GDP, DURABLE GOODS, FINDING BUSINESS CYCLES

Bernanke is Cautious on Employment, Looks at Demand

Today Fed Chairman Ben Bernanke appeared before Congress to provide his semi-annual monetary policy testimony. He said that improvement in employment must be closely monitored in view indicators that show demand not strengthening in kind. Such sentiment disappointed equity markets, which closed down, despite good GDP numbers and success coming from the European Central Bank's second LTRO.

Unemployment has fallen to 8.3% from 9%, where it hovered for most of 2011. Apparently the fall in unemployment has been rather fast and deep, with the current rate at the Fed's low end of its year-long 2012 forecast. Unemployment started to decline in November of last year dropping to 8.6%. What is surprising is that quarterly GDP numbers leading up to November weren't very strong. Q1 showed GDP advancing by .4%; Q2, 1.3%; Q3, 1.8%. Today, GDP showed Q4 growth at an impressive 3.0%, with an annual gain of 1.7%.

Still, throughout 2010, a time when GDP numbers were consistently stronger than in 2011, and in fact ended with 3.0% annual growth, unemployment numbers didn't budge. What's special about Q4 2011 to  bring down unemployment in a dramatic fashion....

Fed forecasts have GDP growth in the area of trend at 2.3% to 2.6% for 2012. According to Bernanke, “with output growth in 2012 projected to remain close to its longer-run trend, FOMC members did not anticipate further substantial declines in the unemployment rate over the course of this year.” For rates of job growth to be repeated, Bernanke said that it would “likely require stronger growth in final demand and production.”

Headwinds are starting to blow against growth in final demand and production. Bernanke saw elevating gas prices pushing up inflation and depressing consumer purchasing power.

Vehicles Have Led Demand, But Demand Needs a Broader Base

Final demand can be seen in retail sales indicators. Monthly results for retail have been flat through Q4, except for the motor vehicle component. Vehicle sales have also influenced consumer credit expansion and the growth of associated manufacturing sectors.

According to today’s release of GDP numbers by the Bureau of Economic Analysis, motor vehicles lead growth across GDP components in Q4, posting growth of .81%, and annual growth at .19%. Last time growth was seen in motor vehicles of this magnitude was in Q3 of 2009, with a rate of .92%. Of course, when vehicle sales increase, associated production also increases and, with it, investment. Investment in industrial equipment showed basic strength through 2011, growing .22% in Q4. Transportation equipment was also strong in 2011, with Q4 results growing .18%.

Contrast vehicle and associated numbers with broader demand numbers. Clothing and shoes, as a component of GDP, looked weak through 2011 with Q1 growth at .07%; Q2 at .05%; Q3, -.19%; and Q4 ending the year with .07% growth resulting in an annual rate of .07%.. Food and beverage purchases looked like clothing---weak, and the particular numbers almost identical. Whereas in 2010, both components were about twice as strong, posting annual growth of .13% each.

Economic numbers show two concerns. Firstly, employment improvement might be more a reflection of vehicles, as opposed to a broader base. Secondly, given the quarterly GDP numbers for most of 2011, with a jump in Q4, is this growth sustainable.

Durable Goods Orders, With GDP Can Tell of Bottom Cycles

Durable Goods Orders reported by the Census Bureau today show a decline in January of -4.0%, following three consecutive months of increase. This data shows anticipated future production. The motor vehicle component looks healthy with January numbers at a .9% increase and a year over year increase of 12.2%. These results comport well with other trends in other economic indicators showing strength in vehicles.

In fact, looking at the stock performance of the Dow Jones Automobiles and Parts Index ($DJUSAP) versus the S&P 500 ($SPX), we see that the auto index outperformed the S&P by growing 27% from a December 20, 2011 low through to a February 17, 2012 high. For the S&P, the growth rate has been 15.4%. However, currently everything is moving sideways, not really advancing and not really declining.

More important, nonetheless, are the areas of weakness in durable goods orders. The most significant class is “computers and related products”, which is different from “computers and electronic products” which includes the semiconductor industry.

For “computers and related products”, surprising decline is seen month over month with a fall in January of -10.1% versus December’s fall of -5.9%. Of considerable note in this industry is a year over year decrease of -13%, that is from January 2010 compared with January 2011. This component is experiencing the largest decreases of all durable goods.

