Is Coal The New Tobacco?

A Comparison Of Two Hated Industries & Turning Hindsight Into Foresight

Today’s post is going to be a bit different from the standard stock breakdown. I wanted to spend a bit of time teasing out some of the parallels between the tobacco sector twenty years ago and the coal sector today. I have written about several stocks in the coal sector, including detailed breakdowns on Peabody Energy BTU 0.00%↑ and Warrior Met Coal HCC 0.00%↑. I have also talked about other companies in the sector, including buyback machine Alpha Metallurgical Resources AMR 0.00%↑.

While it’s important to be very familiar with each company for individual investors, I think it also makes sense to zoom out and take a look at the big picture. Each industry and company is different, but I think there are some interesting factors that make for an interesting comparison between the tobacco sector in the early 2000s and the coal sector today. Both sectors are routinely villainized and targeted by holier than thou investors and institutions. Both sectors have cheap valuations that provide a wide margin of safety for contrarian investors. The last, and most crucial point, is that the coal sector has the potential for massive capital returns in the future, similar to the dividends and buybacks that drove outperformance for tobacco stocks for the last twenty years.

When the perception of an industry is different from reality, that creates an investment opportunity. There is a lot of money to be made when the perception of an industry or stock goes from peak pessimism to a more balanced view on the prospects for an industry or that stock. Peak pessimism in the coal sector is already in the rear view mirror, and many of the stocks in the sector have had massive runs in the last couple years, but I don’t think we are anywhere close to fair value or a balanced view on the sector. I don’t think the market beating returns are done, and there is still plenty of meat left on the bone when it comes to coal stocks in my opinion. Each sector and company is different, but I think there are some similarities between the situation the coal sector is in today and the tobacco sector from twenty years ago.

The Beginning Of The End For Big Tobacco?

The Tobacco Master Settlement Agreement (MSA) was entered on November 23, 1998, originally between the four largest United States tobacco companies (Philip Morris Inc., R. J. Reynolds, Brown & Williamson and Lorillard – the "original participating manufacturers", referred to as the "Majors") and the attorneys general of 46 states. The states settled their Medicaid lawsuits against the tobacco industry for recovery of their tobacco-related health-care costs. In exchange, the companies agreed to curtail or cease certain tobacco marketing practices, as well as to pay, in perpetuity, various annual payments to the states to compensate them for some of the medical costs of caring for persons with smoking-related illnesses. The money also funds a new anti-smoking advocacy group, called the Truth Initiative, that is responsible for such campaigns as Truth and maintains a public archive of documents resulting from the cases.

The settlement also dissolved the tobacco industry groups Tobacco Institute, the Center for Indoor Air Research, and the Council for Tobacco Research. In the MSA, the original participating manufacturers (OPM) agreed to pay a minimum of $206 billion over the first 25 years of the agreement.

- Wikipedia

Shares of Altria MO 0.00%↑ (known as Philip Morris at the time), the owner of Marlboro and several other brands, sold off significantly after the settlement. Shares were down more than 60% over the next two years, going from approximately $14 to bottom out under $5 in spring of 2000, right as the tech bust was happening. Contrarian investors that took advantage of Altria’s selloff and negative sentiment on the tobacco industry from 1998 to 2000 set themselves up for massive returns over the next couple decades. To show how cheap shares got at the bottom, the quarterly payout of $0.48 in 2000 translated to an annual dividend yield over 38%. I’m sure it looked like a yield trap to some at the time, but the company also had a track record of double digit dividend growth. Even if investors didn’t pick the bottom below $5, there were plenty of opportunities over the next three years to lock in a yield over 20%.

For a quick recap of what happened with the company after the settlement, there are a couple noteworthy events. In early 2003, Philip Morris rebranded to Altria (probably to distance the company from prior history). In 2008, Altria completed a spinoff of Philip Morris, which operates primarily in international markets. At this point, investors who bought at the point of peak pessimism now owned shares of both companies, which both have paid growing dividends for years. The spinoff makes it difficult to calculate total returns, but the point is that long-term investors who bought Altria (and/or other tobacco companies) anytime from 2000-2005 made a small (or large) fortune over the next couple decades by taking a contrarian view on the investment.

Hindsight is 20/20, but if you can learn some lessons from the past and hindsight, you might be able to turn it into some degree of foresight. That’s why I think the coal sector offers a similar opportunity for investors today that tobacco offered two decades ago. Like the tobacco industry in 2000, investors willing to buy coal stocks today that are priced like they are going bankrupt in the next 5 years could be set up for huge returns over the next decade.

