Peabody Energy Corp Plans to Cut Production Costs By Transitioning to In-House Operations

Categories: Analysis, Energy

Peabody Energy Corp posted disappointing second-quarter results, with revenue of almost $2 billion (a year-over-year decline of 0.49 percent) falling short of the Bloomberg consensus estimate by about 3 percent. The mining firm’s adjusted EBITDA came in at the low end of management’s forecast and missed the consensus estimate by 5.2 percent.

Management reduced its forecast for full-year sales volumes by 5 million tons, to between 230 and 250 million tons, and cut its estimate of 2012 Australian sales volumes by 2 million tons, to between 31 and 34 million tons.

However, Peabody Energy’s forecast for third-quarter earnings per share ($0.20 to $0.45) and adjusted EBITDA ($350 million to $450 million) proved to be the biggest disappointment, prompting analysts to reduce their 2012 estimates once again.

Despite the headwinds buffeting the US market for steam coal, Peabody Energy’s domestic operations held up reasonably well, with revenue from these operations increasing 4 percent from a year ago.

As expected, the company’s US coal shipments declined from year-ago levels because of voluntary production cuts and renegotiated contracts with customers that deferred the delivery of roughly 4 million tons of steam coal until 2013. Higher price realizations offset this decline.

The resilience of Peabody Energy’s domestic coal business stems in part from management’s prescient decision to spin off coal mining assets in Central Appalachia (CAPP), a region where rising costs remain a permanent headwind, with the initial public offering of Patriot Coal (NYSE: PCX).

Not only did Peabody Energy monetize these mature assets in a bull market for coal, but the move also enabled the company to focus on developing its low-cost operations in the Illinois Basin and the Powder River Basin (PRB).

By all accounts, PRB-focused producers are in better shape than their CAPP-focused peers. Coal-to-gas switching among utilities that burn PRB coal has slowed and started to reverse now that natural gas prices have recovered to levels that make the fuel less economic. Peabody Energy also estimates that inventories at utilities that burn PRB coal are about 25 percent lower than those that receive supplies from the CAPP.

Management indicated that, based on this 2012 output numbers, the firm has between 70 percent and 75 percent of its 2013 production sold under contract.

In the second quarter, Peabody Energy’s extensive operations in Australia increased total production by 26 percent year over year, largely from mine expansions and acquisitions, but price realizations tumbled 19 percent because of lower benchmark settlements. Australian shipments totaled 8.2 million tons during the quarter, 3.6 million tons of which were metallurgical coal and 2.7 million tons of which was seaborne thermal coal.

Management attributed the firm’s disappointing guidance for the third-quarter to near-term headwinds in Australia, including a less-favorable production mix that includes a higher percentage of lower-quality coals. The challenge stemmed in part from disruptions related to maintenance at its open-cut Wambo mine. The timing of certain export shipments will also weigh on result.

That being said, CEO Gregory Boyce outlined a plan to transition contractor-run mines to in-house operations as a means to improve the reliability of these mines, while reducing production costs by about 15 percent to 20 percent. Replacing the smaller-scale mining equipment favored by contractors with larger equipment will require less manpower for day-to-day operations and increase overall efficiency. By April 2013, management expects owner-operated mines to account for about 75 percent of its Australian production.

Peabody Energy also reduced its planned capital expenditures by $200 million, to between $1 billion and $1.2 billion, taking advantage of the soft market to slow the modernization of the Metropolitan Mine, a move that will enable the firm to add up to 1.5 million tons to its nameplate production. The firm has also opted to spend additional time planning the expansion of the Wamb open-cut mine and the development of the Codrilla project.

Despite the challenging environment, Peabody Energy continues to generate solid cash flow, reduce its debt and buy back shares, making it a reasonable dividend investment. I remain bullish on the company’s long-term growth prospects and exposure to rising demand for metallurgical and thermal coal in emerging markets.

Elliott Gue is an investment analyst at Investing Daily.

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