Looking at a similarly related component on the GDP report, its growth has been weak over 2011. This implicates a business cycle ready for an uptick in demand.

Ultimately, vehicles really showed up in Q4, while other things weren’t as strong as one would like to see. Ideally, one would like to see employment steady at its rate or obviously improve, while retail aside from vehicles improves. From there, perhaps the cycle for some of these underperforming components will tick up.

MORNING'S EUROPEAN LEAD, PART II

Help by ECB Long Term Refinancing Operations

Channels through which the European countries and IMF lent their support remain very unclear. However, it does appear that the G-20 last weekend drew a line in the sand. They said before we give Europe anymore money, make the money tied up in your financial facilities and mechanisms work.

The real relief to the European experience has been through the European Central Bank. Sovereign bonding is one issue, while the functioning of European banks is another. In the end, both are tied together, but for band-aid purposes seen today.

Sovereigns must function to keep the tax revenue stream rolling, at least. Banks, on the other hand, must keep their liquidity rolling, at least. Where sovereigns get international support, banks aren't as directly supported, but have large financial implications in the event of failure.

For banks, the risk paradigm is surrounded by their past of borrowing their loan funds lower than the rates of their loans. These funds came from short term interbank markets. Add to this the collateral deterioration of what European banks previously pledged to obtain their loan funds (being in large part sovereign debt), and the ECB had to shore up the European banking community. Just as with the LIBOR 3 month rate chart in the article below, U.S. equities also enjoyed the relief from banking liquidity support.

In Europe, with sovereigns experiencing whispers of default, interest rates rose beyond the rates at which European banks originally borrowed. These original borrowing rates composed the base of European banking lending.

The LIBOR 3 chart shows how high, and how the rates corrected. The S&P 500 index chart to the right shows financial stress, until the ECB took its steps.

Steps taken by the ECB started on December 21^st, 2011 with their first Long Term Refinancing Operation. Which is to say, they accepted collateral from Euro banks in exchange for guaranteed money at a rate of 1% for three years This rate of lending lets Euro banks barrow at 1% and buy Euro sovereign bonds at a much higher yield--a carry trade--which should have a symbiotic effect.

The secret to the success represented by the charts amount to the ECB first buying sovereign bonds to assist in sustaining prices and reducing yields on the bonds. Secondly, on December 28, 2011 the Federal Reserve, Bank of England, Bank of Japan, Bank of Canada and Swiss National Bank all agreed to lend dollars at reduced rates in the bank liquidity system. This made U.S. dollars, or Eurodollars, available to meet European banks' demand for U.S. dollars. Eurodollars, as a unique form of currency deferential, funds so much of European commerce. With the ECB's LTRO, the eurodollar recovered, while interest on money went down, and U.S. equities went up.

Tomorrow, we will learn of the response to the ECB's next round of LTRO's. Should the uptake by banks be in the range netting 320B to 340B euros, all should maintain and stability in markets prevail. A deviation from these amounts could open a can of worms.

So far, this dynamic looks almost like a form of quantitative easing by the Federal Reserve, but only maintains banking liquidity. At the same time, the real issue of how sovereigns pay their bonds still searches for cash and international support

IN THE MORNING, EUROPEAN CRISES GETS NEW LEAD, PART I

Essentials of European Debt Crises

Ultimately there is a difference in Europe between its sovereign debt crises and the inability of its banks to function. Since December, we have learned that where banking functions can be buttressed, the ability of sovereigns to address their debt is more concerning.

Countries such as Portugal, Ireland, Italy, Greece and Spain have experienced their time in the media. However, so has IMF Global through declaring bankruptcy due to excessive bravado over risky European debt. Dexia, a major Belgium-French bank, likewise needed relief, for like reasons. With these developments, the nerves of the international banking community grew raw.  The LIBOR 3 month rate increase shows how short term rates grew to stress European banks on their loans.

Out of Europe, through last year, grew a worry of something larger than a Lehman Brother's collapse. Where Lehman witnessed a collapse of some $600B, markets saw a two prong problem in Europe. Firstly, Greece found the inability to pay its bond obligations and, secondly, banks through the region held not only Greek bonds, but PIIGS bonds--a moniker for the list of countries stated above.

If Lehman's withdrawal of $600B created enormous ramifications, what about a larger collapse occurring in any of the above countries? Should such a collapse occur, the foundations of European banking would be destroyed, given their investment in sovereign bonds. Accordingly, many methods of CPR and respiratory ventilators were deployed.

