Forget Alternative Energy Stocks, Buy This Instead

In the world of investing, no news can often be good news.

A wide range of energy sources have been hit by bad news in recent months. Yet one key energy source has been out of the spotlight, but is likely to actually benefit from the unfolding events of 2011. I'm talking about coal, which now stands to play a greater role in global energy generation than many had previously thought.

Not like tobacco
During the past decade, many investors have viewed coal stocks in the same light as tobacco stocks. Each industry appeared headed toward the sunset due to changing values regarding health and the environment. And with growth prospects dimming, shares of many stocks in these two industries were stuck with very low price-to-earnings (P/E) ratios and EBITDA (earnings before interest, taxes,depreciation  and amortization) multiples. Indeed, almost all of the key coal players are also very cheap in relation to free cash flow (FCF). Shares of Arch Coal (NYSE: ACI) and Alpha Natural Resources (NYSE: ANR) sport eye-popping 18% (FCF) yields, based on consensus 2012 projections.

Yet coal now looks to shake off the perception that is in decline, if only because other energy sources are running into their own troubles. For example: 
 

• The events in Japan have surely jolted the prospects for nuclear power plants. Many countries had plans to meet their rising energy needs through new nuclear plants. Those plans are now on hold and, if some of these countries decide to diminish their focus on nuclear, then coal stands to benefit.
   
• The Obama administration had aggressive plans to develop solar- and wind-power plants in the United States, but a more hostile Congress more closely aligned with King Coal and Big Oil, coupled with the fact that solar and wind can't really make a sizable dent in our energy needs means that efforts to de-emphasize coal are waning.
   
• The U.S. trade deficit is one of the key factors behind bipartisan economic concerns about our competitive positioning. As oil surges toward the $110 per barrel mark, pressures on the trade deficit only increase. As the United States is the "Saudi Arabia of coal," our nation's trade deficits could be meaningfully curtailed if we boost our use of coal.

Right now, none of these factors have come to roost. These recent developments will take time to play out. But the view for 2013 or 2015 just got brighter for coal.

What about natural gas?
In recent years, natural gas has stolen the spotlight, as it's relatively clean-burning and quite abundant. That's why all new power plants currently under construction will focus on gas. But all is not rosy with natural gas either. A recent study has just concluded that natural gas' benign environmental profile has been overstated. The methane released during gas production now appears to be affecting the climate in more insidious ways than carbon dioxide. (I should note that I am in the camp that sees rising atmospheric carbon as the result of human activities, and I also believe we should be more aggressively addressing the issue. But as an investor, I need to rationally assess coal in the view of the current political and regulatory climate.)

If concerns about natural gas' impact continue to build, coal-fired plants may get a new life. Moreover, if natural gas is increasingly seen as a viable transportation source in the United States, then rising demand could push prices up, benefiting coal prices in tandem.

That scenario is still in question. What's not in question is coal's rising demand from our trading partners. Exports of coal are starting to build, a process which will only be aided by the newly-weakened dollar. Plans are afoot to build a string of coal export facilities in the Pacific Northwest, though it will be several years before the first one comes online. Exports should be a key theme on upcoming industry conference calls. "European prices will now attract exports, and we expect significant discussion of port capacity and export potential," note analysts at UBS.

Analysts also anticipate a continuation of the recent industry consoliadtion that has seen companies likeWalter Energy's (NYSE: WLT) 2011 purchase of Western Coal and Alpha Natural Resources' 2011acquisition of Massey Energy. International Coal Group (NYSE: ICO) is widely rumored to be the next company to be acquired.

The best ways for investors to play
Wall Street analysts each have their own favorite names in the coal sector. Here's a sampling:

 Citigroup recommends Peabody Energy (NYSE: BTU), thanks to a very high degree of exposure to Australia and Asian markets. The $74 price target is 15% above current levels.

•    Goldman Sachs is a big fan of Walter Energy, noting that the Western Coal deal should bring strong growth prospects. They see shares rising from $130 to $165, or roughly 25%.

•    Brean Murray favors Alpha  Natural Resources, noting that its Massey acquisition should yield a   lot more synergies than most analysts are currently forecasting, perhaps upwards of $200 million. They see shares rising from a current $54 to $81 -- a 50% move.

 
Action to Take --> Coal stocks remain off the radar for most growth investors. But industry consolidation, newly-emerging problems for other energy sources, and a weaker dollar that is fueling exports can give this industry a much longer shelf life than many had assumed. As an alternative to the stocks I mention above, investors should also consider the Market Vectors Coal ETF (NYSE: KOL), which holds a basket of coal stocks and offers broad exposure to the sector.