Arch Coal (ARCH) 18Q1 Results

Arch reported 18Q1 diluted EPS of $3.91, up from $2.75 in 17Q1 and well ahead of the consensus estimate of $2.71.  The gain in earnings came despite a 3.5% decline in revenues to $555.2 million, primarily because of lower expenses and ancillary items, including lower depreciation, an increase in the fair value of coal derivative contracts, lower amortization of acquired sales contract costs and lower selling and administrative expenses, partially offset by lower other operating income. Yet, Arch’s adjusted EBITDA (according to my definition) did improve from $101.7 million to $105.0 million, due entirely to cost management.

Although conditions in the thermal coal market remain challenging, Arch is upbeat about its future prospects, primarily because of its favorable outlook for metallurgical coal.  Cash margin on metallurgical coal increased from $83.6 million (or $47.64 per ton) in the prior year quarter to $91.4 million (or $50.95 per ton).  Met coal volumes were flat at 1.8 million tons, but the average sales price increased 1.9% to $118.22 per ton and average costs declined 1.6% to $67.27 per ton.

The met coal market is being supported by strong global demand for coking coal (used to make steel).  Arch’s met coal profits are buttressed by the strong competitive position of its Leer mine, which is located in West Virginia.  Leer has 30 million tons of recoverable reserves, accessible through long wall production, with an average seem thickness of 5-6 feet, a 1,400 tons-per-hour processing plant and a direct transportation hook-up with the CSX railroad. Leer produced 3.5 million tons of High Vol A coal in 2018 and its production is sold out for 2019. Arch is looking to open a second mine, Leer South, at the same location by 2021.

The cash margin increase at Arch’s met coal segment was more than offset by declines in its Powder River Basin and Other Thermal businesses, due in large part to heavy rains experienced last year which spoiled coal stockpiles and interrupted rail traffic.  Cash margin at the PRB fell from $27.3 million to $20.4 million, while Other Thermal fell from $15.3 million to $5.6 million.

Despite the decline, management is sanguine about its prospects in thermal coal.  It believes that the multi-year decline in power plant coal inventory stockpiles is at an end and while it expects that power plants will burn less coal over time (declining about 1.0%-2.0% each year), it anticipates acceptable performance from the PRB because of the quality of its coal and its low production costs.

Barring a major downturn in the met coal sector, Arch’s strong financial position gives it staying power.  On the conference call, management noted that the company has bought back roughly one-third of its outstanding shares over the past few years, including $78.3 million in the first quarter, and its board has authorized the purchase of another $300 million worth of shares.

Arch finished the quarter with $383 million of cash on its balance sheet and about $100 million available under its bank credit lines for total liquidity of $490 million.  Its ratio of debt-to-total capitalization at quarter’s end remains low at 30.9%  It has more cash than debt – $383 million vs. $266 million- and its ratio of debt-to-adjusted EBITDA (my definition) is only 0.6 times.

On the day of the release of the better-than-expected first quarter results, the stock gapped up sharply at the open and closed the session up 9.1%.  Although it has so far held on to that gain, the odds are (in my view) that the stock will fall back, retracing that gap in the weeks ahead.

Even so, I believe that ARCH remains a good long-term holding and a hedge against a potential spike in oil and natural gas prices.  Its dividend yield, though not as attractive as it was a couple of years ago, is still respectable at 1.8% and the company should continue to have the capacity to increase it going forward. Despite the stock’s gains over the past couple of years, it is still cheap to the overall market, trading at less than 7.0 times 2019 projected earnings and 10 times projected 2020 earnings. Likewise, its enterprise value-to-EBITDA multiple is just 4.7 times.

April 29, 2019

Stephen P. Percoco
Lark Research
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