These devises of modern financial prosthetics sought to support the immediate need  and are new in global experience. Add to the experimental nature of these devises, the political trend of fiscal politicians to point the finger.....and politics will get bogged down. Then add the resignation of Prime Ministers and cabinet dignitaries, one can see an eroding of trust in the capacity to solve a crises.

The European debt crises is nothing short of countries once experiencing high tax revenues and politically leveraging such revenues into re-election promises. When times were very good, programs were created that even then went beyond existing tax revenue income. Sadly for the Eurozone, so many countries are on the same currency, but do not experience equal capacity for tax revenue, nor the ability to serve up political promises. This inequality, while living off the same currency, comes from an unequal capacity of economic growth, which is and has been driven by the economic leaders of the European Union.

In this quagmire, the international community responded through the IMF. Responses joined the European Financial Stability Facility....which sold bonds that encountered poor demand....and the European Financial Stability Mechanism....which might take a lead role. While European countries bring their support, international funds come through the IMF.

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LOOKING AT THE WEEK AHEAD

Oil and Gasoline Price Movements and Drivers

A growing concern in this country is the rise in petroleum prices. Looking at retail sales for gas stations, we see strength in October, declining in November, really dipping in December, and flat for January. While petroleum and gasoline inventory reports vary, due often to tankers or hub manipulation, consumer purchases show a trend. This trend is associated with retail pricing the consumer must pay. Simply put, the consumer will reduce gas consumption when prices rise. The table reflects the most recent retail sales data from the U.S Census Bureau showing October 2011 through January 2012 data.

Now the issue is the price difference between U.S. West Texas Intermediate (WTI) crude and North Sea Brent crude. Traders bet that the price of WTI will decline, or not rise as fast, when compared with Brent crude. Brent crude has been moving the price of gasoline.

The cause for Brent leading is because traders expect U.S. petroleum to get stuck in distribution hubs such as the one in Cushing, Oklahoma. While WTI can’t move due to infrastructure deficits, Brent is brought in by tankers and feed petroleum needs. Should the spread in price grow, should WTI get bogged in the inability to be distributed, the past has shown increased gasoline pricing. Should the WTI/Brent spread expand, look at gasoline price responses.

Change in European Plans to Bail Out Greece

Europe is always a thing to watch in the week ahead. Over this weekend, the G-20 group met, considered issues and…..Apparently everybody wants improved firewalls from the Eurozone to insure against Greek contagion. U.S. Treasury Secretary Geithner said that he isn’t prepared to ask for more money from Congress for IMF bail-out efforts. Emerging markets, such as Brazil, have also said that other Eurozone money exists to shore up guards against insecurity.

Anticipation now is for funds to be taken out of the European Financial Stability Facility, which nobody really understood, and its bonds demonstrated as much. This money is to be diverted to the more stable European Stability Mechanism. With this, IMF chief Christine Legarde has unforeseen issues to deal with before convincing the IMF board to commit more cash to Greece, which is supposed to occur in early March.

Accordingly, watch results of legislative votes in Germany and Finland on the Greek bailout. Then, March 1-2, a Eurozone summit will be held to address the “firewall” issue.

China Shows Issues with Growth Moderation and Sustaining Liquidity

China is looking to restructure local government debt and the facility platforms sponsoring such debt. Apparently some 1.8 Trillion yaun ($286B) is coming due in 2012. Current growth rates aren’t supporting the debt and to prevent liquidity risk, a restructuring should bridge the gap.  

Economic Reports  

 Hard data releases will include on Monday; the Dallas Fed MFG Survey and pending home sales. Tuesday; Durable Goods Orders, Richmond Fed MFG Survey. Wednesday; U.S. GDP, Chicago PMI. Thursday; Jobless Claims, ISM MFG Index. Then China reports its PMI manufacturing numbers, while the Eurozone releases its retail sales and PMI manufacturing numbers.

TARGET CORP.: SHOP THERE, INVEST THERE?

Looking at Target, Sales Grew When Profits Declined and Earnings per Share Maintained

Many indicators point to economic growth, particularly in the manufacturing and service sectors. In recent articles, vehicle sales and its reverberations into other industries have been identified as a potential explanation for the positive numbers. These indicators are, nonetheless, joined by a long awaited improvement in employment data.

