Why Arch Coal's Fire Can Still Burn In The Long Term

Jul.29.14 | About: Arch Coal (ACIIQ)

Summary

On a relative basis, we have to agree that Arch Coal is still trading at a discount to Alpha Natural Resources.

Given the deficits with which management has had to work, I don’t believe anyone who understands this industry was expecting a miracle.

With Arch Coal stock now trading on the assumption that it will not grow at all, I believe these shares will trend higher in the next 6 to 12 months.

With shares wallowing near 52-week lows, investors in Arch Coal (ACI) have had little to be excited about. Much of this have had to do with an industry that has become grossly commoditized due to weak prices of coal and natural gas. Unlike rivals like Peabody Energy (BTU), it seems Arch Coal has seen the worst of the slump. Over the past five years, the stock has plummeted more than 90%.

Shares closed Monday at $2.86, after reaching yet another 52-week low of $2.82. The stock is down 35% on the year to date, trailing the energy sector's 14% gain. Investors weren't sure of what to expect when Arch Coal reported earnings Tuesday. But suffice it to say, investors were starving for some good news. And Arch Coal didn't disappoint.

With the help of a 7% decline in operating costs per ton, the company reported a smaller-than-expected quarterly loss. High costs have been one of the reasons for the industry's struggles. As the company has battled weak coal prices, management has looked for ways to increase production of metallurgical, which is a higher margin business.

To that end, the company reported a loss of 46 cents per share (excluding items), narrowing down from estimates of 49 cents per share. The company's operating costs per ton fell to $20.55 from $21.19. Revenue arrived at $713.8 million, down 7% year over year and missing the average analyst estimate of $714.6 million.

Despite the revenue decline, investors cheered, sending the stock up by close to 7%. While the numbers -- in absolute terms -- were far from breathtaking, they do suggest that the worst is over. Recall, Arch Coal is coming off a period where the harsh winter weather impacted its North American operations. The question now, though, is to what extent does Arch Coal present long-term value?

Management reduced its full-year 2014 revenue forecasts to reflect ongoing risks with a decline in steel production. Not to mention, there are still concerns about the effects of the transportation bottlenecks. These are areas that need to be addressed before these shares can generate the sort of spark needed to excite investors.

The good news is that, for now, Arch Coal stock has seen its worst. And it also shows the difference that can be made when a committed management team places a strong emphasis on operational efficiency and profitability. Given the deficits with which management has had to work, I don't believe anyone who understands this industry was expecting a miracle.

Even so, investors have to be encouraged by the recent uptick in coal demand, spurring positive outlooks from rivals like Cloud Peak (NYSE:CLD) and Alpha Natural Resources (ANR). Combine this with the progress management is making in shifting the business from coal to natural gas, I believe it's possible that Arch Coal's stock may have bottomed Monday at $2.82.

Not only that, but on a relative basis, we have to agree that Arch Coal is still trading at a discount to Alpha Natural Resources. This is even though Arch Coal is outperforming in revenue growth and gross margin. With Arch Coal stock now trading on the assumption that it will not grow at all, I believe these shares will trend higher in the next 6 to 12 months.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's energy sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.