Arch Coal Looks Attractive At Current Levels

| About: Arch Coal (ARCH)

Recent Trends Overview

Arch Coal (ACI) engages in the production and sale of steam and metallurgical coal from surface and underground mines throughout the United States, with primary operations in the both the Powder River Basin and Appalachia. The Company closed its purchase of International Coal Group (ICG) in 2011, which greatly expanded the Company’s reserves of met coal in the Appalachians, although at a high price. The Company clearly believes that the long-term trend in met coal will result in significantly higher coal prices in the future. Additionally, on December 30, 2011, the Environmental Protection Agency's Cross-State Pollution Rule was delayed by the U.S. Court of Appeals D.C. Circuit. The reason cited for delay was to further review of the regulation. This should further delay the retirement of the nation’s older coal plants, which should lead to short-term higher demand for the Company’s profits.

Investment Rationale

The Company earned approximately 73 cents over the trailing 12 months and we expect this to increase to $1.97 in calendar 2012. The Company’s recent results were adversely affected by nearly $120MM in costs related to the ICG acquisition, significant flooding in the Midwest which limited sales from the PBR (down 20% compared to YoY quarter), and production delays at the Company’s Mount Laurel mine per the most recent 10-Q. At a normalized run rate, we conservatively expect the Company to earn 25 cents in the 4Q, assuming some continued difficulties with the Company’s Appalachian mines and further integration costs associated with the ICG merger. Our $1.97 estimate for next year assumes normalized production of 138,600 tons at PBR, 32,000 tons in Appalachia (with improved product mix due to heavier met coal mix), and about 17,000 tons of Western Bituminous, which represent 5% increases over the actual 2011 normalized run-rate. Aside from normalized production, 2012 profits are also boosted by the fact that the company has locked in a significant portion of its 2012 production at favorable prices compared to 2011 prices (increase of 5-7%) – most of this price increase should flow directly to the bottom line. Given that 2011 costs were higher than the Company has generally experienced due to some of the production issues noted above, we expect the cost per ton to modestly improve in 2012 as well.

Additionally, the Company pays a 3% dividend while you wait for the investment thesis to pay off.

Key Risks

Risk number 1: In order to fund the ICG transaction, the Company greatly expanded its debt burden, nearly doubling its quarterly interest payments to $77MM, resulting in the Company having a capital structure significantly higher (52% debt) than observed historically and preferred by the Company (<40% as stated on the recent quarterly earnings call). Given that the Company has stated its intention to reduce its financial leverage in 2012, and given that a majority of 2012’s pricing is locked in, we think that this is a limited risk to the Company’s financial performance.

Risk number 2: Sales may not be as robust as we expect either as a result of continued production challenges or global economic weakness. Based on the Company’s 3Q conference call, we believe that many of the 2011 challenges are not systemic events, and given that production at Mount Laurel has resumed, we think that future delays will now exceed the 45 days of down-time observed in the 3Q. As for the global economic climate, this is a serious concern for the longer term horizon; however, given that the most significant economic weakness is currently expected in developed countries with a lower coal fuel mix compared to BRIC and other developing countries where the Company is looking to export a significant component of its thermal coal, met coal prices should remain acceptable given forward pricing. Long-term demand remains strong based on EIA's 2011 Energy Outlook of 2.1% annual growth in non-OECD countries. Some of the pricing risk is reduced due to the effect of the delay in the implementation of the EPA’s Cross-State Pollution Rule.


We initiated a position at 14.98 on 1/6/12 with a target price of $25. Other significant coal mining companies that you may want to consider include Patriot Coal (PCX), Peabody Energy (BTU), and Alpha Natural Resources (ANR).

Disclosure: I am long ACI.