Arch Coal (ARCH) 18Q1 Update

2018 First Quarter Results. On April 26, Arch Coal reported disappointing 2018 first quarter results. Adjusted EPS for the quarter was $2.95, up from $2.82 last year, but behind the consensus forecast of $4.22.  Revenues declined 4.3% to $575.3 million, $20.4 million below consensus. Total tons sold declined 7.8% to 23.7 million. All three of Arch’s business segments – the Powder River Basin, Metallurgical and Other Thermal suffered volume declines.

Powder River Basin. Despite a normally cold winter season, electric utilities continued to favor alternatives to coal-fired electricity production. Natural gas-fired production continues to benefit from ample supply and low natural gas prices. Steady growth in wind and utility-scale solar generating capacity has helped renewables continue to gain market share. Although total U.S. electricity generation increased 5% in the 2018 first quarter, electricity generated from coal-fired plants dropped 3.6% as coal’s market share declined from 30.7% to 28.2%, according to the U.S. Energy Information Administration.

Arch’s unit sales volume from the Powder River Basin, which primarily supplies thermal coal to U.S. power generators, fell 7.4% to 19.7 million tons. The drop in sales and ongoing roll-off of higher-priced sales contracts helped push its average PRB sales price down 3.3% to $11.15 per ton. Higher commodity costs, mostly for fuel and explosives, more than offset Arch’s cost control initiatives, so that its PRB cash margin per ton fell 38.4% from $2.24 to $1.38. With lower revenues and higher costs, Arch’s adjusted EBITDAR [1] from its PRB operations fell by 42.7% or $20.5 million to $27.5 million.

Metallurgical Coal. Global demand for metallurgical coal remains strong. U.S. producers like Arch have benefited over the past year from increasing global demand for steel and weather-related disruptions to Australia’s coal exports.

Arch sold 14.9% fewer met coal tons in the 2018 first quarter (vs. the 2017 first quarter), entirely due to the sale of the Lone Mountain mining complex in the 2017 third quarter. Weather and supply chain disruptions early in the quarter and loading delays at East Coast ports stalled some shipments in Q1. (Arch estimates that the sale of 100,000 tons of met coal slipped into the second quarter.) In addition, the company ran into geological problems once again at its Mountain Laurel mining complex, which will be resolved by moving a longwall. Strong performance at the Leer mine was a bright spot in the quarter.

Despite the decline in tons sold, Arch’s met coal business realized a 27.7% increase in its average sales price per ton to $115.97 – due in part to Arch’s decision to commit less production to North American fixed price contracts in order to capture more of the higher spot pricing available in the international met coal markets, especially for High Vol A. Although one-offs and the problems at Mountain Laurel helped push its cash cost per ton higher, Arch was still able to realize a record high cash margin of $47.64 per ton, up 43.6% from $33.17 last year. As a result, its metallurgical coal adjusted EBITDAR increased by 22.6% or $15.4 million to $83.7 million.

Other Thermal. Tons sold declined 5.5% to 2.2 million due primarily to delayed shipments from two export vessels (totaling 0.2 million tons). The sales price per ton remained essentially flat at $35.59 due to continuing strength in the thermal coal export markets. Costs per ton increased 19.8% to $28.53, due to lower planned shipment volumes at West Elk (which shifted to less productive continuous mining machines in order to sustain longwall production), higher shipments from the Viper mine and higher maintenance costs at the Coal-Mac mine. With the increase in cash costs, Other Thermal cash margin per ton declined 39.6% from $11.69 to $7.06 and its adjusted EBITDAR fell 42.5% or $11.4 million to $15.7 million.

2018 Business Outlook. As a result of first quarter developments, the company reduced its guidance for 2018 sales volume and increased its expectations for metallurgical sales prices and cash costs. At the midpoint of the ranges, Arch now expects sales volume of 88.5 million tons, down 7.5% from its previous guidance (given on Feb. 13). That would also represent a decline of 9.9% from the 98.2 million tons sold in 2017. Virtually all of the decline from previous guidance is due to lower expected thermal coal sales volume (from the Powder River Basin).

The reduction in thermal coal sales volume guidance reflects a decision by ARCH to pass up spot market and other sales at current prices. Management does not want to accept lower prices merely to meet volume objectives. It believes that its PRB coal reserves are more valuable than the current price around $11 per ton. It says that it is willing to cut production in order to get a better price in the future. Yet, some of the 2018 first quarter increase in inventory occurred in the PRB; so sustaining production there might have only served to push prices even lower. At the same time, we should remember that there is some uncertainty in this guidance and ARCH could ramp up production later in the year if pricing improves.

