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Arch Coal, Inc. (NYSE:ACI)

Q4 2012 Earnings Conference Call

February 5, 2013 11:00 ET

Executives

Jennifer Beatty - Vice President, Investor Relations

John Eaves - President and Chief Executive Officer

Paul Lang - Executive Vice President and Chief Operating Officer

John Drexler - Senior Vice President and Chief Financial Officer

Analysts

Brandon Blossman - Tudor Pickering Holt & Company

Mitesh Thakkar – FBR

Shneur Gershuni - UBS

Brian Yu - Citi

Jim Rollyson - Raymond James

Lucas Pipes – Brean Capital

John Bridges - JPMorgan

Kuni Chen - CRT Capital Group

David Gagliano - Barclays

David Martin - Deutsche Bank

Andre Benjamin - Goldman Sachs

Chris Haberlin - Davenport & Company

Meredith Bandy - BMO Capital Markets

Evan Kurtz - Morgan Stanley

Lance Ettus - Tuohy Brothers

Dave Katz - JPMorgan

Operator

Good day, everyone and welcome to this Arch Coal Incorporated Fourth Quarter 2012 Earnings Release Conference Call. Today’s call is being recorded. At this time, I would like to turn the call over to Ms. Jennifer Beatty, Vice President of Investor Relations. Please go ahead.

Jennifer Beatty

Good morning from St. Louis. Thanks for joining us today. Before we begin, let me remind you that certain statements made during this call, including statements relating to our expected future business and financial performance may be considered forward-looking statements, according to the Private Securities Litigation Reform Act. Forward-looking statements by their nature address matters that are to different degrees uncertain.

These uncertainties, which are described in more detail in the annual and quarterly reports that we file with the Securities and Exchange Commission may cause our actual future results to be materially different than those expressed in our forward-looking statements. We do not undertake to update our forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required by law. I would also like to remind you that you can find a reconciliation of the non-GAAP financial measures that we plan to discuss this morning at the end of our press release, a copy of which we have posted in the Investor section of our website at archcoal.com.

On the call this morning we have John Eaves, Arch’s President and CEO; Paul Lang, Arch’s Executive Vice President and COO; and John Drexler, our Senior Vice President and CFO. John, Paul and John will begin the call with some brief formal remarks, and thereafter, we will be happy to take your questions. John?

John Eaves

Good morning everyone. Today, I’d like to spend a few moments highlighting milestones that Arch achieved in 2012 despite the market downturn we have been facing. Last year, Arch generated $688 million in EBITDA. As 2012 unfold, it became clear that we were going to see a contraction versus 2011 thus we began cutting our capital spending significantly. As a result, we ended the year in only slightly negative territory for free cash flow even if we are moving ahead on the Leer mine development.

We also successfully bolstered our cash and liquidity resources in 2012 to write out the storm and to emerge as even stronger players when market recovers. John Drexler will highlight those financing initiatives in his prepared remarks. Of course, one of the most important milestones that Arch achieved in 2012 was another strong performance in safety and environmental stewardship. For the seventh year in a row, we ranked first among our major diversified coal peer for our safety record and garnered 24 external awards for outstanding achievement in our core values. In addition, five of our complexes completed 2012 without a single safety incident on environmental violation. What’s more, we advanced the build out of our low-cost high-quality metallurgical coal platform in Appalachia and held the line on cost in other regions. We believe the addition of Leer will further enhance our competitive position within the industry and will serve us well in the coming market up-cycle.

Lastly, we are building momentum in the seaborne coal markets. Our exports hit a record 13.6 million tons in 2012, that’s a fourfold increase since 2009. We sent met and thermal coal to Europe and South America and to new places in the Middle East and Asia. Our top destination for exports in 2012 was South Korea. Our increased participation in the seaborne coal trade reflects the growing worldwide consumption of coal as well as the strengthening of Arch’s position in the competitive landscape. With our low-cost operations and growing port access, we are well-positioned to benefit from the changing dynamics in the seaborne market. We see exports as a long-term development opportunity as a way to diversify our customer base and as a way to unlock further value for our reserves. Growth overseas will also help offset our expectation for a relatively flat coal use here at home.

While these international netback prices don’t always offer a substantial return today, we believe prices will rebound as market fundamentals improve. In fact, we continue to field enquires about shipping our coal overseas and are building new business in this rapidly growing arena. That’s why we think U.S. exports will continue at elevated levels and certainly exceed 100 million tons in 2013 whether we approach the record levels achieved in 2012 remains to be seen and we’ll ultimately dependent on the evolution of coal markets throughout the year.

Turning now to discussion of coal market fundamentals, 2012 could well prove to be at the trough. Global benchmark metallurgical prices declined 50% since their peak a year and a half ago while U.S. thermal coal consumption declined to levels we haven’t seen since the mid-90s. Needed economic activity, unseasonably warm weather and low natural gas prices all converse the dampen coal demand, causing coal stockpiles to grow to near record levels by May of last year. However we’re encouraged to see stabilization in the back half of 2012 based upon these dynamics we believe that we’re moving up the bottom as we head into 2013. Net coal markets are beginning to show some signs of life, inquiries that were non-existent six months ago are emerging. Utilization of steel mills is improving and China’s economy seems to be picking up.

On the supply side production cuts and constraints are beginning to take hold and should start to have a greater impact as the year progresses. Thermal coal markets appear poised for better days as well while winter weather has not been very cold, it has been better than last year. So far this season heating degree days are up 5%, we estimate coal stockpiles into 2012 in a 182 million tons well below the peak from last May but about 10 million tons higher than they were at the end of 2011. Thus we expect to exit this winter season with coal inventories above normal but are forecasting draw downs in January and February.

That’s still a lot better than the 30 million ton build we had from last winter. In addition prices for natural gas are high enough to give western coals an economic advantage on the dispatch curve. At the same time we believe that natural gas prices were unsustainably low today as companies cannot make sufficient returns to justify continued investment as evidenced by the rig count decline.

Overtime we expect market forces to move gas prices higher which further boaster coals competitiveness in the power sector. We also believe that coal that U.S. generators enter 2013 with conservative burn forecast and could potentially fund themselves needing coal as the year progresses. This development should initially help to reduce the stockpile overhang that could eventually lead to more active and dynamic market in the second half of the year and into 2014. One area that’s definitely helping to turn coal markets around the supply shut-ends.