Yet, Standard & Poors reported on February 3^rd that earnings for more than half of the firms reporting so far this season, show an earnings growth rate of only 7.53%. This is a decline from the double digit growth rates previously experienced and expected through 2013. Reasons provided include global macroeconomic concerns with Europe and Emerging Markets being first, through to the consequent destocking in supply chains.

Looking at the performance of large general merchandising retailers, we see that the last four sequential quarters have been hard. On February 21^st, Walmart reported its Q4 2011 numbers, which showed a 6.5% increase in sales y/y and an increase in net income of 3.38% y/y. This contrasts with Target, which recently reported, showing a 5% decrease in net income and Kohls also recently reporting an 8% decline. Kohls also gave disappointing guidance for next quarter. Costco will be reporting its earnings on February 29^th.

What is particularly significant about the performance of these companies is a trend of flat to declining sales and profits have been developing sequentially quarter over quarter. With Target and Kohls, the trend was not broken with Q4 results, as occured with Walmart. Aside from these companies confronting competition for the consumer's tightly held dollar, their operational efficiency and innovation becomes acutely noticeable in this environment.

Target reported their earnings for Q4 2011 on February 23^rd. They reported sales of $21.29B versus a year earlier Q4 number of $20.66B. This results in a year/year Q4 sales gain of 3.3%. However, Target’s profit dropped by 5% for the same period. Despite this, their stock gained substantially due to their upbeat and positive forecast for better days.

 Add to Target’s Q4 y/y sales and profit problem their flat to declining sales over quarters 1 through 3, and one must ask questions. That being, how tough is this business environment? Essentially, the question is how tough is the macroeconomic setting for Target, and what are they doing to operationally adjust.

The table to the right is a 5 quarter review for Target based on their income statement. Quarters 1 through 3 show declining to flat sales. These quarters also show declining to flat EBITDA and earnings that were mostly down—especially in view of Q4 2010 results. The table also shows that for these three quarters, operations costs (SG&A) essentially grew….at rates faster than sales and EBITDA.

Target’s Data Reveals a Problem in Metrics Effecting Profit Growth 

A good measure of a store’s performance is one that Walmart uses and comments upon in its SEC filings. Firstly, is the store controlling operating expenses such that net sales exceed operating expenses. Secondly, is the store growing operating income (EBITDA) faster than net sales. These metrics can give insight into how efficiently a store is operating and how it is leveraging its efficiencies to grow operating income.

In Target’s case, while sales were falling, they didn’t succeed very well in either making SG&A expenses fall at a faster rate than sales, as in Q1, or they allowed SG&A to grow at a rate faster than sales. This demonstrates a quarter over quarter trend in growing operational costs against a challenging sales environment.

This trend probably explains why their sales for Q4 2011 were 3.3% higher than Q4 2010, but their net profit was down 5%. Between the two quarters, sales weren’t the only thing that was higher. Cost of goods sold (COGS) increased 3.7%---higher than the growth rate of sales. Importantly is that operational costs (SG&A) increased 4.2%---also higher than the growth of sales.

Target described its challenging sales environment in its earnings conference call. They said it was one marked by inflation in the cost of goods sold (COGS). They said that they controlled this inflation by managing costs and raising retail prices to maintain their gross margin. Of note is that management said that customers purchased fewer units in categories that saw retail price increases.

Basically, customer traffic in their stores declined and with it the number of sales transactions. To make up the lost volume, retail prices increased, the average purchase value increased, while the volume purchased decreased.

The table to the left shows the nature of Target’s transactions. Quarter over quarter, you can see slowing in the number of transactions and increasing prices. With SG&A being up 4.2% q/q, one can surmise that Target didn’t demonstrate very much flexibility in adjusting its operational expenses to the decline in the volume of merchandise moved.

Looking at the units/purchase in the table, in 2010 Target saw an increase of 3.6% units, whereas in 2011, the increase was only .90%. However, year over year inventory increased by 4.2%. This suggests that Target didn’t respond very efficiently to declining volume sales and adjust inventory to reflect the declining volume.

Target’s Approach to Conditions Can be Expensive

What’s perhaps more is that in the competitive retail environment, to raise prices to support margins amid declining volume, the consumer has to justify the price increases in their mind. This means that any company engaged in such a dynamic must add to the aesthetic, promotional and service experience. Such value additions naturally result in increasing operational costs (SG&A).

