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Mark Deluzio

Avinash Gandhi

CNX AT A GLANCE

P/E ► 13.4 AVG EV/EBITDA ► 6.85 AVG ROA ► 8.6% AVG ROE ► 35.7% AVG Debt to Equity ► 3.08 HIGH Current Ratio ► 0.692 LOW Interest Coverage Ratio ► 39.1 HIGH

 

 

 

 

 

 

CONSOL Energy Inc. (NYSE:CNX) is a vertically integrated coal and natural gas producer. Its main revenues come from the sale of these two fuels to energy generators and metal producers in the Northeast United States. Primarily, CONSOL mines coal or extracts natural gas from land that it owns, processes it for sale, and then ships it to customers using its transport network.

CNX is the U.S.'s fifth largest producer of coal, the primary fuel used to produce electricity. Coal Power accounts for 49% of U.S. electricity production, and roughly 40% of world electricity ^[1]. CNX's Northern Appalachian coal has the advantage of burning hotter than other coal, but it also contains more sulfur - until recently a big disadvantage for CNX. However, recent environmental legislation requires coal plants to install "scrubbers" to clean sulfur out of exaust from burning coal, muting the disadvantages of Northern Appalachian coal and allowing CNX to charge higher prices.

The company has land valued at over $4 billion dollars with proven coal reserves of 4.5 billion tons, as well as a river transport system that delivered 11.1 million tons of coal in 2006 ^[2].

Business Financials

Breakdown of Segments

CNX Coal

This subsidiary is the basis for CONSOL's operations. All other segments developed out of support for the primary activity of mining coal. CNX Coal operates 17 mines in the US, and all but one of these are underground mines. Because of the make up of CNX's mines, the primary (88%) method for extraction is longwall mining ^[3]. There are several advantages to this method, including low variable costs (allows CONSOL to change output quickly and manipulate supply/demand) and improved recovery rates (longwall gets more coal out of the same source than other methods). Once the coal has been mined and processed by CNX Coal, it is ready to be shipped to customers by CNX Services.

CNX Gas (CXG)

Once entirely owned and operated by CONSOL, this subsidiary was partially spun off in an Initial Public Offering in January of 2006. However, CONSOL (CNX, the parent company) still maintains control over the public CXG unit through its 81.5% ownership stake. CXG business model focuses on the exploration, extraction, processing, and sale of natural gas. It extracts methane gas from coal beds in the Appalachian Basin^[4]. CNX Gas contributed over 50%, or $41 million, of Consol's net income in the first quarter of 2008. In the second quarter, the company produced 18.8 bcf, a record and up 18% from the first quarter.^[5]

CNX Land

The primary operation of this subsidiary is to support the coal and gas operations by developing and purchasing real estate holdings. In addition to this, CNX Land also creates value for CONSOL and its shareholders through timber extraction and sales, leasing land to other miners for royalty income (company pays CNX Land for the right to extract minerals from their land), as well as retail development and asset sales. On the retail development side, CNX Land has reclaimed land at defunct mines for malls, communities, and other projects to be constructed. In addition to the profitable operations of this unit, they strive to donate reclaimed land to various conservation groups. CNX Land currently controls 400,000 acres in the United States and Canada ^[6]

CNX Ventures

This unit seeks out joint ventures and other forms of innovation that will help support and create value for the core gas and coal operations. In 2002, CNX moved to vertically integrate their business model even further by creating a joint venture with Allegheny Energy (AYE). CONSOL owns a 50% interest in the natural gas fired facility, which will generate electricity in Southwestern Virginia ^[7]. This allows CONSOL to hedge against severe price movements in the spot market for natural gas; they can now convert the gas directly into electricity and seek utility income.

CNX Services

This subsidiary represents the "support" activities in bringing coal to customers. The term support here refers to all of the other necessary steps along the value chain to bring coal and gas to CONSOL's customers. CNX Services operates the Marine Terminals division, which both transports coal along inland waterways and exports it overseas. The division collectively transported 30 million tons of coal in 2006 ^[8]. Of these 30 million tons, 5.5 million tons were sent overseas though the company's Baltimore Terminal and 24.5 million tons were moved along the waterways. Additionally, CNX Services generates revenue by transporting the coal of other companies ^[9]. This accounted for 13.4 million tons in 2006. CNX Services also operates the Research and Development unit for CONSOL.