The higher estimates, net coal supply cuts, totaled nearly 35 million metric tons annualized. On the thermal side the cuts are even larger. According to recent industry data the U.S. coal industry reduced production by nearly 80 million tons in 2012. PRB led the way with 38 million tons of volume reductions and Central App was close behind with a decline of 36 million tons.

In fact, Central App, produced just a 148 million tons in 2012 but even more striking is fourth quarter run rate is below a 130 million tons annualized. For 2013, we expect global supply to fall further as high price contracts roll-up, trader inventories liquidate and the higher cost supply exists the market altogether. These trends should help rebalance supply and demand as the year progresses, setting the backdrop for a reason. In closing I want to reiterate, whereas it's never found at the bottom of the market cycle we as a company had been here before and we know what it takes to manage through the trouble so we’re ready to capitalize on the market rebound.

Underlying fundamentals and begin to improve first and our financial results will follow. In the meantime we’ll continue executing the strategy, it has allowed us to mitigate the headwinds that we have been facing.

We’ll stay focused on what we can control, capital spending, cost and commitments. We’ll also look for ways to optimize our portfolio and won't roll-out further curtailments or divestitures as we focus on unlocking value for assets. With that in mind, I’ll now turn the call over to our COO, Paul Lang for discussion of Arch’s recent operating performance and outlook for 2013. Paul?

Paul Lang

As John mentioned I would like to highlight our continued focus areas in 2013, these are keeping our cash cost and capital spending levels low and continue to strength our sales commitment portfolio. In the fourth quarter our overall cash cost per ton declined from the third quarter levels and represented our best quarterly performance of the year. Driving these results was an exceptional fourth quarter performance in our Western by bituminous region which helped offset higher planned maintenance expense in the Powder River Basin. For full year 2012 we held the line on cost in all of our operating regions, this was a notable accomplishment when you consider how significantly we reduced production over the course of the year as you know spreading highly fixed cost over lower volume effects unit cost and that is reflected in our operating performance in 2012.

In our largest volume region, the Powder River Basin our cash cost in 2012 were up 7% year-over-year while our sales volume declined 11%. We proactively mitigated the impact of the weak coal market by adding equipment and took other steps that contain cost. During the downturn, we stepped up our reclamation efforts and received the benefit of completing this work faster and add lower costs than we have been incurred with contractors. Our efforts will also allow us to sequence future reclamation work with greater flexibility. Going forward, the demand outlook for this region is expected to improve, but at this time, we have two draglines and eight shovels as well as their related support equipment idle at our operations. As domestic supply overhang corrects, we expect to deploy this equipment and recapture some of the loss volume which will benefit our cost structure over time.

In our Western Bituminous region, we successfully reduced our cash cost per ton year-over-year despite running at lower volume levels in 2012. Late in 2011, we significantly restructured our operating profile in the region by reducing production out of our Dugout Canyon mine and shifting volumes to other lower cost mines. We also transitioned to a new mining area at our Skyline mine in the fourth quarter of 2012 successfully completing a major transition of that operation. Looking ahead, we are optimistic about the market for Western Bituminous coal, we are seeing a slight pickup in domestic demand due to improvements in the construction sector and higher natural gas prices. In addition, export opportunities are improving for this region and should increase further as port capacity materially expands in 2014.

In Appalachia, our sales volume declined in 2012 as expected with our portfolio realignment in the region. During the year, we closed 10 higher cost thermal and incremental metallurgical operations. We decreased production at other active operations and we’ve reduced our overall workforce by nearly 17%.

Our overall cash cost per ton increased in Appalachia during 2012 which is consistent with our ongoing shift to a higher metallurgical coal output. Even with this cost increase, our Appalachian segment represents for the lowest cost operating profiles in the region. Looking ahead, we continue to optimize our assets in Appalachia and anchor our thermal production at our lowest cost asset coal met mine. Our metallurgical platform will consist of our lowest cost mine, Mountain Laurel along with operations producing higher quality coal such as Beckley and Sentinel.

As John mentioned, our coking coal profile will further be enhanced by the addition of the Leer mine as that operation reach full production in 2014, we project its cost structure will be in line with our overall average for the region. In the fourth quarter, we have continued to make solid progress on the development of the Leer mine and we completed the slope construction in December. We have also started the process of test marketing the coal with steelmakers in North America, Europe and Asia. Just like Mountain Laurel, we believe Leer will be a sought-after premium brand in its category, given its large reserve base, good cost structure, and homogenous quality. We also recognized that it takes times for steelmakers to introduce new coals into their blends. Currently, we expect the longwall at Leer to startup sometime during the third quarter and continue to monitor the state of the coking coal markets closely.

Turning now to capital spending, we have cut about $200 million that of our capital plan since 2011 and our actual spend in 2012 came in $25 million favorable to the target. For 2013, we expect capital spending of $350 million or less. That level allows us to adequately maintain our existing operation and still that suspend on value-enhancing projects, including the Leer development as well as the replenishment of our reserve base.

Lastly, I want to touch on our sales commitments. On the metallurgical side, we sold 7.5 million tons at an average price of $113 per ton in 2012. We are targeting higher sales in 2013 mainly due to incremental volumes from Leer. At the same time, our product mix is improving. In 2013, 40% of our metallurgical sales should be a blend of low-vol and high-vol A coal, and we expect that percentage increase in the future. To give this change on context, our product mix is already up from roughly 33% of low-vol and high-vol A in 2012, and it was less than 20% in 2011. We are not only producing more metallurgical coal, but we are producing a higher quality product mix.

We have booked nearly half of our targeted metallurgical sales in 2013 in an average price of $93 a ton while that pricing is lower than what we garnered in 2012, it reflects the higher blend of high well-being in PCI sales than we had last year as well as some carry over volume. For 2013, we’ve strategically left open a larger percentage of our higher quality brand such as Beckley. Although international prices are low at the moment, we expect those markets will strengthen as we progress through 2013 and remain optimistic about to play some of those products both domestically and overseas. While on the thermal side we’ve layered in some sales to run our mind efficiently in 2013 while continuing to produce a slight significantly reduced volume levels. We’re roughly 90% committed based on the mid-point of our guidance range and have maintained sales leverage where we believe opportunities will present themselves over the course of the year.