This business structure has an ultimate flaw demonstrated by other large retail chains. There comes a point where diminishing returns are realized by increasing prices while also enhancing the shopping experience, all to compensate for volume losses. That point of diminishing returns can warn of itself when you see persistently higher rates of SG&A growth, with increasing pricing. Certainly the point warns of itself when in Q4 2011 a company makes more money than in Q4 2010, but profits fall 5%.

Where profit fell 5% over the two quarters, earnings per share were $1.45 in Q4 2010 and $1.45 in Q4 2011. To explain this, Target’s reduced profit was spread over fewer shares, which balanced out the loss to show no decline in earnings. In Q4 2010, outstanding shares were at 708 million, in Q4 2011 the outstanding shares reduced to 669 million---a reduction of some 5.8%.

Target’s challenges show both the condition of the U.S. consumer, and methods by which companies respond to conditions. Target is a good company and one to watch. They are innovating by expanding into more product offerings such as grocery. This “PFresh” remodeling program currently includes 900 stores with an expected addition of 230 in 2012. The addition of groceries is leading Target’s same store sales advances with double digit gains.

Target is also introducing a smaller store to be oriented toward more of a neighborhood type of market, these stores are called CityTarget. With this, Target will be expanding into Canada and stores are planned to open in 2013.    

AUTOS LEAD: WHERE FROM HERE

Autos Contribution to Consumer Credit, Wholesale Trade and Industrial Production

Growth in auto sales is generally considered the cause of gains made in outstanding consumer credit’s non-revolving component---its largest component (not credit cards). December numbers, reported on February 7^th, show a gain of $19.3B. Analysts expected an increase of only $7.0B. Of the $19.3B gain, some$16.6B came from non-revolving credit. That is, term loans. This leaves only $2.8B for revolving credit. Cars are bought on term loans and not revolving credit.

November consumer credit gains revealed an increase of $20.4B, with analysts expecting only $7.6B. Of this November’s increase, non-revolving credit grew by $14.8B, with revolving increasing by $5.6B. November’s increases were also handed to auto sales. Auto sales have been the lead on broad retail sales, while staples and discretionary have faltered. That is, people are buying cars and home improvements.

One can come to this conclusion of what is driving the economy based on the Retail Sales table in the below article. After all, Consumer credit grew at only $6.9B in September and by $7.7B in October.  

We try at this blog to know where growth is slowing, or beginning on the supply chain continuum. Currently, the consumer is showing exceptional strength in buying cars and home improvement products. At the same time, other sectors are also benefiting from the strength in autos. Such being mining, machinery and industrial manufacturing. In fact, the evidence shows that where global weakness otherwise exists, autos have had a ringing effect throughout associated sectors. Wholesale results demonstrate the point.

The Census Bureau’s wholesale trade numbers came out February 9th showing December results. This report monitors wholesale inventories which approximate 26% of total business inventories. Retail inventories occupy 1/3 of the total, and manufacturing inventories account for 41% of the balance. According to the wholesale trade report, sales of merchant wholesalers were up 1.3% for December at $413.1B. Wholesale inventories were up 1.0% at $473.2B. And, the inventory/sales ratio is stable at an efficient 1.15. Durable goods lead the way with an increase of 2.4% for December versus November and an increase of 13.3% y/y. Nondurable goods showed a December .4% rate with a yearly gain of 10.7%.

Looking at the components of wholesale trade reveals the effects autos have been having. Automobile sales grew 3.9% in December compared with November and are up 25% versus a year ago. These gains have helped metals wholesalers with the metals industry showing a 6.5% December sales gain with a 21.7% increase over last year. Machinery wholesalers are also profiting from a drive in autos. Machinery sales were up 5.2% in December and up 22.3% compared with last year.

Industrial production results were reported on February 15th. They also show the building pattern of the influence of autos strengthening Q4 economic indicators. January industrial production came in flat at 0.0%. However, motor vehicle output climbed 6.8%, after growing 3.8% in December. Non-durable goods production fell-0.2%, after growing 1.3% in December.

Sustainability of the Auto's Influence

Based on the evidence, it appears that auto sales have been providing a major boost to the economy. Given the nature of auto production, this boost has ramified through various other sectors such as metals and overall manufacturing. Thereby cause for suspicion exists.

