Walter Energy Will Warm Your Portfolio

Stock in Alabama-based mettalurgical coal maker, Walter Energy (NYSE: WLT), popped 21% Wednesday. Is it too late to energize your portfolio by buying its stock?

Why the pop? An article in the Times speculated that Walter could be taken over by Anglo American, for $7.5 billion to be exact -- and that's $2.8 billion more than Walter's market value before the article came out. Nevertheless, after the stock's 21% rise, it still stands $2.1 billion below that rumored offer price.

This suggests that investors are far from certain that this rumor will turn into a deal. London-based investment bank Liberum Capital suggested a reason why Anglo won't make an offer for Walter -- Anglo would want to export its coal by sea and that's not feasible given the location of Walter's coal reserves, according to Bloomberg.

Should you invest in Walter's stock? Even if the deal does not go through, there are two reasons to consider investing:

• Low valuation. Walter's price-to-earnings-to-growth ratio of 0.66 (where a PEG of 1.0 is considered fairly priced) means its stock price is cheap. It currently has a P/E of 12.1, and its earnings per share are expected to grow 18.3% to $12.29 in 2012.
• Rising sales and profits and strengthening balance sheet. Walter's sales have decreased while its profits rose. Its revenue fell at a 5.3% annual rate from $1.3 billion (2006) to $1.6 billion (2010) while its net income has increased at a 25.7% rate from $156 million (2006) to $389 million (2010) — yielding a wide 24% net profit margin. Its debt has plunged while its cash has risen. Specifically, its long term debt fallen at a 47.2% annual rate from $2 billion (2006) to $155 million (2010) and its cash rose at a 23.2% annual rate from $127 million (2006) to $293 billion (2010).

Two reasons against:

• Poor earnings reports. Walter has been able beat analysts' expectations only once in its past five earnings reports.
• Under-earning its cost of capital. Walter is earning less than its cost of capital – and it’s getting worse. How so? It’s producing negative EVA Momentum, which measures the change in “economic value added” (essentially, after-tax operating profit after deducting capital costs) divided by sales. In the first half of 2011, Walter's EVA momentum was a whopping -39%, based on first six months’ annualized 2010 revenue of $1.4 billion, and EVA that plunged slightly from first six months’ 2010 annualized $154 million to first six months’ 2011 annualized -$404 million, using a 12% weighted average cost of capital. This was due largely to a huge increase in Walter's assets from $1.7 billion to $7.2 billion in the wake of a big acquisition.

The reason companies are interested in Walter's met coal reserves is that floods in Australia have cut off part of the global supply -- thus raising prices. Walter's financial statements have become uglier as a result of its 2011 merger with Western Coal and it does not currently have a CEO.

But at its current low valuation, Walter stock is cheap. If it does become the target of a bidding war, the price will likely rise. If not, its earnings should justify a higher valuation.