As discussed we’re encouraged by what we’re seeing in the domestic and international arena for Western Bituminous coals and in Appalachia the domestic industrial sector remain solid which is helping to provide an offset to soft thermal markets in the region.

In the Powder River Basin, we placed some business in 2013 for both 8800 and 8400 coals that will reduce our sales exposure in near term and position us to operate our minds more steadily. We’ve also leveraged those sales throughout the year commitments at more attractive prices and have retained a productive to significantly benefit from improving market fundamentals. While our sales profile in 2013 will likely be waived down by lower realized prices on export sales we continue to pursue key contracts to fulfill our longer term strategic goal increasing our stake in the seaborne coal trade.

As John noted South Korea is the single largest country, we did business with on the international front in 2012. We believe this relationship will continue to grow as country builds out a coal generation fleet that is designed burned sub-bituminous coal with its consistent quality, high reliability and extensive reserve base, the Powder River Basin will increasingly play a larger role in Korea as well as the broader Asia-Pacific region.

With that I’ll now turn the call over to John Drexler, Arch’s CFO to provide an update on our consolidated financial results and liquidity position. John?

John Drexler

Thank you Paul. As John and Paul have described we’re beginning to see some signs of improvement in coal markets, however the timing and magnitude of a recovery remain uncertain. This reality is what prompted us to undertake the financing transactions that we completed in the fourth quarter. We increased our cash on hand by nearly $370 million and decreased our short term borrowings by 100 million. At the end of 2012 we had cash and short term investments of just over $1 billion and no borrowings under our credit facilities. Our available liquidity totaled 1.4 billion at December 31 which was up $400 million compared to the third quarter. Following these strategic moves we’re in a very strong liquidity position with the majority of our liquidity in the form of cash. In addition, these transactions relax the financial maintenance covenants in our revolving credit facility creating ample financial flexibility to manage through the market headwinds.

Although we don’t expect the current cycle to be prolonged, we’re prepared for that contingency. We have a structure in place that will allow us to fund our operations and our ongoing growth plans with (inaudible). While aggressively allowing us to pay down debt as market fundamentals improve. Turning to our quarterly results, Arch reported adjusted EBITDA of $71 million for the three months ended December 31. These results were impacted by a $58 million charge or $0.17 per share that reflects the rejection of a customer supply contract by the U.S. bankruptcy court and the assumption of the contract obligation by Arch. Absent the charge EBITDA would have been $130 million. Other notable items in the quarter’s results were intangible asset impairment charges totally $231 million or $0.97 per share. With the vast majority of VAT charge related to goodwill. We’re required to perform a goodwill impairment review on an annual basis or as conditions warrant. The results of our testing indicated that a portion of our goodwill was impaired mainly due to the material decline and benchmark metallurgical coal prices.

This one-time non-cash charge did not impact our cash flows, liquidity, our on-going business operations. Income taxes for the fourth quarter included a charge of $24 million or $0.11 per share to increase the valuation allowance for certain state net operating loss carry-forwards. Our evaluation of our deferred tax assets indicated that these loss carry-forwards were likely not recoverable requiring them to be written off.

Finally, the income statement line for coal derivative and trading activity reflects an expense of $13 million in the fourth quarter. As I discussed on the third quarter call, this paper loss was primarily due to the expiration of in the money API-2 swap position that we entered into to hedge the price of export shipments. The cash income we received from the settlement of those positions more than offsets that loss, but for reporting purposes, the corresponding income is reported under the other operating income lines.

Lastly, I’d like to discuss our guidance for 2013. We expect thermal sales volumes in the range of 125 million to 135 million tons with met sales in the range of 8 million to 9 million tons. Cash cost in the range of $10.75 to $11.50 per ton in the Powder River Basin; cash cost between $24 and $27 per ton in the Western Bituminous region; cash cost of $66 to $72 per ton in Appalachia; and cash cost of $34 to $36 per ton in the Illinois Basin. DD&A in the range of $510 million to $540 million, SG&A in the range of $130 million to $140 million, interest expense between $360 million and $370 million, and capital expenditures of $330 million to $360 million. Given our current outlook and the impact of percentage depletion, we expect the tax benefit in the range of 30% to 50%.

Our guidance assumes that we will continue to manage cost and capital in 2013 as we successfully did in 2012. Depending on the trajectory of markets during the course of 2013, it is likely that our operating cash flows will be below that of last year. We will continue to work towards improving cash flows for the year from continued expense reduction and ongoing capital discipline to even more stringent working capital management to asset divestitures. We are confident that Arch is well-positioned to weather this downturn and to outperform and create substantial shareholder value as market conditions improve.

With that, we are ready to take questions. Operator, I will turn the call back over to you.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question will come from Brandon Blossman of Tudor Pickering Holt & Company.

Brandon Blossman - Tudor Pickering Holt & Company

Good morning. Let’s see any more detail available on what was sold on the met side for ‘13, it sounds like more than -- for the prepared comments more than the average amount of high-vol B, is that indeed the case? And then what can we think of as far as netbacks to the mine and price at the port in terms of rail transport charges, still seeing some differentials there between high-vol A and lesser grades and should we expect that on a go-forward basis?

Paul Lang

Brandon, this is Paul, I will try and answer your question. I probably won’t get too far into the pricing, but I will try and help you on the volume question. We have committed about half of our metallurgical volume for 2013 at an average price of about $93. If you look at those numbers, these sales were about 60% PCI low-vol B as well as some carryover from 2012. The remainder of the sales was kind of roughly 25% high-vol A and 15% low-vol coals. We have done a good job of maintaining our domestic sales position. And as a rule, we have only our higher quality coal left to sell just kind of round numbers what’s left is about 15% low-vol, about 30% high-vol A, and about 55% high-vol B.

John Eaves

Brandon, this is John. On your question on the railroad too, I mean most of the sales that we made on the met side thus far have been domestically. All that transportation is actually contracted with our customer, we’re now entering the negotiating season with our international customers where the rail transportation comes more into play. I would say that we have seen the rail roads be pretty proactive in terms of facilitating more thermal and net volumes in the international market.

