Arch Stock May Easily Double, Ditto For Consol And Patriot

| About: Arch Coal (ARCH)

While I have generally been most bullish on natural gas resources, coal resources are also substantially undervalued. Investors remain all too bearish on future industrial activity and, as a result, have kept one of our top energy sources at low prices. The Dow Jones U.S. Coal Index is worth nearly one-third of its 52-week high. The last time the index was around this cheap, shareholders virtually tripled their returns up until the recent high. In my view, there is little reason to doubt that the index will return to that April 2011 high as the global economy moves towards full employment.

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Source: Google Finance

Moving onto specific stocks, I find Arch Coal (ACI) to be substantially undervalued. Patriot Coal (PCX) and CONSOL Energy (NYSE:CNX) also have very favorable risk/reward. Let's first consider Arch.

Source: Internal research. Note: Arch's EPS over the past 5 years.

Arch has lost more than one half of its value over just three short months. This, again, appears to be overblown. If you take a logarithmic regression of EPS over the last decade, you would extrapolate 2016 EPS to be $1.77. This is the level of earnings that the company was producing near the economic collapse.

In order to make any sense out of my 2016 EPS projection, we need to make an exit multiple calculation that is appreciative of peer levels and the past. The 5-year average PE multiple of Arch is 35.8x versus the 14.1x current multiple. On the other hand, the firm's PE multiple is 24% more than its industry's. Multiplying my 2016 EPS projection by a conservative PE multiple of 11.5x yields a future value north of $20 ($20.36). Discounting backwards by an aggressive WACC of 12% yields a bearish target price of $11.56 for nearly a 100% minimum margin of safety. Yes, coal is risky, but the market seems to be factoring in a WACC of 27.5% for Arch - highly absurd given the context of a macro turnaround.

CONSOL Energy is even cheaper than Arch on a multiples basis and even offers a 1.8% dividend yield. What makes CONSOL also attractive to me is that it is diversified in natural gas, which is also at a historical low and supported by positive secular trends. Natural gas, in my view, will eventually become the #1 energy source in America given foreign policy, environmental, and economic efficiency concerns. At the same time, CONSOL has also done well hedging against risks in the Marcellus and Utica by reaching deal with reliable partners. Strong execution also enables the firm to have a powerful position at the bargaining table when it comes to selling volatile assets.

In any event, the market also appears to have overreacted to poor first quarter results. Weak performance then was an isolated event and contrasted by the fact that management beat expectations by an average of 10% in the preceding two quarters.

Patriot Coal is riskier than CONSOL and Arch given how it burned $50M worth of free cash flow in FY2011, which is 43% of its market value. It also has a shaky history of losses in 2002, 2003, 2006, 2007, 2010, and 2011. The firm is 200% more volatile than broader indices, but this sets the tone for substantial appreciation if coal prices head to where I expect them to.

Patriot lost more than four-fifths of its value over the last three months (with the bulk of the losses occurring in just the last month). Relative to peers, the erasure of market value was more than warranted: CONSOL and Arch fell by 17.6% and 51.5%, respectively. I feel that this was overblown given that first quarter results were a 21.1% miss versus 25% for CONSOL and 123.5% for Arch. The Street actually predicted a profit of $0.17 per share in Arch, and the firm yielded a loss of $0.04.

Even though Arch, CONSOL, and Patriot produced disappointing returns in coal, the secular trends are still pointing upwards. Investors who are willing to take on the supposed risk are likely to accrue abnormally-high risk-adjusted returns. And as my near conservative 100% margin of safety calculation for Arch shows (to say nothing of the absurd 27.5% WACC the market is factoring), coal has very favorable risk/reward.

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.