coal is from Appalachia. That western coal is the most insulated from substitution but fracking costs continue to come down as more is learned about the process. That’s not just a function of lower cost of services, it’s a fundamental change in the technology. I have no idea where that settles out in terms of relative costs of coal versus gas but so much of our electrical capacity is coal it’s not going to quickly be rendered idle.

    To some degree, what you lose in coal, you gain in oil produced by fracking – not sure if that’s a net positive or negative.

    When Buffett bought BNSF, coal versus gas wasn’t in the headlines. I think he just considered the advantages in the first paragraph and figured that whatever is shipped across the west will mostly go by rail.

    1. Great comment Pat. Thanks for the input. Yeah coal is a huge part of the railroads currently (19% of revenue) and it’s the largest commodity. But my research so far leads me to believe that the transition from thermal coal to nat gas at power plants is one that will take many, many years. And maybe oil can offset that, at least somewhat. It seems that with rail cars catching on fire, you’d think that there would be more political and public pushback (which you would think would benefit the pipelines, which seem to be a safer way to transport oil), but I’m not sure how that shakes out.

      Oil has a long way to go to replace the coal revenue, but as you say, that won’t disappear overnight. Thanks for the comments.

      1. Nice article, John.

        Pipelines are probably the lowest cost transport when you have high enough volume from an area. Eventually, I suspect that infrastructure will be built in areas like North Dakota (regardless of what happens in the near term with projects like Keystone).
        Another consideration that Buffett mentioned is that high oil prices are good for railroads two ways – not only for oil transport, but because the fuel costs of trucking increase with oil prices. Thus, perhaps part of the recent decline can be attributed to an improvement in the operating margins of the railroads main competitors.

  3. hi – happy to chat with you about rails. great businesses with massive barriers to entry and strong pricing power that only seems to be getting stronger. volumes don’t matter as much, and 2013/2014 were very strong years for volume so this flat/-1% y/y isnt that bad over a 3-year period

  4. >I’ve come to the conclusion that the aggregate equity across the entire US coal industry could be close to being worthless (so no coal stock is on my great business watchlist).

    The collective coal industry of the U.S. is not going to go bankrupt. That would be a national disaster.

    Alliance Resource Partners is low cost and has low debt. Cloud Peak Energy is one of the lowest cost producers in the world and is far from going bankrupt.

    The economics of coal guarantee that no company is going to get outstanding returns on capital unless management is savvy with capital allocation (arguably Alliance Resource Partners fits this category). I wouldn’t write them off wholesale because of that though.

    1. Yeah a few people have mentioned Alliance. They seem to be much more conservatively financed. I haven’t investigated that company. And yeah, they’ll likely be a few low cost producers that can survive this turmoil in the coal markets, but I do think we’ll see some consolidation, and likely a few more restructurings as well. Coal will survive, but the industry (or at least the highly leveraged met coal producers) will likely need to restructure first.

      Thanks for the comment.

  5. Hey John, really enjoyed this article. Those railroad companies are quintessentially American, which appeals to an Ameriphile like me. Just trying to get a sense of the downside, though. It seems like they’ve been on a fantastic run, with a lot of interest in them and analysts nearly unanimous in recommending a buy. What can go wrong? Or rather, why will they continue to outperform? You mentioned operating margins – do you think it’s likely that they improve from their already high percentages? Thanks in advance – great article.

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