Brandon Blossman - Tudor Pickering Holt & Company

And then Paul just real quick. PRB cost ranges exactly the same as it was a year ago forecasting basis, lower volumes year-over-year 13 to 12, any expectations, you fell exactly into the middle of that range for 12, is that a fair expectation for 13 and what would move one way or the other?

Paul Lang

As I mentioned in my comments Q4 was the best cash performance for the quarter and the guys did a pretty good job, in the Powder River Basin you know our volumes were down and our cost were up a little bit and we were able to mitigate a lot of that by ideally equipment taking other steps and in the basin we did can’t be understated although took care of a short term issue, it should help us going down the road. You know my sense on 2013 is pretty much where we’re at, we’re expecting the volumes to be about the same and we think with the little uptick in volume we will be able to offset most of the minor inflation everything’s that will come along. You know I think there is a lot of positive things on the cost side but you know despite all that I’m definitely not satisfied where we’re in controlling cost and you know it will remain our focus for 2013.

Operator

And our next question will come from Mitesh Thakkar of FBR.

Mitesh Thakkar – FBR

My first question is on the Western Bituminous cost, Paul obviously good job during the quarter. When I look at the guidance though, it looks like there is a significant bump not only versus the full year 2012 but meaningfully higher compare to the fourth quarter, what is driving that? If you can kind of give us a bridge on that, that will be great.

John Eaves

All right Mitesh, you know we have an extraordinary cost quarter in Western Bituminous, quarter-over-quarter cash cost went down 22% while the sales volume decreased 18%, the net result was an 18% and 68 per ton cash margin and 13.47 for the year. I don’t want to take away anything from great accomplishment by the team but there was some non-recurring items that occurred in the quarter the biggest which of was the run-out of the Dugout Longwall. Obviously we’re not forecasting, operating in the Dugout Longwall in 2013 but we’re keeping our options open and we really remain encouraged by the market in this region. I guess taking all that into account though we’re still forecasting a cash cost of $24 to $27.

Mitesh Thakkar – FBR

Okay great and just looking at the contracting, obviously when you do math on the PRB coal it looks like you sold $15 million - $16 million tons at around $10 which is kind of below your cash cost. Can you give us some color about you know what is in there maybe is it a function of mix or like the weak export markets which you talked about, can you talk about the net backs right now on the export side as well?

John Eaves

As we walk our way through this trough you know we remain focused on the longer term opportunities and still view the PRB as a long lived asset that’s going to support us for a lot of years. I guess without any apology we took some volume off the table for 2013 and reduced our exposure, so we could run the minds at a reasonable rate. But we also had success at leveraging the 2013 numbers for volume and price in the outer years, for a little more color you know the numbers are weighted down by a couple things, some of its market based agreements, some of it's the blend of 84 and 8800 coal as well as the drop in the international prices. When you think about it the end of January the Indonesian 4900 kilocal coal is in the mid-60s you know about a year ago that was $80 or $85.

You know obviously, $15 or $20 in the PRB is a huge number and you know we continue to want to pursue these international things and we don’t want to be a swing supplier in the trade, but I think if you stand back, I think very positive thing on the pricing is we have seen significant production response to current pricing and that includes Australia and then Indonesia. And I think as we work through our gradual stockpile drops in the PRB at the utilities, we should see some price recovery later in the year. And looking at 2014, we have been able to take this and we are sitting at about 55% or 60% of our thermal position committed based on 2013 guidance. So, I think the strategy is paying off.

Mitesh Thakkar - FBR

Alright, great. And one last follow-up if I may on the Leer mine, have you contracted any coal from Leer and if not what is your expectation in terms of pricing given where the met markets are currently?

John Eaves

Without going into specific pricing, we have not contracted anything, but I wouldn’t have expected too either. We are focused on the early production out of the mine going to steelmakers to do test burns to get it into their blend. So, I wouldn’t have expected to really sign any term agreements for that operation till next year.

Paul Lang

But we do have some tests going on in the coal that are going well.

Mitesh Thakkar - FBR

Great. Thank you very much guys.

Operator

And our next question will come from Shneur Gershuni of UBS.

Shneur Gershuni - UBS

Good morning guys.

John Eaves

Good morning.

Shneur Gershuni - UBS

Just a very quick follow-up to Mitesh’s last question with respect to the PRB cost versus what you have sold, the actual tonnage that you booked was that actually technically done at a loss or just given the fact that their pricing differentials, royalty calculations and so forth and fixed operating leverage that those tons are not actually booked at a loss or close to breakeven, if you can sort of talk about that for a second?

John Drexler

Hey, Shneur you hit on an item that you do have to take into consideration. I think Paul touched on that it can be a variety of factors as we look at each of the individual sales including mix at a 400, at a 800 BTU coal, but another important item that you mentioned as well, the sales sensitive cost impact of what we are looking at. So, a third of the sale price is sales sensitive cost. You need to take that into account into what we report from a cash cost perspective over the course of 2012 with the realizations that we had at that time also. And I think when you adjust for those items you will see that maybe we weren’t selling these at a loss in that region.

Shneur Gershuni - UBS

Great. Just two quick questions here, one if we can start with contracting you had mentioned that you have kept some of the better or higher quality met coal back for the market as you expected to move up and so forth. When we think about where benchmark pricing was for metallurgical coal and where you booked the high-vol in PCI for the domestic contract and so forth, was it better than expectations or the relationship between the two was there a contraction or widening of the spread at all kind of how we think about how you contracted those specific tons?

John Eaves

Yeah. I think it was about as expected. I mean, we as Paul indicated a lot of it was weighted down with a high-vol B in PCI. And as we see the international market materialize, we hope that the prices will improve. I mean, we believe right now at the 165 benchmark there is a large percentage of the suppliers in the seaborne market that don’t have a cost structure that can play in that market at that price. So, we think you are already seeing kind of moving along the bottom maybe bumping up a little bit if you look at spot prices. So, with the 35 million tons we have seen come out of supply maybe some more coming up versus second quarter, we do think there is a real possibility for prices do respond particularly in the back half of the year. And that’s why strategically we tried to manage and maintain more of our high-vol A and low-vol open at this point whereas last year we had committed a higher percentage of that.

