<This post is published at Stockbit.com, where I regularly interact with other investors under the name ‘coolspot’>

Some people asked me about entering $PTBA. I used to have a very positive view of this company, and i still have my notebook, where I wrote that I will seriously consider $PTBA at Rp.7,000 and $ITMG at Rp.18,000. However, my recent study has caused me to change my rosy view on the whole sector.

The key of investing is to value the company based on normalized earning power. That means, we have to buy the company based on the long term earning power. With FMCG and manufacturing companies, these are easy once we understand the business characteristics and their earning power. However, cyclical companies will need to be analyzed carefully. Through my short investing experience, I realize that investing in commodity companies is harder because you are dealing with a much longer time horizon. But on the other sense, it is simpler because you are betting on the commodity price in the long run. It is true that it is hard to calculate fair value of commodity, but usually people have general sense of whether a commodity class is expensive or cheap.

Let’s take coal for example then. A quick look at the first chart might give and impression that coal will recover soon. I have met many analysts who keep saying that the coal price will recover, as it is currently much cheaper than it has been normally. Those arguments appeal to the same principle that I will keep referring in this post: the reversion to the mean. COAL

I won’t discuss the concept of reversion of mean generally here, as it has been covered by many resources in the internet. However, I want to apply the concept of reversion of mean in this case, regarding coal price. What those analysts I referred before missed is not the concept, in fact they are applying the same framework in arguing that the coal price will return. What they failed to do is to use proper time frame in understanding the whole picture. As seen in the second chart I will post separately, you will not say that the price will soon recover. In contrary, to me, it is much likely the price will drop further, as in the normalized environment, coal price should be hovering at $40. Of course this is a quick observation, as one needs to take into account the value of money and inflation. However, the point is, you need to look into a bigger picture in order to apply the reversion to the mean.
If we take a simple assumption that coal price is normally priced at $40 ( or even $50, or whatever you think the number is), then we need to look at coal company’s financial at that time. This means we need to look at $PTBA before 2004, where the coal price is still considered ‘normal’. I only have data from 2001-2004. Here are some observations of 2001-2004 vs 2005-2014 vs current :
1. Av Net Margin: 11% vs 20% vs 15%
2. Av Gross Margin: 34% vs 40% vs 30%
3. Av Dividend/FCF Ratio: 58% vs 67% vs 80%
4. Av Dividend/Operating CF Ratio: 37% vs 49% vs 50%

If the phenomena of reversion is true, then we would expect that $PTBA business characteristics will deteriorate further. This means that the P/E ratio that most investors like cannot be the guideline to cheapness. Earning per share is at around Rp.900, FCF/share is at Rp.575 and 2014 dividend is at Rp.462. Looking at point 3 and 4, we can probably conclude that the recent dividend policy is straining the company’s finances. I have a minimal understanding of what the company is spending its money on, but definitely they cannot invest and give out dividend ratio with this kind of number (which explains the recent needs of financing). They need to either reduce their investment or reduce the dividend paid, or both. It is interesting mentioning p/e in the context of cyclical company. If this is true, then we can expect to see companies that are high-risk investment when they have low P/E, and companies that are low-risk investment when they have high P/E.

The question now is how far it will deteriorate more. On this question, i am unable to render a judgment worth posting. The big black box for me is whether the drop of coal price will go further than the ‘normal’ before it snaps back to normal. Usually this kind of situation will force companies to go out of business (especially those with high leverage), but I doubt $PTBA will die in the process. I cannot say the same with $ITMG (since they have low reserve, althought their capital allocation is quite decent, which make it bearable). Company like $HRUM will definitely go out from my checklist, since they have both extremely low reserve and bad shareholder protection.

Disclosure: $PTBA consists <5% of my portfolio