Motor vehicles remain a single economic component. This raises questions over the sustainability of economic progress powered by the automobile. Preferably, one would like to see balanced growth spread among various sectors. I would also like to say that the growth in autos and consumer credit bodes well for retail in general by indicating a revived consumer. However, looking at other aspects of retail sales, together with the business operations of companies like Walmart over the last couple of  quarters….(albeit, Walmart did well in Q4).

Looking at the weekly chart to the left, the Dow Jones U.S. Automobile index is compared with the Dow Jones U.S. General Retailer’s index. As one can see, from March of 2009 through December of 2010, the auto index has outperformed the general retail index.



However, starting in early 2011, general retail started to beat autos substantially. Ironically, despite the contribution auto sales have apparently made to economic indicators, the auto index’s performance in Q4 and into Q1 has been biased up, but very choppy. This could reflect hesitancy on the part of investors regarding the sustainability of high auto production. In fact, given the almost flat performance since October of autos against general retail given stock pricing, it appears that investors simply aren’t convinced of retail’s strength in general.

Speculation exists that the Census Bureau’s flat retail numbers over Q4 could very well result in a downward revision in Q4 GDP. Hopefully the surge in auto production and sales is the start of consumer engagement and simply not a flash.

CARS TOW RETAIL

Retail Sales Show Strength in Autos, and Autos

Explain Economic Progress.

Ron McWilliams

Last week, the U.S. Census Bureau released a couple of reports that can aid in discerning the nature of this economy, and potentially where it might go. The first release was the Advance Monthly Sales for Retail and Food Services. The Bureau then released its Monthly Wholesale Trade: Sales and Inventories.

Based on the retail sales report, from October through December, motor vehicle sales lead the index by closing out the year with a m/m increase of 2.5% and a y/y increase of 10%. Grocery and general merchandise stores saw weak growth, and even negative numbers, while gas stations ended 2011 strong but behind autos.

U.S. Census Bureau Retail Sales (October 2011-January 2012)

	January		December		November		October
	m/m	y/y	m/m	y/y	m/m	y/y	m/m	y/y
Total	0.4	5.8	0	6.2	0.4	8.3	0.6	7.5
Mot vehc	-1.1	7.3	2.5	10	0.9	8.3	0.8	7.5
Build mat	0.2	8.1	2	6	-0.1	5	1.4	5.3
Grocery	1.3	4.3	-0.6	4.2	-0.2	4.7	0.6	5.9
Gen. Merc	2	5.8	-0.7	3	0	2.7	-0.1	4.6
Gas	1.4	7.4	-2.6	7.4	0.9	14.6	-0.4	15.6



Mot vehc = Motor Vehicles  Build Mat = Building Materials  Gen. Merc = General Merchandise  Gas = GasStations

I’ve noted in the past that the ICSC-Goldman Same Store Sales weekly index showed signs of anemia through January. Notably, the index showed a couple of weeks with significant declines (of up to -5.4% for the week of 1/7), met only with a couple of weeks of minor gains (in the .1% area). For the start of February, the index registered a gain of 1.8%, but then showed a decline of -2.0% a week later. The most recent week of 2/18 shows a good 3.0% increase, with a y/y change of 3.2%. This y/y number is down from December’s close of 3.9%.

Where the ICSC-Goldman index doesn’t include autos, the Bureau’s retail index does. The Bureau’s retail index shows weakness in consumer staples and discretionary areas, but considerable strength in autos, building material suppliers and gas stations. Autos have essentially driven strength in retail while consumer staples and discretionary seem to be lagging.

COAL IS NOT DEAD: Fight to Win

jlk

COAL IS NOT DEAD. LONG LIVE THE KING. THE WORLD NEEDS POWER, AND WE HAVE IT.  WITH ASSOCIATED JOBS…and retail growth.

Ron McWilliams

On January 24, Peabody Energy (BTU) announced its quarterly results. At the time of its announcement, shares dropped 4.8%, bringing the stock down 8.4% for the past three months.  Though the firm reported a 5.9% increase in profits and record revenues, analysts cited growing environmental scrutiny, rising costs and competition from natural gas.

Peabody, as the largest U.S. coal producer, is poised to compete globally, through demand’s  necessities of logistics. Natural gas has its potential to be realized domestically and globally. But coal’s future home is global, and has a comparative advantage in competing for that home better than gas.