Shneur Gershuni - UBS

Great. And just one final question, you have definitely made some great strides with respect to CapEx and so forth. Once Leer is up and running and it looks I assume you don’t make any land acquisitions, it sort of seems you are running at about $170 million maintenance CapEx number. Is that how we should be thinking about 2014 and beyond? And does this low CapEx or maintenance CapEx run-rate impair your ability to ramp up production if you see a pricing uptick?

Paul Lang

Clearly, we are focused on that reduction as well as cost control. And if you look at the (buckets), 2013 maintenance CapEx is about $170 million. If you recall though in October, we are also getting the benefit this year of about, you could argue a number of $40 million or $50 million of equipment that we ideal that some of the minds of the east and we are able to transfer and take advantage of so I think you take that into account, you’re looking at kind of a normalized maintenance capital for us next year.

John Eaves

As we think about growth capital once we do have the Leer up and running at steady state we have some land additions which would be LBA and some smaller stuff about $60 million to $80 million a year, beyond that it would be just maintenance capital until we sell some improvement and market that really justified spending more growth capital. We’re fortunate though when we think about the next several years of having the (inaudible) value reserve which is just to the west of Leer could be another longwall and another continuous (inaudible) and then we have the big Bakken and the Southern Illinois quarry, those very attractive projects but until we see some improvement in the market the ability to go put some thermal to bed longer term then we’re going to kind of sit where we’re right now.

Operator

(Operator Instructions). Our next question will come from Brian Yu with Citi.

Brian Yu - Citi

My first question is just on the coal sale, what’s the anticipated volumes that you would expect to produce and sell out of Leer this year?

John Eaves

I think we’re going to have about a million tons in total.

Brian Yu - Citi

And that would be both production and sales?

Paul Lang

Yes and you know obviously that’s going to be very heavily weighted to Q4 when longwall starts up.

Brian Yu - Citi

All right and so if you’re doing some development you mentioned you did some test burns now, would that excel your once go into the second and third quarter and then would that be geared towards international markets? Or would you try placing them domestically?

John Drexler

Brian as far as the accounting for some of those sales that occurred during development between now and the startup of the longwall from an accounting perspective those aren’t booked through on P&L, those are an adjustment CapEx. That’s traditionally in our industry as you develop a longwall, have the accounting for that is. As far as the target for test burns and whether it's domestic or international I will turn that back over to Paul and John.

John Eaves

I clearly say we had a lot of interest particularly in Asia out of this coal and I think I’m just going to have to take a shot but I would say about 70% of what we shift is going to Asia for test burns.

Brian Yu - Citi

Okay and just switching topics on this, on the PCX related tons we took the charge, is any of that, can you provide more detail than to how that may or may not impact your future operating results as you delivering those contracts?

John Drexler

As far as what occurred during the course of the quarter, there was a contract with the customer being serviced from Patriot that ultimately had an obligation of Arch attached to it. We have been very explicit in what our exposure to those contracts has been over the last several years and specifically over the last quarter since the bankruptcy. During the quarter that contract was rejected in bankruptcy so the obligation came back to Arch, the way that specific contract works as it's been amended over the years is it's a required fixed payment schedule between now and 2017 for which we have obligations to make those payments. So once that was rejected in bankruptcy the obligation came back to us. We recorded the full liability for that amount and will just make ongoing payments between now and 2017, not material to any given here.

Operator

(Operator Instructions). Our next question comes from (inaudible).

Unidentified Analyst

I guess first off it seems like you’re getting more encouraged by 2013 on a burn expectation. So when you’re looking at that 50 million ton expectation, how much of that do you think will come from new business versus coming from burning down existing stockpile level?

John Eaves

I think it will be a combination, I mean we finished the year at a 182 million tons and you know depending on where you call target levels we think that’s you know a good 30 to 40 million tons above normalized levels so some of it's got to come off existing inventories and we will expect you know a draw in January or February but we would expect as the year progresses on that there will be some new business opportunities to sell coal as well, but clearly we need to draw the next 45 to 60 days in the inventory to make that happen, because we go into the (shiver) season. So, I think it will be a combination, but I think the first order business is to pull down the inventories that we ended the year with. So, we see that happening and if we did encounter some mild weather for the next 45 to 60 days, I mean, it’s possible that it could delay that, but we are hopeful that we continue to get some cold weather here.

Paul Lang

And I think we are clearly getting a sense from several customers that they are being cautious on their contracting in 2013 and we are going to be careful. And as John said as the burn comes off or the stockpiles come off, I think that will determine what we see later in the year as far as new sales.

John Eaves

Yeah, I mean a lot of these get burned a few years ago and they have been pretty conservative in their buys. And if you did see inventories come down, you actually could see those guys come back to market in the third and fourth quarter and based on pretty heavy buying activity.

Unidentified Analyst

Great, that’s very helpful. And I think just following up on that, obviously you have had a lot of changes in your Appalachian thermal footprint over the past year with all the mine closures, what do you think is a good run-rate to think about the actual production in the basin right now? And if we do see the stockpiles get drawn down lot of spot (in these), how long would it take you to ramp up this production capacity and how much could you ramp it up?

John Eaves

Well, I mean, we are going to be very cautious. I mean, we are not going to bring production on for short-term opportunities. We are guiding to 8 to 9 million tons of met. I think you could see a comparable level in the thermal side. I think it just depends on what we see from a market perspective. Paul and his guys were encouraged by what they are seeing on the industrial sector and you saw that reflected in our pricing that we did during the quarter. So, we will see how it goes, but I think if we sell and improve sustained market, there is an opportunity that we could bring on some additional volume back half of the year, but as you know cap as a whole was off about 36 million tons from 11 to 12 and we are forecasting another pretty significant step off in cap as we move into 2013. As I mentioned in my opening comments, if you just take fourth quarter run-rates and annualize them, it’s below 130 million tons in Central App, which is pretty significant from where we have been over the last five plus years.

Unidentified Analyst

Great. That’s all very helpful.

Operator

Thank you. Ladies and gentlemen, we will take our next question from Jim Rollyson of Raymond James

Jim Rollyson - Raymond James

Good morning everyone.

John Eaves

Jim.

Jim Rollyson - Raymond James

John, going back to that inventory question just when you guys looked in your internal modeling and assuming normal weather, where do you think inventories get down to in that – under normal weather scenario this year and maybe what do you think they need to get down to, to really jump start some opportunity for better pricing?