Similarities vs Differences

While tobacco isn’t going anywhere (humans have used tobacco in some way for generations, and that will continue), coal demand is actually growing. The tobacco stocks have actually performed very well in a period of secular decline for cigarette smoking, but I wanted to lay out some things that could be similar between the coal industry today and things that might be different.

Similarities

If it isn’t obvious by now, tobacco stocks had a dirt cheap valuation and bombed out sentiment in 2000. While coal stocks have rallied significantly off the bottom a couple years ago, the valuations across the sector still provide a wide margin of safety. Another similarity is that they have been targets of the ESG movement (Environmental, Social, and Governance), albeit for different reasons. ESG investing was just getting started at the time, but it has grown into the disaster it is today. The tobacco industry was one of the first targets, primarily for social reasons. Tobacco use has negative health side effects (they aren’t all negative, but that is a separate discussion).

Institutional investors avoided the sector, limiting the flow of money into the stocks. Not only did equity become more expensive, the debt side became more expensive as well. This restricted the flow of capital into the sector, despite the potential returns. Coal is one of the primary targets of the ESG movement today, and political leaders push for “decarbonization” of the hydrocarbon industry with an overly simplistic mindset. I could poke holes the idea that the world will stop using coal by 2030 (or by 2050 for that matter) all day, but the point is that capital coming into the sector has been restricted. Investors avoid buying the stocks, and many banks outright refuse to offer debt financing to the sector.

If you need any convincing, just look at some of the recent M&A activity in the coal sector. Teck Resources TECK 0.00%↑ arguably sold their best segment to Glencore for a song, and Whitehaven Coal stole the Daunia and Blackwater mines from BHP BHP 0.00%↑ but had to get creative on the financing due to the lack of capital available to the sector. One of the other things that is similar between the tobacco sector and the coal sector is that once operations are up and running, it doesn’t take a ton of reinvestment to keep the business operating. This brings us to the capital returns that drove returns for tobacco stocks for two decades, something that I expect will drive returns for investors in coal stocks for at least the next three to five years.

Capital Returns

Investors in coal stocks can’t count on multiple expansion, despite the cheap valuations. Cheap stocks can be cheap for a reason, or they can stay cheap for longer than most investors can stay patient. There needs to be some catalyst, whether it’s dramatically improving operating results, or capital returns. Depending on the coal stock, buybacks have already created huge returns for shareholders, or have the potential to create huge forward returns for patient investors.

Just think about how accretive it is to buy back your shares at a low-single-digit multiple of cash flow and a fraction of replacement cost of your assets. Especially as there are now constraints on ever adding more capacity in many of these industries. The accretion is just insane, and shareholders are starting to wake up to this fact when they decide which “deplorable” to invest in. It makes me wonder why anyone would ever issue a dividend, yet these management teams keep doing it….

It’s time that we hold these management teams accountable and tell them to just smash the buyback button. If someone will sell the shares cheap, then take advantage of those idiots. Look at some of the coal companies that have bought back huge percentages of the shares outstanding over the past few years. Despite that, they still trade at between two and four times cash flow!! Imagine how much worse the share-price performance would have been without the buybacks?? Guys aren’t selling these coal companies because they’re no longer cheap—they’re the same cash flow multiples that they were a few years ago. Rather, guys are selling because they have redemptions. Just keep taking advantage of this fact, until the situation changes. Smash the buyback button…

- Kuppy: Just Smash The Buybacks

If you have the time, I would strongly recommend reading Kuppy’s post that lays out his thoughts on buybacks. I’m fine with Peabody’s and Warrior’s token dividend payouts, but I want to see them follow in AMR’s footsteps and plow the rest of their excess cash into share buybacks over the next couple years. I have talked about this with other investors, but the companies that are repurchasing 15-20% of their shares each year are effectively going private via buybacks. I wouldn’t be surprised if we see more consolidation over the next couple years, and potentially a bid to take one of these companies private. Eventually we get to the point that these companies almost have no choice but to start paying larger dividends, but at these valuations, buybacks are the obvious best use of capital.

Differences

One of the main differences is that the tobacco industry was on its way to a secular decline two decades ago, while the coal industry today is actually seeing record demand. This is mainly driven by demand from China, India, and Southeast Asia, which are expected to account for 3 out of every 4 tons of coal consumed worldwide in 2023. This is one of the largest disconnects between perception and reality. Just because the US and other western nations are stubborn in their efforts to phase out coal for electricity generation and steel production doesn’t mean that the rest of the world will follow suit. The fact remains that coal is one of the cheapest ways to generate electricity and accounts for 70% of the world’s steel production.