 Looking at the chart for the Dow Jones U.S. Coal Index, coal stocks have taken a beating, and have not realized the recovery in price experienced by the broader market. Where the S&P 500 experienced a downward trend from spring of 2011 running into the fall, it has recovered much of its losses and is running laterally against resistance.

Just as the S&P 500 is meeting resistance, it appears that the coal index is running laterally at support.  The chart for Peabody is essentially identical to the coal index’s chart. 

Perhaps the reason for the slide of coal shares starts with a general view, reflected in a comment made by Deutshe Bank’s Keven Parker, global head of asset management. On January 2, 2011, in an article by the Washington Post, Parker commented that coal fired electrical generation faces severe headwinds. He said that “Banks won’t finance them. Insurance companies won’t insure them. The EPA is coming after them…And the economics to make coal clean don’t work.” See, Washington Post, January 2, 2011, http://www.washingtonpost.com/wp-dyn/content/article/2010/12/31/AR2010123104110.html.

This followed action against coal by the EPA in March, 2011. Some 11 years prior, the EPA issued a determination that mercury emissions needed to be curtailed and coal was identified as a suspect. The EPA didn’t take action, which resulted in a lawsuit in 2008 by environmental groups. In 2009, a settlement was reached and on March 18, 2011, the EPA proposed new rules limiting various emissions from coal-fired power plants.

CONSEQUENCES OF REGULATORY CHANGE

The projected up shot of this is that scrubbers will be needed. If the more expensive devises are necessary, closure of coal-fired facilities could cut U.S. domestic coal demand in the eastern U.S. by 76 million tons through 2015. The cut in the west could be 50 million tons. This results in a total drop in U.S. demand of 126 million tons annually. Compare this with current demand. In the period through Q3, 2011, the U.S. consumed 776 million tons according to the Energy Information Administration.

If a cheaper form of scrubber suffices, the result will amount to a 31 million ton reduction in the east, not necessarily the west. The reason is that western coal, from the Powder River Basin, tends to burn cleaner.

Going from the EPA to Australia, we know that carbon emission taxation must figure into the above charts. Despite PM Kevin Rudd losing his position due to the carbon debate, the new PM,  Julia Gillard,  proposed a renewed effort for carbon taxation in April, 2011. Her proposal suggested a taxation rate of only $23/ton. The initiative passed parliament, and then became law in November of 2011 by passage of the Senate.

Carbon taxation passed in a major natural resource supplier to the world. In Australia, the initiative produced fear among Australian people. They worried about their power bills, while industry worried about reduced margins, and developing LNG companies worried about added costs.

Still the proposition passed. U.S. based ETF iShares MSCI Australia Index Fund (EWA) shows the performance of Australian stocks. Its’ decline seems to mirror U.S. coal stocks, especially in terms of the early timing of the stock down turn. Certainly, this Australian fund shows recovery like the S&P 500, and thereby diverges from U.S. Coal stocks.

Perhaps the various propositions against coal energy made the globe feel even more insecure. After all, Europe’s financial issues  are serious, add to it already shrinking GDP propositions, with fiscal austerity…..why not break the spine of the established and reliable infrastructure and supply of coal energy.

COAL IS NOT DEAD: Run for First Place

COAL IS KING, LNG SEARCHES FOR A PATH

Certainly the globe has a readily available and established alternative to coal at hand, being natural gas. So goes the convention…I suppose.  But how does one distribute natural gas among long transportation lines. Apparently, as goes the evident logic, a firm can move gas through the long routes that coal has known for several decades. But natural gas has to be liquefied. Australia saw this market opportunity and pursued it.  Within 18 months ending in Q4 2011, Australia approved some 6 new liquefied natural gas (LNG) plants.  The cost is at $180 billion and prospects don’t look good.

 Overall, these high hoped projects were at the start, very high priced, and required either new infrastructure as with Australia, or very expensive reversal of existing infrastructure, as with the U.S. In Australia, when projects do come in, they are late and over their billion dollar budgets.

 For instance,  Woodside’s Pluto LNG project at $14.9 Billion (Australian dollars, or some say $40B U.S. dollars,) is projected to come on line in March, 2012. But it has so far proven to be a year delayed and $1B over budget. In fact, it appears that Woodside is looking to sell 23% of its 46% stake in the project, for a projected price of $1.5B U.S. dollars.