John Eaves

Jim, as we look at normalized weather we look at natural gas prices kind of where they are now in that mid 3s. Our internal forecast would have it somewhere around 155 plus or minus at the end of this year, which is maybe slightly above normalized levels, but getting much closer and I would say that we have really setup a pretty nice first half in 2014 in terms of buying activity.

Jim Rollyson - Raymond James

And as far as getting back to some sense of pricing, I mean obviously the gas prices to cooperate as well, but what do you think normal levels are today more like it used to be the 140 to 150 as you think that’s more like the 130s given reduced burn?

John Eaves

Well, you have had some generation come up obviously, so that number is probably going down a little bit, but I would say it’s probably mid-130s to mid-140s range for normalized. I mean, it depends on the customer, but with some of the plant closures we have had thus far, I think that number probably gets a little bit lighter than the old 150 number.

Jim Rollyson - Raymond James

Alright. And as the last follow-up, can you just refresh us maybe how we should think about the cost contribution from the Leer mine, obviously this year you are going to be working on getting it up and running, but as you go forward into next year and get it running at a full run rate, how we think about Leer costs in relation to your overall met costs?

Paul Lang

Jim, what we have been saying and I guess with any new mine you want to be cautious, but what we are saying is the average cost will be in line with our regional average, so I think that’s a good number start modeling with.

Operator

And our next question will come from Lucas Pipes of Brean Capital.

Lucas Pipes - Brean Capital

My first question is on potential asset sales, maybe if you could give us an update on kind of what type of assets you’re looking at with transportation assets also be considered?

John Eaves

You know as we said in the past and we continue to look at our asset base and we have always been not only buyers of assets but we have been sellers of assets and that’s something that we continue to look at. You know I don’t want to set the expectation or something that’s definitely going to happen but you know if there is an asset it's not necessarily strategic to what we’re doing. Somebody could come in and provide value that we don’t see certainly something that we’re willing to consider. I’ll say that we are not in a position where we have to buy or sell assets and will not do that, we’re always reviewing our portfolio and making sure that it fits with what we’re trying to do. I mean if you look at our diversity, we think we are well positioned in the U.S. with our production based in the PRB, our improved performance in western kind of growing presence in Illinois and then if you look at our almost billion tons that we have in Appalachia which about 40% of that is low cost in that. We do think that we’re pretty well positioned, so if there is something in that asset base that didn’t fit, we would certainly consider modernization.

Lucas Pipes - Brean Capital

Great and then a quick follow-up question. I mean a lot of prognosticators you see in the U.S. met coal exports are a little bit lower this year. First kind of what is your take on that and then secondly you actually increased your met coal guidance year-over-year, direct back to, first should you expect to take market share from your peers and if so is that result of your cost structure in the basin?

John Eaves

Well I mean obviously 2012 was a big year, on a short term basis we shift a 124 million tons, I mean I think it's too early to say that we’re going to be in that level. I mean what we’re saying it's going to be a plus 100 million ton market and how the market evolves over the balance of the year will determine where those final numbers shake out.

I wouldn’t tell you that based on what we see in global demand, yeah we’re bullish longer term, when we look at the new coal fire generation that we see being built around the world to the tune of about 300 gigawatts we think over the next three or four years there is going to be an additional 900 million tons of coal that is going to be required to service that growth and demand and when we look at steel production you know we’re forecasting about a 3% increase in steel production from 12 to 13. So we do see some improvement in China. We see some improvement in Europe and a little improvement in South America.

So as a company we want to make sure that we’re well positioned to take advantage of those opportunities and here in the U.S, if you listen to some of the auto guys, I mean their forecasting low to mid-15s in terms of units being produced in 2013 which you know translates into a good met market for us. So, you know we’re cautiously optimistic and kind of watching the market and we will be selective in taking new business.

Operator

And our next question will come from John Bridges of JPMorgan.

John Bridges – JPMorgan

I wondered if you could give us a bit more detail on the Korean exports you were talking about, is that PRB is it squeezing out to the west coast or is it coming out of the gulf? And is it like going Panamax because I would think the rates would be a bit tight now.

Paul Lang

I will start your question, as we look in Korea, we exported both thermal and metallurgical coal to Korea, the thermal coal obviously came out of the PRB, the met coal came off the east-coast majority of it went through DTA and Curtis Bay.

John Bridges - JPMorgan

And the PRB is going out to the West Coast?

Paul Lang

Yes sir.

John Bridges - JPMorgan

Okay and then just as a follow-up the two draglines that are ideal, this is a really sum how much production would that represent?

Paul Lang

You know John I guess I would rather not go there on specific numbers, you know I think you can just look at our overall guidance and look at our history as to what those volumes would amount to.

Operator

And our next question will come from Kuni Chen of CRT Capital Group.

Kuni Chen - CRT Capital Group

Hey, good morning folks.

John Eaves

Good morning.

Kuni Chen - CRT Capital Group

I guess just first question on the PRB, obviously in the fourth quarter you layered in some tons here to run at an efficient level for 2013, are you basically there already or do you have to layer in perhaps a few more tons in the first half to keep your cost structure within the range?

John Eaves

I guess without citing it specifically, we are sitting at about 90% committed, which is really one of the better positions we have been in a long time. And I think the market outlook and the volumes we have to sell are kind of baked in our guidance. So, I think we have taken it into account.

Kuni Chen - CRT Capital Group

Okay, fair enough. Then I guess just on the Central App, it looks like you committed some tons in the fourth quarter at sort of a high $70 per ton type of range. Is that something with the mix there? Can you just give us some more color on that?

John Eaves

Yeah. I think there is a little bit of noise I think in those numbers, but what you are seeing is I think what you are seeing particularly in the east is kind of a bit of a combined impact of volume dropping off and gas pushing up the industrial accounts. And some of those customers going back to coal are obviously since we have some higher quality products we have been able to capitalize on this and pick up some of that market segment in otherwise what’s been a pretty tepid thermal market. Bottom line is our marketing guys did a good job and these -- what you see is clearly a great effort, but I think the number is probably little high from what you are seeing in the market.

Operator

And our next question will come from David Gagliano with Barclays.