On the metallurgical side, expected 2018 volumes are little changed at 6.3-6.7 million tons. Management did, however, take down the high end of its previous guidance by 300,000 tons to 6.7 million tons. That decline reflects weather-related delays at East Coast ports during the first quarter and the problems at Mountain Laurel. Although those port delays have passed, ARCH apparently believes that it might not be able to make up for all of the lost first quarter sales.

On the other hand, metallurgical pricing is clearly a bright spot for Arch in 2018. The company’s guidance now suggests that its fixed pricing on committed North American and seaborne sales is now $117.54, up 13.1% from $103.96 in the past three months. A portion of that higher average price will be offset by an expected $4.50 per ton increase in average metallurgical cash costs to 60.00-$65.00 per ton. Although a significant portion of the increase in costs represents “one-offs”, like higher workman’s compensation expense, it appears that Arch is taking advantage of the very favorable pricing by being more aggressive in recognizing certain operating costs.

Meanwhile, the outlook for Arch’s Other Thermal segment – which includes the results of its West Elk (CO), Viper (IL) and Coal-Mac (WV) mines is largely unchanged. Average committed pricing declined only slightly from $36.88 to $36.71 per ton; while expected average cash cost declined by $0.50 per ton to $27.00-$31.00 per ton.

On balance, therefore, the reduced outlook for Arch’s 2018 performance represents lower expected sales and profits in the PRB, offset partially by higher expected cash operating margins in the Metallurgical segment.

Market Dynamics. Arch’s recent performance incorporates domestic and international market dynamics that affect both demand and pricing. The weakness in PRB prices, for example, reflects the continuing decline in demand brought on by 1) low natural gas prices (which favor natural gas-fired power plants), 2) increases in renewable energy capacity (especially wind) and 3) ongoing shutdowns of coal-fired capacity (albeit at a slower pace).

The U.S. thermal coal market has been adjusting to this decline in demand for the past five years, but U.S. coal-fired plants still have excess coal inventories, which is why Arch Coal management has decided to trim production further in 2018. Even so, the adjustment process seems to be nearing an end, so the downward pressure on coal prices should subside within the next year or so.

According to the EIA, electricity generated from coal-fired plants fell at an 8.6% annual rate from 4.33 megawatt hours per day (MWh/d) in 2014 to 3.31 MWh/d in 2017. The annual rate of decline slowed from 14.5% in 2015 to 2.3% in 2017. Coal-fired power plants’ share of the total electricity generation market over that period declined from 38.6% to 30.1%.

Over this same time frame, the U.S. electric power sector’s consumption of coal declined at just under 8% per year from 852 million short tons in 2014 to 665 million tons in 2017. Electric power sector coal inventories peaked at 196 million tons in 2015 and then fell at a 16.4% average annual rate in 2016 and 2017. By my calculations, the sector’s supply of coal inventories peaked at 97 days in 2016 and then dropped to 75 days at the end of 2017. On a rolling 12 months basis at March 31, 2018, I calculate that the sector had 70 days of coal inventory on hand.

In its June Short-Term Energy Outlook report, the EIA projects that coal consumption by the electric power sector will decline by another 5.3% in 2018 and that inventories will fall to 119 million tons or by 13.2% from year-end 2017 levels. That would represent a drop in inventory supply to 69 days, which is where EIA figures suggest it will stay through the end of 2019.

On its first quarter conference call, Arch management confirmed the 70 days of supply as of the end of the first quarter; but characterized it as still too high. Even if 70 days is the bottom, EIA’s forecast, which anticipates another 1.8% decline in electric power sector coal consumption in 2019, suggests that the sector’s coal purchases will bottom at 611 million tons in 2018, down 4.5% from 2017, and then increase by 1.2% to 618 million tons in 2019. If so, that would mark its first increase in coal purchases in more than five years.

In its 2018 Annual Energy Outlook, the EIA reported that net coal-fired power plant capacity declined by 60 gigawatts (GW) or roughly 19% between 2011 and 2016, partly as a result of compliance with the U.S. Environmental Protection Agency’s Mercury and Air Toxic’s Standards. (Because of the decline in natural gas prices over this period, many older, less efficient coal-fired power plants effectively became obsolete and were not worth retrofitting to meet the EPA’s MATS standard.)

