Depressed Valuations Are One Of Many Reasons To Buy Arch Coal

| About: Arch Coal (ARCH)

Arch Coal (ACI) is a diversified coal producer in the U.S., with its exposure to both thermal and met coal operations. The diversified exposure provides ACI with ample opportunities to benefit from a coal market rebound. Also, the company has been making efforts to lower its operational costs to reduce operating risks, as current market conditions remain weak. I believe ACI is likely to benefit from a recovery in thermal coal markets, as coal inventories have fallen below normal levels. Also, the company has a relatively strong balance sheet, with a healthy liquidity position and no debt maturity till 2018. I am bullish on ACI, and believe the stock remains a good investment opportunity for long-term investors.

Financial Performance
The company reported a slightly weak financial performance for Q4 2013 and full-year 2013, mainly due to weak coal market conditions, geological issues in Appalachia and rail issues in the Powder River Basin. The company reported an adjusted loss of $0.45 per share as compared to consensus estimates of a loss of $0.38 per share. Revenues for the recent fourth quarter dropped by 17% year-on-year to $719 million and adjusted EBITDA dropped to $38.4 million from $71 million in the corresponding period last year.

Full-year 2013's financial performance for the company was also adversely affected by weak coal market conditions. ACI's revenues and adjusted EBITDA for the full year (2013) dropped by 20% and 38% year-on-year to $3 billion and $425 million, respectively. As coal market conditions remain difficult, the company has been making aggressive efforts to lower its cost curve. As revenues for the company dropped by $750 million year-on-year in 2013, the company was successful in lowering its operational cost by $500 million in 2013. ACI remains committed to further improving its costs structure, to preserve cash and enhance operational efficiencies. Consistent with its cost control efforts, the company is expecting selling, general and administration to be in a range of $122-$130 million for 2014, as compared to $133 million in 2013. The ongoing cost control efforts will support the company's weak earnings and portend well for the stock price.

Inventories and Coal Contracting
Lately, an increase in natural gas prices has resulted in higher coal-fired electricity generation. Coal inventories at electricity producers are on the decline, as coal inventories have fallen below 60 days of burn. As coal-fired electricity generation will increase, coal inventories are expected to drop further, which is expected to rationalize the market. However, excess capacity could be an overhang, as available capacity could be brought online, which will put a lid on a recovery in coal prices.

The company is expecting coal shipments to drop by 2% year-on-year to 131.5-142.4 million tons in 2014. ACI's thermal coal production is expected to be in a range of 121-134 million tons, down from 133 million tons in 2013. On the other hand, met coal production is expected to increase from 6.8 million tons in 2013 to 7.5-8.5 million tons in 2014. The expected increase in met coal production is mainly attributed to the ramp up at the Leer Mine; I believe an increase in met coal production will keep met coal markets oversupplied and keep prices weak. Given its sales volume guidance for 2014, ACI's volumes are almost 80% priced and committed for 2014 and approximately 45% priced and committed for 2015.

Liquidity and Balance Sheet
Managing a healthy liquidity position remains important for ACI, as it waits for a recovery in coal markets. The company has done well to strengthen its liquidity and balance sheet in the prevailing tough market conditions. I believe there is very little to no bankruptcy risk for ACI, as it currently has total liquidity of $1.4 billion, including $1.2 billion of cash and short-term investments, no debt maturities until 2018 and no debt covenant concerns till mid-2015 at the earliest. The company has been making efforts to improve its financial flexibility and liquidity by opting for non-core asset sales and lowering expenditures. To preserve cash in the ongoing tough market conditions, the company has lowered its Capex by $100 million, as it is expecting Capex to be in a range of $180-$200 million for 2014. The company has sufficient liquidity to navigate through the market downturn and wait for a market recovery. The following chart shows the debt maturity profile for ACI.

Source: Investors Presentation

The recent increase in natural gas prices will benefit thermal coal markets as coal-fired electricity generation will increase. Also, declining coal inventories at electricity producers will benefit the thermal coal market as an increase in demand will result in market rationalization. However, oversupplied met coal markets remain a concern for ACI in the near term, and coal producers have to curtail their met coal production in response to excess supply. Moreover, the company has been taking corrective measures to lower their costs, and preserve cash. Furthermore, current valuations remain depressed for ACI, which make it an attractive investment option to play a coal market rebound; the stock is currently trading at a P/B of 0.35x and P/S of 0.25x. Due to the above-mentioned factors, I believe the stock remains an attractive investment option for long-term investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.