David Gagliano - Barclays

Great, thanks for taking my questions. My first question back on the PRB volumes overpriced in the fourth quarter, I just want to step back for a second even if we assume for example the sales based cost come down in etcetera, etcetera. It looks like it’s still the best kind of a breakeven commitment on 16 million tons. So, my question is the obvious question obviously can you just walk us through the logic of why that’s better than shutting it down leaving in the ground and then selling it at $1 or $2 per ton margin in 2014 for example?

John Eaves

Dave, this is John. A couple of things and Paul touched on I think the fact that we are able to turn that into additional business in ‘14 and ‘15 at very attractive prices, I mean, you’ve just seen ‘14 we are not showing you ‘15, but we really have turned it in multi-year business. I think the second piece is that we are trying not to be shortsighted as we look at strategically in terms of our global customer base. And we don’t wanted to show up when things get good, we want to make sure that we have established long-term relationships with some of our international customers that we are ready when the market does turn. And we know it’s going to turn, because when you look at the new coal, our generation being built around the world we are struggling on where all that supply is going to come from. So, Arch has been very proactive in developing that international customer base. We have been very proactive in going out and getting port capacity. We want to be part of that, because as we look to the U.S. over the next three to five years, I mean, let’s face it, I mean demand is going to be pretty flat. And if we are going to grow we have to look at that market and we can’t wait a year or two down the road for markets to improve to be part of it. So, I think the marketing guys have done a great job in developing relationships all over Asia, long-term relationships, port relationships that we think will serve us well. And I mean, if yeah, we don’t like the prices either, but we do think strategically it’s important to do that now versus late.

David Gagliano - Barclays

Okay, I have just a two-part follow-up question. First of all, the midpoint of your full year volume target, it implies another 14 million tons obviously to go, I am assuming that’s all in the PRB. It’s related to one of the questions earlier. My first part of my question is that how should we think about that? Is that, that’s going to be sold at whatever the prices are or is there potential for that to be shut-in? That’s my first question. And then my second question along the lines of your commentary, I am just curious over the last 14 years that covered the company like it has changed in terms of the view towards the PRB. This is the same company that for the first 12 years I looked at it 13 years or whatever would consistently say we are not going to sell the coal if it’s not at the right price and we will leave it in the ground, what’s changed in the last year such that now it's more about maintaining long term relationships et cetera.

John Eaves

Well I think it's both, I mean we always evaluate every transaction and make a decision accordingly and we’ll continue to do that. As Paul mentioned we got a lot ideal equipment in the PRB right now that we don’t plan on bringing back on until we see sustained demand. But I think what has changed is the marketplace and the marketplace has changed to gear us more to the international market and to establish that market, we got to go out and develop relationships and sell coal and that has you know put us in a position where we have done some of that that we think will serve us well when the market turns. Is it a given that all the uncommitted coal at our met points is going to be sold, no, it's not, I mean we’re going to evaluate the market and we will make a decision at the time whether we sell it or we leave that production in ground.

Operator

And our next question will come from David Martin of Deutsche Bank.

David Martin - Deutsche Bank

Was hoping you can give us a little color on the moving parts related to your app cost guidance for 13, is it essentially that had a change in mix you know offsets the benefit of high cost mine curtailments and then I was going to ask about Leer startup cost impacts but I think John you said earlier those don’t get reflected in average cost.

John Eaves

Yes from the startup cost impact David you’re correct under the accounting those essentially get capitalized into the development of the operation.

Paul Lang

I think just to add a little color, if you look at our cost you know they went up about $6 compared to 2011 and a lot of that in 2012 will be in 2013 as the shift a higher percentage of metallurgical production. You can garner from the numbers will be about evenly split in 2013 between met and thermal in the east and that’s got an obvious cost impact.

David Martin - Deutsche Bank

Okay and then secondly I just wanted to come back to the earlier comments on sales related cost and don’t take my question the wrong way. I know I guess what I’m trying to understand is where are those sales related costs are embedded ‘cause I look at your for example your SG&A cost guidance and there is really no difference year-over-year.

John Drexler

Yeah David from sales related cost the royalties and taxes that are paid on the sale of coal in any of our regions and any of our operations off loads through the cost of sales line and is considered a cash cost. So as you look at as an example our regional per ton analysis, the sales sensitive costs are part of that cash cost per ton. SG&A is really all corporate overhead related items, anything associated with the sale of that cost is flowing through our income statement on cost of sales and it's reflected in our detail analysis, regional cost analysis and the cash cost per ton.

Operator

And our next question will come from Andre Benjamin of Goldman Sachs.

Andre Benjamin - Goldman Sachs

I was first hoping that maybe clarify how you’re thinking about the balance sheet and the use of cash that you built up. I know you have indicated that you like to be capitalized to handle a potentially extended downturn. So should we continue to expect that you’ll just hold that cash until the market is stabilizes and then prepay the callable debt or when things stabilize, can we see you turn around and use some of that cash on some of the growth opportunities you have highlighted that target value reserves on the (inaudible) basin.

John Drexler

Clearly as we indicated, we felt it was prudent in the fourth quarter to go and bolster liquidity on the balance sheet for the market downturn and for whatever the extension on that downturn is even if we don’t expect it to be prolonged. So right now we’re in a position where we’re going to be managing to that liquidity closely as indicated in my prepared remarks you know we expect operating cash flows to potentially be below where they were last year so we will watch this closely but as we have indicated over the course of the call we’re beginning to see signs of improvement and given the positioning of Arch as things do improve as markets do turn we think the earnings potential cash flow potential is significant, a very primary focus for us once we begin to see that turn we begin to get confidence in those markets moving forward in a very positive way for an extended period of time. We will have the ability then to go and address what we believe is higher leverage than what we would like to have. So, that will be a primary focus for us. However, clearly, wherever the markets are going, we will way the opportunities we have with organic growth projects etcetera, but as we have indicated numerous times, our primary focus will be de-levering as we move forward as the markets do turn.

Operator

(Operator Instructions) Our next question comes from Chris Haberlin of Davenport & Company.

Chris Haberlin - Davenport & Company

Hi, thanks for taking my call.

John Eaves

Hi Chris.

