Many investors are quick to discount the secular trends in coal. In my view, however, this resource is about to experience one of the most shocking bull runs over the next few years. In this article, I will run you through my DCF model on Arch Coal (ACI) and then justify the result with an exit multiple calculation and a review of the fundamentals compared to Peabody (BTU) and Alpha Natural Resources (ANR). I find that these companies are significantly discounted to intrinsic value.
First, let's begin with an assumption about the top-line. Arch Coal finished FY2011 with $4.3B in revenue, which represented a 34.5% gain off of the preceding year. This was an acceleration off of the 23.6% growth experienced in 2010. I model growth trending from 10% to 21% over the next six-year period.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures and taxes. I expect cost of goods sold to eat up 77% of revenue versus 3.1% for SG&A and 10 - 13% for capex. Taxes are estimated at around 12% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model).
We then need to subtract out net increases in working capital. I model that this will hover around -0.1% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $14.31, implying 40.7% upside. With that said, any DCF model for Arch Coal is not very reliable. My sensitivity analysis that considers a variety of perpetual growth rates and WACC inputs yields a standard deviation of $4.81. This represents more than a third of the intrinsic value.
All of this falls within the context of strong investments:
"2011 was a transformative year for Arch Coal as we executed on our long-term growth plans that boosted our reserves by 1.3 billion tons, added low cost productive capacity in our core operating basins, and expanded our reach into the global coal arena. To that end, we deepened and broadened our met coal profile with the acquisition of ICG. Facilitated continuing penetration into the overseas market with new offices in Asia and Europe, and bolstered our port access along the East, West and Gulf Coast. All supporting our objective of delivering even stronger financial returns in the years ahead."
From a multiples perspective, however, my DCF model is justified. Arch Coal trades at just a respective 13.8x and 8.5x past and forward earnings versus corresponding figures of 7.7x and 6.6x for Peabody and 64.2x forward earnings for Alpha Natural. Assuming Arch Coal maintains its multiple and yields a conservative $1.03 per share in earnings, the stock would hit $14.21 - in-line with my DCF result.
Consensus estimates for Peabody's EPS forecast are that it will fall by 24.5% to $2.84 in 2012 and then grow by 51.1% and 10.7% in the following two years. Assuming a multiple of 11x and a conservative 2013 EPS of $4.19, the stock would hit $46.09, implying 63.2% upside. Yes, 15 of the last 17 revisions to EPS fell for a net change of -12%, but the fundamentals are still strong given emerging market growth. Management has significantly increased exposure to met coal and placed greater focus on China. China already accounts for nearly half of global steel output, so this is a risky bet. With that said, the bar really has been set low.
Consensus estimates for Alpha Natural are is that it will suffer an earnings loss of $0.29 per share and then turn positive in 2013, hitting above the half-dollar mark in 2013. I see the company more as a short-term play off of the gains in Peabody and Arch Coal. I believe that the company could be a takeover target given the revenue synergies that would be unlocked from greater scale.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.