The EIA now projects that another 65 GW of coal-fired capacity will be retired between 2017 and 2030 (at an implied average rate of about 4.64 GW per year), due to low forecasted natural gas prices and increasing renewables generation capacity. (The EIA’s “Reference” case anticipates Henry Hub prices of $4.07 per million BTUs in 2025 and $5.01 in 2050.) It sees coal-fired capacity leveling off near 190 GW from 2030 to 2050.

In its “Low Oil and Gas Resource and Technology” case, in which the country produces less oil and natural gas from domestic resources, the EIA anticipates that Henry Hub prices would increase to $6.50 in 2025 and then to $9.40 in 2050. In that case, it projects that coal plant retirements would total 40 GW (or 20 GW less than in the Reference case) to a stabilized level of about 210 GW. With higher natural gas prices, renewables generating capacity would increase at a faster pace, offsetting some of the potential benefit for coal-fired producers.

Said another way: Higher natural gas prices would stall the retirement of coal-fired plants, but also trigger the development of more renewable energy capacity. The price of natural gas is obviously a key consideration for the future of coal-fired electric power.

Futures markets currently anticipate that the price of natural gas will remain below $3.00 per million BTUs for at least the next few years, except during the 2019 peak winter season, when they are expected to rise to about $3.10. The futures markets are apparently anticipating that natural gas supply will continue to outstrip demand and also the capacity to convert it to LNG for the export market. If that forecast is correct, the pressure on coal-fired power plants and coal producers may very well continue.

Still, if natural gas prices remain low indefinitely, coal price levels will still depend to a degree upon the response of coal producers. Recent evidence suggests that Arch and other coal producers will choose to cut production capacity ahead of demand, if necessary, to avoid a continuing slide in the price of thermal coal. Lower volumes would still put downward pressure on the revenues and profits of coal producers, but they would preserve the ability of producers to earn an acceptable return on investments in reserves longer-term.

In contrast to the U.S. thermal market, the metallurgical coal market has continued to recover since the fall of 2016, when international producers were caught flat-footed as China re-entered the market in a fairly big way. Back then, the consensus view anticipated that the spike in met coal prices would not last, because producers would eventually ramp up production to meet demand. However, prices have held up at a higher level than I (and I believe many others) thought that they would.

Although the chart depicts Australian thermal coal prices, it is, I believe, a reasonable proxy for the entire Australian coal market, which is driven primarily by export demand. The second spike in Newcastle prices, which occurred during 2017, was apparently precipitated by weather-related production and shipment delays. One industry source recently reported that Australian supply jitters are continuing, in part due to a regulatory dispute, and Chinese demand for met coal remains strong. Although China has put U.S. coal on a list of retaliatory tariffs, supply shipments may shift – with the U.S. selling more to other countries – to meet continuing strong international met coal demand.

The optimistic outlook for coal exports can also be seen in the API-2 of the ARA Monthly Coal Price Index published in the Argus/McCloskey’s Coal Price Index Report. The API-2 covers coal imported into northern Europe. The chart below shows the June 2018 contract NYMEX futures price. Since its April 26 conference call, when Arch reported that the API-2 price was strong at $80, API-2 has continued to rise, closing at $96.80 on June 18. Assuming that the East coast port delays have been resolved, there should therefore be some upside to Arch’s guidance, even though futures markets suggest that the favorable API-2 pricing will ease to $94 by December and then to $85 by December 2019.

Arch is also more optimistic about the outlook for met coal in the U.S. The Trump administration’s decision to slap a 25% Section 232 tariff on steel has raised the outlook for domestic steel production. U.S. Steel, for example, announced on June 5th that it is restarting the second of two blast furnaces, the “A” furnace, at its Granite City Works. It had announced the start-up of the “B” furnace in March. According to the St. Louis Post Dispatch, the start-up of the “B” furnace is progressing and the “A” furnace should come on line in October. Although it is still unclear how long the tariffs will remain in place and what their long-term impact will be, U.S. Steel by reopening Granite City has apparently concluded that any final solution will be positive for domestic steel producers. The presumed boost in demand will help increase sales and perhaps prices for domestic met coal producers, like Arch.

