2 Reasons Why I've Chosen To Avoid Arch Coal In The Wake Of A Recent Downgrade

| About: Arch Coal (ARCH)

On Tuesday, October 9, analysts at Goldman Sachs downgraded shares of Arch Coal, Inc. (ACI). The firm lowered its rating on the stock from a Neutral to a Sell and set a $5.00/share price target. As a result of the downgrade (which has had seemingly no effect on the stock), shares of ACI reacted quite nicely trading up as much as 2.25%. It should be noted that Goldman Sachs had this to say about Arch Coal:

"The firm sees ACI as overvalued given weak liquidity and even weaker returns. We expect ACI to lag as it is forced to cut met coal growth guidance on insufficient FCF after various debt pay downs, and declines in its weaker-quality coal."

In the wake of the Goldman downgrade, I wanted to examine the company a bit further and take a look at how it compares to some of its industry-based peers. There are two companies within the coal sector I chose to compare with Arch Coal, Inc., and they are James River Coal (JRCC) and Alpha Natural Resources (ANR). I've chosen to compare and demonstrate how Arch Coal outpaces Alpha Natural Resources in terms of margins and to compare and demonstrate how Arch Coal outpaces James River in terms of returns on both assets and equities. Why have I chosen these particular companies? To demonstrate the fact that although Goldman is placing a sell rating on ACI, I think there are a few fundamental reasons to avoid the company as well.

Overview: Arch Coal, Inc.

"Arch Coal, Inc. engages in the production and sale of steam and metallurgical coal from surface and underground mines located in the United States. As of December 31, 2011, it operated or contracted out the operation of 46 active mines, and owned or controlled approximately 5.33 billion tons of proven and probable recoverable reserves. Arch Coal, Inc. was founded in 1969 and is headquartered in St. Louis, Missouri."(Profile: Yahoo Finance).

Margin Comparisons

As a whole, I've found that the coal sector has one of the widest ranges of profit margins when compared to some of the other industries I've written articles on. In the last 12 months, Arch Coal has managed to demonstrate a profit margin of -7.83%, whereas direct competitor Alpha Natural Resources has demonstrated a profit margin of -36.81%. If we examine those numbers a bit closer, we'll notice that Arch Coal has outpaced Alpha Natural Resources by a ratio of 4.70 to 1, which, in my opinion, represents a very positive catalyst for those looking to establish a position within the company.

As we move on to operating margin comparisons, we'll notice that the ratios are also very similar. In the last 12 months, Arch Coal has managed to demonstrate an operating margin of 7.25%, whereas direct competitor Alpha Natural Resources has demonstrated an operating margin of 2.21%. If we examine those numbers a bit closer, we'll notice that once again Arch Coal handily outpaces Alpha Natural Resources by a ratio of 3.28 to 1.

Would I consider a position in Arch Coal based on the company's recent margin comparisons, in the wake of the Goldman Sachs downgrade? Although the company's profit and operating margins are somewhat solid, Arch Coal still makes me a bit cautious from this perspective. Why? Even though both profit and operating margins outpace Alpha Natural Resources, I'd be a bit more comfortable if both percentages were a bit more positive and higher than 10%. At this time and based solely on those comparisons, I'd consider a small position in the company.

Returns on Assets and Equities over the Last 12 Months

In the wake of a very mediocre showing on the part of Arch Coal, in terms of both profit and operating margins, there is one more comparison to examine, and that is the return on both assets and equities Arch Coal and direct competitor James River Coal have demonstrated over the last 12 months. Arch Coal managed to demonstrate a return on assets of just 2.04%, whereas James River managed to demonstrate an even poorer return on assets of -0.36% (which was outpaced by ACI 5.66 to 1).

A similar comparison can be said of these companies in terms of returns on equity, even though both have demonstrated negative numbers. In the last 12 months, Arch Coal has managed to demonstrate a return on equity of just -10.59%, whereas James River only managed to demonstrate a pretty dismal return on equity of -18.12%. Even though both numbers demonstrate a clear need for improvement, Arch Coal does in fact outpace James River by a ratio of 1.71 to 1.

Do ACI's returns on both assets and equity strengthen the case for potential investors to establish a position? I really don't think they do, and if anything those numbers actually make me more cautious than I was before. If we consider the fact that Arch Coal has managed to demonstrate poor returns on top of even poorer margins over the last 12 months, we'll notice there really isn't much the company can do to substantially improve those numbers.

Final Analysis

Are there any positive catalysts ahead for potential investors of Arch Coal? There are a few factors to keep in mind before establishing a position in ACI. According to my fellow contributor Jonathan Verenger, there are four very viable reasons to establish a position within the coal sector, and more specially companies such as Arch Coal, Inc. He says that we should "look at what has happened over the past year which is laying the groundwork for a massive rally in coal stocks":

(1) Shale gas economics have been called into question which could support much higher nat gas prices.

(2) Coal producers have drastically cut back production.

(3) Electricity demand has returned to normal just in time for winter season.

(4) Demand from India, China and other emerging countries continues to expand.

Should potential investors consider a position in Arch Coal given the weak fundamentals of the company and Verenger's positive outlook on the sector? No. Based the comparative analysis I've presented, which demonstrates the fact that ACI's margins and returns need room for improvement, I'd remain very cautious on the company and the sector as a whole. In my opinion, I'd want to see how both the emerging markets and the reduction pan out before establishing a position.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.