 Fitch recently downgraded the Australian LNG projects to negative due to them going over schedule, over budget, while also confronting high labor costs and high interest rates compared to competitors.

A major competitor is here in the U.S., and is Chenier Energy (LNG). Gas must be processed into a liquid for transport overseas. Chenier has developed many long term contracts with foreign concerns, but Chenier has a $3B debt bill.

Still, Chenier has its contracts with their 4 foundational partners. All suggest 20 year agreements, for some 16 million tons per annum (mtpa) of its Sabine Pass, Louisiana’s plant, which has a total capacity of 18 mtpa.

While Chenier has sold much of their anticipated capacity, they do own debt.  Just in December Chenier sold some $300M in equity, apparently in anticipation of a debt payment of $500M in May of 2013, while a $1.7B payment is scheduled for 2016. In 2016, Chenier expects to make their first shipments on their contracts.

Chenier’s contracts so far are with GAIL, India Ltd.; Gas Natural SDG, of Spain; BG Group Plc. of England; and most recently, Korean Gas. While Chenier is developing these contracts readily, they also plan an LNG plant in Corpus Christi, Texas.

LNG CAN LEAD, BUT COAL IS LEADING THE WORLD, AND SUPPLIES GLOBAL ENERGY DEMAND

Where hope resides for LNG to meet the globes energy needs, coal remains the current supplier of such needs. While LNG requires so much needed and expensive new infrastructure, coal has historical infrastructure, and remains cheap.  Essentially, while we wait for alternatives to coal, coal is historical and its global demand reflects the case. The International Energy Administration estimates that global coal demand will increase by 600,000 tons per day over the next five years. Emerging economies have been increasing electrical generation at untold rates.

Peabody spoke of coal demand under the pressures of the Sarbanes Oxley Act. In 2010, Peabody predicted that seaborn coal demand would increase 6 to 8% in 2011, and perhaps exceed 1B tons. True….In their Q4, 2011 report, they informed that seaborn coal rose by 6% and exceeded 1 billion tons. This was led by thermal demand with 81 gigawatts of new coal generated power plants being brought on line in 2011. This world demand in coal also reflected a 32% increase in global metallurgical coal.

Coal appears to stay very much in global demand into 2012. Peabody sees seaborn coal demand rising by 100M to 120M tons in 2012. On top of a billion tons, this could mean a strong rate of increase over 2011 results. The usual suspects account for this increase. That being China, Japan, India and Germany.  Also, in 2012, 91 gigawatts of coal electricity are expected to be put onto the grid at a demand of an expected 300M additional tons of coal/ year.

China’s GDP grew by 10% in 2010, with net coal imports of 147M tons over 2009, a 41% increase. Peabody said in this last quarterly report that in 2011, China’s coal fired power generation rose by 14% to roughly 182M tons of imports. Still, in 2011, China’s GDP grew by only 8.9%. The weakest rate of growth since Q2, 2009.

This ultimately bespeaks of economic growth. In periods of major growth, so much capacity comes on line. In the end it actually produces, and must be fueled to maintain production. At China’s growth rate, and given their coal consumption indicators, China, as with a similar Asia, including India, all such countries are poised to consume additional power, for perhaps sometime.

Peabody’s financial results show the magnitude of price in a growing and demanding market.  The table below shows Peabody’s essential financials, over the course of time.  This table shows a building on pricing and a recapture of volume.Bottom of Form

	Revenue	EBITDA	Net Income    Tons Sold		Cash	LT Debt	Total Assets	Total Net Assets
2011	7.97 bln	2.13 bln	957.8 mln	250.6 mln	799.1 mln	6.6 bln	16.733 bln			11.22 bln
2010	6.74 bln	1.82 bln	774.0 mln	244.2 mln	1.3 bln	2.7 bln	11.363 bln			6.7 bln
2009	6.01 bln	1.29 bln	448.2 mln	243.6 mln	989.0 mln	2.74 bln	9.995 bln			6.2 bln
2008	6.60 bln	1.85 bln	952.9 mln	256 mln	449.7 mln	3.14 bln	9.822 bln			6.2 bln

While Peabody shows a strengthening of 

While Peabody shows a strenthening of its balance sheet, where are companies committing themselves in this market driven by the most competitive source of energy? Peabody seems to know, look above.  2011 results in terms of debt and assets certainly reflect Peabody’s major $5.5B acquisition of Australia’s Macarthur Coal.