Arch Coal: A Dividend Play With Turnaround Style Appreciation

| About: Arch Coal (ARCH)

By Mark Bern, CPA CFA

I just couldn’t let the Christmas holiday go by without writing about the growing demand for coal! Arch Coal (ACI) is the second largest coal producer in the U.S. with low-sulfur coal coming from its 18 mines. The stock has been pounded since its high of over $56 in 2006 and now sits at $14.82 (as of the close on December 23, 2011). The current dividend is $0.44, providing a yield of three percent. The good news is that the company has increased its dividend over the past five years at an average annual rate of 20 percent and has increased its dividend for eight straight years. Earnings are rebounding from a low in 2009, but stalled somewhat this year due to economic weakness in the U.S. and Europe. But, barring a collapse of the global economy in 2012, further improvements in earnings should help turn this stock into a good long-term gainer.

I expect earnings per share to continue its advance toward record levels, surpassing the old record $2.45 by 2015. With an historic average price-to earnings ratio of about 20 well-earned again by that time, I expect the share price to hit $50 sometime before 2016. That would turn an investment today of $5,000 into $16,859, a three-bagger. I also expect that the dividends will continue to rise during that period by a more modest annual average of ten percent per year.

The key to demand growth for coal lies in the emerging markets. Demand growth for coal in North America has increased by 50 percent since 1980 to 1.1 billion short tons per year, according to the Energy Information Agency (EIA). The EIA has a great page on its site that uses animated bubble graphing to show the growth of coal demand around the world. The really interesting part of that page shows how coal demand has growth in Asia. Compare the 1.1 billion short tons of use in North America to the use by China of 3.7 billion short tons of coal in 2010. The growth rate for China over the period of 1980 to 2010 was nearly five-fold. China now accounts for almost half of global demand for coal and 73 percent of demand in Asia, followed by India, Japan and South Korea. In total, demand in Asia reached 5 billion short tons of coal in 2010.

In the EIA’s International Energy Outlook report on coal, developed nations demand for coal is expected to remain near 2008 levels, while demand from the rest of the world is expected to increase by 2.1 percent per year through 2035. That assumption relies on alternative energy sources to grow in prominence as sources of energy. We can only hope the agency is right or coal consumption will grow much faster and producers may have difficulty keeping up with demand. In other words, unless alternative energy sources like wind and solar can generate enough electricity to supply the majority of the rising demand from emerging markets, we could see price trends for coal similar to what we are experiencing with oil sometime in the not too distant future. I’d like to think that won’t happen, but I wouldn’t rule it out completely.

Let’s get back to Arch Coal. The acquisition of International Coal Group looks like a winner as Arch should benefit from the huge reserves of metallurgical (met) coal gained. Met coal is used in the steel-making process because it produces higher heat. Met coal also has higher margins. Exports to China, India and South Korea have been running at or near record levels in 2011 and I expect the demand from those markets to continue to expand.

Again, barring a global economic meltdown in 2012, I expect further improvements to Arch’s bottom line. The next five years could be very interesting for owners of Arch Coal; far more interesting than the last five years, in my humble opinion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.