Chris Haberlin - Davenport & Company

You in your release, you talked about consumption, coal consumption increasing this year by approximately 50 million tons and it sounds like you are looking for an inventory drop through the year of 25 million to 30 million tons. So, that kind of leaves sales at 20 million or 25 million tons and how do you – I guess, how do you think that incremental sales volume should be distributed across the major thermal basins in the U.S.?

John Eaves

Well, I think it depends on where gas prices are. I would tell you that with that kind of inventory draw of natural gas prices in the $3.40, $3.50 range where we have been seeing we think that the PRB and probably the Western Bit coals will do pretty well. And we are actually seeing that today. If you look at the marketplace both of those coals are dispatching on the curve. And as that inventory comes down, I think the buying activity will only improve and you should see improvements in both the PRB and the Western Bituminous for Arch.

Operator

And our next question will come from Meredith Bandy of BMO Capital Markets.

Meredith Bandy - BMO Capital Markets

Hi guys. So, most of my questions have obviously been asked and answered, but one question I had was in Appalachia in 2014, you gave us new sales guidance there of 1.7 million tons sold at $53.98. I was just surprised that, that number fell so drastically. When was that sold? Would you see the current market as being – is that indicative of the current market, is the current market better or worse than that?

John Eaves

I believe that, that’s some carryover volume that we got through the ICG transaction and that we see the markets better than that in 2014, but that is for the most part carryover from ICG.

Operator

And our next question will come from Justine Fisher of Goldman Sachs.

Justine Fisher - Goldman Sachs

Good morning.

John Eaves

Good morning.

Paul Lang

Good morning Justine.

Justine Fisher - Goldman Sachs

So, my question is on the kind of the production plan given potential outcomes in 2013 and it seems that most of the coal companies are not planning to increase production this year even though we hear a lot of talking about how the second half could be stronger, especially with natural gas. And so I know why you are not, because you have answered to other questions that you don’t want to do it until you see a meaningful increase in demand, but the question is how quickly could you bring that tonnage back if you did see meaningful demand? And then also would you or would you just say no, I am sorry we are not going to produce that much and let prices get really higher, do you think that you guys would produce into that higher price environment?

Paul Lang

Well, I think the answer how fast that production could come back depends on the base. In the PRB obviously I think we are poised very well to respond to whatever the market brings. And obviously we will be very careful. Same in Western Bit, we have the longwall that’s idle at Dugout Canyon, and you saw how effective it was in Q4 of 2012. The east, I think is a tougher issue. I think a lot of the production I know the stuff that we shutdown, some of that’s not coming back very easily and I think it take a significant market shift for us to even think about the Eastern operations bring back thermal coal.

John Eaves

Yeah, I think you have seen some structural changes in the east. And as to Paul’s point, I mean you are going to see a lot of those tons that will not come back and that’s why we are optimistic about what’s going to happen in the PRB and to a lesser extent maybe Western Bit, and we think as that demand starts to reassert itself, we think that PRB comes into play pretty quickly.

Operator

And we will now move on to Evan Kurtz of Morgan Stanley.

Evan Kurtz - Morgan Stanley

Hi, good morning everyone.

John Eaves

Good morning.

Paul Lang

Good morning.

Evan Kurtz - Morgan Stanley

Just a quick question on met coal, in 2012 what was your split between export tons versus sales of domestic steel mills and how do you see that changing in 2013?

Paul Lang

I think our export in 2012 was 65% thermal and 35% met. My guess is excuse me 2012 – 2013 my guess is the metallurgical volumes will tick up a little bit as compared to the thermal volumes on the export side.

Evan Kurtz - Morgan Stanley

Okay got you and then could you provide me a color perhaps on how domestic met coal contracts ship out this year maybe on a differential from a light quality basis.

John Eaves

I will just say in terms of volume we did a very good job of maintaining our market share and I’m very pleased with where the guy shook out and you know if you look at it, what we did was we took off the table in the domestic market, most of our PCI and lower quality high (inaudible), and obviously that’s with the anticipation that the higher quality coals will travel overseas better and garner better prices.

Operator

And we’ll take our next question from Lance Ettus of Tuohy Brothers.

Lance Ettus - Tuohy Brothers

Just wanting to know you know on just on the asset sale side, I mean have a lot of I think excess reserves in PRB and also (inaudible) basin, those bases are still viable and you know the only base reserves obviously to wrap your fiber volume properties and maybe that area maybe is considered not core. I guess kind of elaborate more in the potential for selling these assets and you know I guess the interest we’re seeing out there maybe we’re approaching those assets.

John Eaves

Well I mean we’re talking to a number of people as we have and we will continue, I wouldn’t I mean in this environment, I think it's pretty challenging to try to monetize assets and again I don’t want to talk about any particular region, I do think the Illinois overtime could very well become a core operating region for Arch Coal depending on how we see the market evolve. I mean obviously, we’re very bullish on the PRB, you know another area that might be somewhat challenged based on our comments is kind of the east and the way we see the thermal market potentially but you know we will have to evaluate the opportunities we have to monetize assets and see if they meet our needs, if not as I indicated earlier we’re not in a situation where we have to buy or sell assets. So somebody is going to have to provide more value than we can provide in order for us to do a transaction.

Operator

And we will take our final question from Dave Katz of JPMorgan.

Dave Katz – JPMorgan

I was just wanting to confirm you guys are still I guess with the amendment that was put through on the credit facility. In November you have the maximum senior secured leverage ratio in 2013 of 3.5 right?

Paul Lang

Correct.

Dave Katz - JPMorgan

And do you anticipate being able to comply with that throughout the year?

John Eaves

We don’t anticipate having any concerns with that the other major item there is the minimum liquidity measurement of $450 million and we feel comfortable with the structure that we have in place.

Operator

And at this time I’ll turn the conference back over to John Eaves for any additional or closing remarks.

John Eaves

Thank you. We certainly appreciate you join us today. We feel good about the way we position the company, first of all our safety and environmental performance for 2012 again showed our leadership in that area. Our ability to maintain cost and capital in a low volume environment, our ability to go out and put additional cash on our balance sheet. We think all these things has positioned us very well that continue to weather this storm and be positioned when market does turn and it will turn. So we look forward to updating you in April on our first quarter results. Thank you.

Operator

And that does conclude our teleconference. Thank you all for your participation.

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Source: Arch Coal's CEO Discusses Q4 2012 Results - Earnings Call Transcript

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