Another difference worth discussing is the different margin profile of tobacco companies versus coal companies. Tobacco companies have historically been high margin cash cows. With tobacco companies, if you have a view on growth and margins, you can have a pretty good idea of how profitable they will be. The coal companies, like other commodity sectors, are very cyclical. Their margins will fluctuate with coal prices, which can be problematic at the trough, but very profitable as the sector improves. With the long term underinvestment in the sector, I think we are going to see higher coal prices over the next three to five years.

One way to think about the difference between the two sectors is the price maker vs price taker dynamic. Tobacco companies typically fall in the price maker category, with significant brand power and ability to consistently raise prices. Just look at Altria’s Marlboro brand. The Marlboro brand has been around for 100 years, and I wouldn’t be surprised if it is still around 100 years from now. Coal companies on the other hand, fall into the price taker category. Companies that need coal to produce electricity or steel aren’t going to be picky based on the company producing the coal. They don’t care if the coal is produced by Peabody, AMR, Warrior, or any other producer. As long as they are getting the right type of coal, they are going to be more focused on the price.

Charlie Munger, who recently passed away at the ripe old age of 99, said this about hydrocarbons:

Running out of hydrocarbons is like running out of civilization…. When the hydrocarbons are gone, I don’t think the chemists will be able to simply mix up a vat and there will be more hydrocarbons. It’s conceivable, of course, that they could but it’s not the way to bet. I think we should all be quite conservative and we should pay no attention to these silly economics and politicians that tell us to become energy independent.

While civilization would march on without tobacco, the world be a very different place without hydrocarbons. This includes oil, natural gas, and last but not least, coal. Coal still accounts for over a third of the world’s power generation and 70% of the steel production. It would hard to be as bullish as I am on coal stocks without growing demand for the underlying commodity. As much as the “green” narrative might say that we are going to stop using coal in the near future, the fact remains that coal will play a key role in electricity generation and steel production moving forward.

Conclusion

Do I know for certain that coal is going to produce two decades of huge returns like tobacco did? No, but I think the risk/reward is still very attractive for at least the next three to five years. I will be reevaluating along the way, but the fluctuating margins and commodity cycles make it much harder to predict where things will be far into the future for the coal stocks. With a stable business that is a high margin cash cow like Altria, investors buying at a dirt cheap valuation could expect huge returns from the dividend alone.

This all happened with the tobacco industry was in secular decline. Demand for coal today, while it isn’t booming, is still growing. Coal consumption is probably going to set another record in 2023 after hitting an all-time high in 2022. As an investor, I think exposure to both thermal coal and met coal makes sense. That is why I own Peabody Energy, which has a mix of thermal and met coal, and Warrior Met Coal, a met coal pure play, which has the potential to significantly grow its met coal production in coming years. I’m wishing I had bought those Warrior calls as shares have had a strong November, but I’m already very overweight coal stocks today.

Peabody is just getting started on their buyback program and I think that their shares have some catching up to do to the rest of the sector. Warrior hasn’t announced a buyback program yet, but I think there is a good possibility that they are debt free and buying back stock in 2024. If they follow AMR’s playbook, I think share prices for both companies will be much higher over the next couple years. The tobacco industry and coal industry are different for a variety of reasons, but I think there are enough parallels to compare the two at different points in time.

In 2000, Altria was priced like it was going bankrupt in a few years and sentiment was in the toilet. Today, coal stocks are priced like they are going bankrupt before the end of the decade, and sentiment doesn’t reflect the potential of the actual businesses. In both cases, the reality on the ground for the sector is very different from the perception of most investors. This wide gap between perception and reality is what makes coal stocks a compelling opportunity today.

Hindsight is 20/20 and foresight is a much foggier picture. For investors, being able to learn from the mistakes of others and the lessons of the past is what develops foresight. That foresight is what can potentially lead to outsized returns. Hindsight shows that the tobacco industry was a compelling investment opportunity in 2000. Will foresight prove that the coal industry was a compelling investment opportunity today? We can’t know the future, but I think so.

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Disclaimer

I own shares of Peabody Energy and Warrior Met Coal. I also own calls on Peabody Energy. You should do your own research before making any investment decisions. Different investment strategies have different risk/return profiles which should be considered before making any decisions.