In the year since Energy Secretary Rick Perry was rebuffed when he asked the Federal Regulatory Energy Commission to force utilities to buy power from coal-fired and nuclear power plants, the Trump Administration has said that it is preparing a similar proposal on national security grounds. FERC and the grid operators, like PJM, say that coal-fired plants are not required to ensure reliability; but some experts believe that they should be included in the mix to ensure resiliency. One argument in favor of coal-fired and nuclear plants is that both store their fuel on site, whereas natural gas-fired plants require just-in-time access to their fuel supply through pipelines. Others note that propping up coal may be costly, but that cost calculation almost always assumes that natural gas prices will remain low [2].

On balance, then, despite the announced cutbacks by Arch on PRB thermal coal production, the U.S. thermal coal market is approaching a supply-demand balance that should soon put a floor on prices. At the same time, the global metallurgical coal market, which has been strong for more than a year, should continue to be strong at least for the balance of the year and probably as long as the global economic recovery continues.

Arch is positioned to sell into market strength, whether domestic or overseas. Although first quarter results were disappointing, management’s guidance seems to represent a floor which the company may very well be able to improve upon as the year progresses. Despite the drop in coal-fired capacity since 2011, plant closures are expected to slow going forward, which should help restore equilibrium to the coal markets. Coal-fired plants still produce about 30% of the nation’s electricity and they will likely remain an important part of the generation mix.

2018-2019 Projections. I anticipate that Arch will post 2018 GAAP EPS of $8.83 and non-GAAP EPS of $9.60, which is within the range of consensus estimates. For 2019, I project GAAP and non-GAAP EPS of $9.86 and $10.17, respectively, which is above consensus. Consensus estimates anticipate that Arch’s 2019 earnings will decline, probably due to expected lower sales volume and lower pricing, especially for metallurgical coal. The difference between GAAP and non-GAAP earnings shrinks significantly from 2018 to 2019 because I am assuming that the amortization of long-term sales contracts will be substantially complete by the end of 2018.

My forecast anticipates that adjusted EBITDA (according to my definition), will remain flat at roughly $347 million in 2018 and 2019, compared with the $394 million recorded in 2017.

My projections anticipate that Arch’s cash and debt will decline slightly in 2018; but that cash will increase by $35 million (to $460 million) and debt will decline by $26 million to $287 million in 2019. Arch’s ratio of debt-to-total capitalization, which does not factor in surplus cash, increases from 31.9% in 2017 to 33.2% in 2018, but then slips back to 29.1% in 2019.

Valuation. At the current price of $77.24 (7/11/18), Arch’s stock is trading at 8.0 times my 2018 non-GAAP earnings projection of $9.60 per share and 7.6 times my 2019 non-GAAP projection of $10.17 per share. Non-GAAP earnings are consistent with the company’s definition, which excludes amortization of sales contracts, non-operating pension costs, and reorganization items.

That 2018 forward earnings multiple is roughly consistent with Arch’s peer group (for those companies that are projected to have earnings). However, my 2019 projection anticipates an increase in earnings, whereas the consensus view continues to expect lower earnings for nearly all companies in the peer group. Consequently, my 2019 forward earnings multiple is below the peer group average. By my calculations, the peer group is trading at an average forward earnings multiple of 9.0 for 2018 and 11.1 for 2019.

Natural resource companies often trade at below market multiples because they regularly bear the cost of replenishing reserves. Coal companies, however, are trading at a greater than normal discount because they are seen as being in a continuing state of decline.

If the U.S. thermal coal market reaches equilibrium over the next 18 months, as I anticipate that it will, and the global metallurgical market holds its ground, then coal company earnings should at least level off or perhaps even show improvement in 2019. That is the basis for my 2019 forecast for Arch, which anticipates a modest increase in Arch’s EPS. If that happens, I believe that investors will bid up the multiples on U.S. coal companies from their current exceptionally low levels. Based upon projected 2019 adjusted EPS of $10.17 and an anticipated multiple of 11, my 2019 price target for Arch is $112, which represents an increase of 45% from the current share price of $77.24.

[1]  Adjusted EBITDAR is defined as net income attributable to Arch before the effect of net interest expense, income taxes, depreciation, depletion and amortization, the amortization of sales contracts, the accretion on asset retirement obligations (AROs), and reorganization items, net. I adjust Arch’s EBITDA further by including the other gains/losses on dispositions, cash impairment/mine closure costs and annual cash settlement on AROs. ARO settlements are provided only on an annual basis, probably because the settlement is not disclosed quarterly and probably completed during the fourth quarter each year.

[2]  “The Losing Proposition of Propping up Coal, WSJ, June 7, 2018, p.A2.

July 11, 2018

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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