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Arch Resources (ARCH) is a coal producer trading at less than 4 times earnings with a strong balance sheet, good earnings visibility, and a potential for significant re-rating over the next 12 months. The company has taken advantage of the spike in energy prices following Russia’s invasion of Ukraine to effectively eliminate its debt and to initiate a shareholder friendly capital return program. Management has committed to returning 100% of discretionary cash flow to shareholders.
There are two excellent VIC write-ups on ARCH by manny in 2020 at $42, and by rosie918 in 2021 at $95. Note that in 2022, ARCH paid over $25 per share in dividends.
ARCH’s price has declined 25% since the beginning of March, in-line with the 25% decline in the spot price of met coal. ARCH gets over 80% of its segment level EBITDA from met coal which is a key input in steel production. Met coal has has felt pressure from a slower than expected reopening in China and fears that a global recession will lead to lower steel demand. Thermal coal prices have been under pressure from lower natural gas prices, and lower consumption due to a warmer than average winter. Many utilities are able to substitute natural gas for coal. Both types of coal saw record high prices in 2022.
ARCH reported earnings of $10.02 per share in the first quarter, and should earn over $30 this year. (Street estimates are $34.50 for 2023 and $25.30 for 2024.) Based on the company’s capital return policy, investors can expect over $25 per share of dividends and buybacks in 2023. (Under the capital return program, ARCH intends to return 100% of discretionary cash flow to shareholders, with 50% in the form of dividends anfd the remaining 50% via share repurchases. Arch increased working capital in Q1 by $170 million, which reduced discretionary cash flow by roughly $9 per share. Some of the working capital build should reverse in future quarters.)
Coal companies are a cyclical, commodity driven business that were easy to hate even before the rise of ESG investing. In the United States and Europe, the two main markets for coal – power generation and steel making have been transitioning away from coal for many years. Coal fired power plants in the U.S. and Europe have been closing in response to the “green” movement. Steel production in the U.S. has been moving away from basic oxygen furnaces (BOF) which need coal to produce coke, to electric arc furnaces (EAF). Coal demand in North America and Europe has been in secular decline for many years.
The rest of the world is a different story. China and India have been adding coal fired power plants at a rapid pace. While only 30% of the steel produced in North America comes from BOFs, over 70% of global steel is produced in BOFs. Wood Mackenzie projects that Southeast Asia will increase its steel production by over 70% between 2021 and 2030. 85% of the increase will be from BOFs.
While there are many grades of coal, coal is typically classified as thermal (used in power generation) or metallurgical or “met” which is used in blast furnaces to make steel. In 2010, ARCH got just 25% of EBITDA from met and 75% from thermal. By 2022, that percentage had reversed. Over 80% of EBITDA came from met coal, and less than 20% came from thermal. ARCH produces met coal from its mines in West Virginia. This met coal sells at a premium price, currently around $200 per ton compared to the low quality thermal coal that Arch produces from its facilities in the Powder River Basin (PRB) of Wyoming. The PRB coal sells for less than $20 per ton.
Management has clearly stated that the company’s thermal coal operations in the Powder River Basin are in run-off, and will continue to operate only as long as they remain profitable. Since the end of 2016, the thermal segment has generated over $1.3 billion of EBITDA on $144 million of capital expenditures. In 2022, the thermal segment contributed $250 million of adjusted EDITDA. Thermal production for 2023 is sold out. Margins are expected to decline in 2023 to $2.45 per ton, largely reflecting operational issues at the West Elk mine in Colorado. (Coal produced at West Elk is much higher quality and more profitable than the PRB coal produced in Wyoming.)
Arch came out of bankruptcy in 2006, and was forced to issue highly dilutive convertible bonds in 2020. As a result, management has taken a fairly conservative financial posture. The company paid off most of its debt in 2022. The remaining $150 million of debt includes $98 million of tax exempt bonds. The company converted the remaining convertible debt in the first quarter of 2023. The balance sheet currently has $220 million of cash and short term investments. ARCH has also pre-funded the reclamation costs for its PRB operations and has materially reduced its pension obligations over the past several years.
The key question for a cyclical commodity business such as ARCH is the price of its product. ARCH’s met coal product is High-vol-A, which is essential for blending with lower grades of coal when making coke, which in turn is essential for making steel in blast furnaces. Per the company’s investor presentation, met coal pricing has averaged $165 per ton over the last 20 years, and $180 per ton since 2010.
Why does this opportunity exist?
Met coal prices ran up earlier this year on expectations of increased Chinese steel production, but have been declining since March based on reduced expectations. While Q1 earnings were in-line with estimates, the $2.45 per share dividend was less than would have been expected given $10 of earnings and a 50/50 split between buyback and dividends.under the company’s capital return policy. The primary cause of the shortfall in free cash flow was a $170 million build in working capital. Investors may also have been disappointed that ARCH chose to focus its share repurchase efforts on retiring deep in the money convertible bonds.
The risks here are fairly obvious, and I believe are reflected in the price. Coal prices are volatile and very sensitive to changes in macroeconomic conditions. Prices for both thermal and met coal increased dramatically following the Russian invasion of Ukraine and have declined sharply over the past two months. In a commodity market, its hard to predict how long or how far prices will fall, there are several mitigating factors with ARCH:
1) Arch has sold all of its thermal coal production for 2023, with 69.3 million tons priced at $16.93. The company anticipates thermal margins of around $2.50 per ton, which should cover more than half of the companies fixed costs.
2) Arch has negotiated commitments for 85% of its anticipated 2023 met coal volume with 3.6 million tons priced at an average of around $200 per ton. (The remaining 5.7 million tons will be priced based on market conditions when it is shipped.) ARCH expects its cash cost of met coal to be between $79 and $89 per ton. With spot prices around $200, spot would have to fall another 50% before ARCH lost money on met coal.
3) ARCH is a low cost producer (bottom quartile to second quartile) of very high quality met coal. In the event prices go lower for longer, other producers are likely to be forced to curtail production before ARCH.
4) Arch is in a positive cash position and therefore is unlikely to be forced into uneconomic behavior to satisfy creditors. Management is committed to the capital return policy, and is unlikely to make a major acquisition.
An inflection in the price of coal. Many European steel makers shut down in the face of last year’s high energy prices. A reopening of European still mills combined with reopening in China, which is the world’s largest producer of steel and has been the largest consumer of met coal should help met coal prices. Natural gas prices have fallen sharply due to the warm winter, which in turn has pressured thermal coal prices. A hot summer or cold winter could result in a spike in both natural gas and thermal coal prices.
ARCH’s dividend payout of $2.45 in Q1 is less than 25% of EPS, due to working capital increases. Assuming working capital stabilizes, ARCH should be able to pay higher dividends even with somewhat lower EPS.
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