Income Statement Analysis

There are several trends observable in the financial data. First, CONSOL had revenue and operating income growth from 2002-5, but had a slight decline in 2006. However, gross profits have increased steadily each of the last four years. The discrepancy here is a result of CNX's decision to spin off an 18.5% interest in its natural gas subsidiary, CNX Gas. This netted the company a gain of $327 million in 2005 ^[10]. The gross profit (sales - cost of goods sold) shows a clearer picture of the company's core operations.

In the first quarter of 2008, Consol's net income decreased year-on-year from $113 million to $75 million; though coal prices rose 9.4% and natural gas prices rose 24%, margins shrank by 37% because of lower production and rising capital costs.

In the second quarter of 2008, Consol's net income decreased year on year from $153 million to $101 million.^[11] 2Q07 income was affected by property sales worth $59 million, however, while 2Q08 coal prices were up 17% period-to-period.^[5]

Consol has also hedged itself against industry risks by diversifying its operations. Granted, the vast majority of its revenues comes from the coal side, it still managed to generate nearly 20% in other subsidiaries. Considering the fact that the major competitor for coal in the short term is natural gas, CONSOL is positioned very attractively relative to other coal companies with the success of CNX Gas.

Key Trends and Forces

Coal Power

Coal Power is easily the cheapest power source for generating electricity. As a matter of fact, the price of a ton of coal ($60-70) is not much higher than the cost to ship it at current dry bulk rates (around $50/ton)^[12].

Although its low prices makes it attractive relative to other energy sources, coal stands to grow in demand regardless of this if energy demand itself grows. One of the main drivers of this is weather. If summers are relatively hot or winters are relatively cold, it is a fair assumption that demand for coal will increase to power heating/air conditioning. The current technology for burning coal to create electricity is also the simplest of our energy sources. Another possible jump in domestic coal usage could come out of the foreign policy area. The U.S. is currently making efforts to decrease our reliance on foreign oil by shutting down oil fired plants. Coal seems to be a great political alternative since the U.S. has the world's largest coal reserves.

Clean Coal

Estimated CO2 emissions per Terrawatt of various electricity sources

Coal may be a cheapest (and most domestically available) power source, but it is my far the worst pollutant of the group. It emits the most Carbon Dioxide of any electricity source. Clean coal in the past has meant purification, filtering ash, and removing NO₂ from emissions. This reduces emissions and pollutants, but still provides ample carbon emissions that can potentially increase the Global Climate Change problem. A more viable, and expensive, alternative is coal liquefaction. Liquefaction is the process of turning coal into a synthetic oil. The technology has actually been around since the early 20th century^[14]. The major roadblock in the past for direct coal liquefaction has been its high break even point. For the process to be profitable in the U.S., oil prices would have to be over $33-35^[15]. However, with crude oil on the threshold of $100 this seems like a favorable alternative.

Sulfur Scrubbers

Recent EPA and congressional regulations have benefited CNX. To meet new and more restrictive emissions standards, coal plants are now installing sulfur scrubbers. These scrubbers eliminate most sulfur dioxide emissions. CONSOL's Northern Appalachian coal has a high relative BTU content (it burns hotter than other coal) and requires low transportation costs because of its proximity to markets, but it is quite high in sulfur. The high sulfur content meant Consol's coal was cheaper in the past, but with the increasing amount of scrubbers in power plants, Northern App now sells on its higher BTU content and commands a premium in the spot market.

Continued Global Growth

World economic growth is at an all time high. A byproduct of this growth is a large spike in energy demand. As this increase in demand of the past few years has driven Oil Prices to record highs, so have the spot market prices for coal followed. This is mainly attributed to the growing demand for electricity. Coal demand is especially growing in Emerging Markets, where they may not have the technology or infrastructure to handle other energy sources. The obvious example here is China, where demand for natural resources is growing at incredible rates. The continued global growth will drive both coal prices and production up in the future. CONSOL has positioned itself for increased foreign demand through its subsidiary CNX Marine Terminals, which operates an exporting terminal in the Port of Baltimore.

Environmental Degradation and Regulation

Coal is one of the dirtiest forms of energy production. It's burning releases a number of pollutants that contribute to smog, acid rain, and higher instances of respiratory problems in the general populace. Furthermore, coal power releases greenhouse gases, which are causing the global warming induced global climate change. This hot-button environmental problem, aside from being a major election issue, will have massive economic, political, and social effects in the future. For this reason, many governments around the world are being pressured by their citizens to regulate greenhouse gas emissions. From mandatory emissions caps to Carbon trading markets to subsidies of alternative, clean, and Renewable energy sources, these legislative regulations are making coal a less attractive energy source by forcing companies to limit coal power production or by making coal expensive relative to other power sources. While coal producers like Consol are attempting to regain public support by developing "clean coal" technologies to reduce pollution emissions, the fact that burning coal will always release greenhouse gases keeps clean coal from being an environmentally viable form of energy, at least until carbon sequestration techniques are perfected. Overall, this trend will either lead to lower demand and, therefore, lower prices for coal or higher costs - either ways, contributing to lower profit margins.

Investment in Coal Power Plants

On February 4th, JP Morgan Chase, Citigroup, and Morgan Stanley stated that they would put into effect a set of "Carbon Principles" by which they would give investment priority to clean energy groups, and force any company planning to build coal-powered plants to show how they would deal with the carbon dioxide pollution in order to get investment money. Without the development of carbon-free coal technology, the creation of The Carbon Principles will be a major setback to the advancement of coal as a major form of industrial power because of its difficulty in obtaining financing.

Competition

The Coal Power industry is very competitive because of the nature of selling a commodity. It is very difficult to diversify and achieve price premiums when the end product is effectively the same across the industry (depending on the variety of coal). There is still maneuvering among company's for prices as can be seen below. There are spot market prices for the various types of coal, and these prices have been steadily rising over the past six months. Additionally, coal company's can secure fixed prices through long and short term contract negotiations that allow it to achieve more stable margin. This plays a major part in how CONSOL achieves their higher prices and margins. They often make the decision to cut production when they feel they can earn a higher market price. CEO J. Brett Harvey has clearly illustrated this strategy, "...if we have to choose between increasing margins and increasing volumes, we will opt for margin expansion." This manipulation of supply and demand allowed them to achieve the highest profit per ton produced.

Source for chart data ^[16], ^[17].

Intrinsicly, buying a coal stock is a bet on global growth. As growth continues the high market prices for coal will at least stabilize, if not increase further. However, CONSOL has managed to position itself in a unique way among its peers. Its ownership stake in CNX Gas offers a hedged play on natural gas demand and prices should the coal sector suffer a setback. Its vertical integration and proximity to markets and exporting terminals provides a lower overhead and dependance on contracted services. Its ownership of vast reserves and avoidance of theMaster Limited Partnership structure allows CONSOL to avoid high lease fees and independently determine pricing and output. CNX's vast majority of reserves being comprised of Northern App Coal allow it to sell for a premium in the spot market. All of these forces justify CONSOL being priced at a premium relative to its coal sector peers.

Stock Valuation

Below are some key metrics in examining CONSOL's stock. It presents just a small, balanced view of its position among the other stocks in the coal sector. Valuing stocks is a maddeningly difficult venture, but a good way to get a picture of where a security lies is to examine its position and price against its peers. The full list of metrics and ratios is available here: CNX Ratios ^[18].

Notes

1. ↑ Energy Information Administration, http://www.eia.doe.gov/
2. ↑ http://www.consolenergy.com/
3. ↑ http://consolenergy.com/main.asp?c=CNXCoal
4. ↑ http://www.cnxgas.com/AboutCNXGas.aspx
5. ↑ ^{5.0 5.1}
6. ↑ CONSOL Energy 2006 Annual Report, http://media.corporate-ir.net/media_files/irol/66/66439/pdfs/AR06.pdf
7. ↑ http://phx.corporate-ir.net/phoenix.zhtml?c=66439&p=irol-newsArticle&ID=534242&highlight=
8. ↑ http://www.consolenergy.com/main.asp?c=CNXServices
9. ↑ http://www.consolenergy.com/content.asp?c=QuickFacts
10. ↑ CONSOL Energy 2006 Annual Report
11. ↑ Seeking Alpha: "Consol Energy, Inc. Q2 2008 Earnings Call"
12. ↑ http://www.iht.com/articles/2007/11/05/business/ship.php
13. ↑ Price data from www.bloomberg.com and http://www.eia.doe.gov/cneaf/coal/page/coalnews/coalmar.html
14. ↑ http://thefraserdomain.typepad.com/energy/2005/07/about_coal_liqu.html
15. ↑ http://findarticles.com/p/articles/mi_m0CYH/is_15_6/ai_89924477
16. ↑ http://www.sec.gov/edgar.shtml
17. ↑ National Mining Association, http://www.nma.org/statistics/pub_coal_survery.asp
18. ↑ Reuters, http://stocks.us.reuters.com/stocks/ratios.asp?symbol=CNX

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