On October 5, Arch Coal officially exited the bankruptcy process. The exit came just short of nine months after it had filed for bankruptcy on January 11, 2016. This was a remarkable achievement, given the company’s size, the large and diverse creditor group and the downturn in the coal industry, which under the plan required unsecured creditors to accept a 98% loss on their claims.
According to my estimates, unsecured bondholders received for each $1,000 face amount of debt roughly $7 in cash, 0.45 shares of new Arch Coal common stock (NYSE:ARCH) and 0.57 warrants to purchase new Arch common at a strike price of $57 per share.
Under the bankruptcy plan, the reorganized company was anticipated to have an enterprise value of between $650 million and $950 million. Excluding an estimated $360 million of debt (pro forma as of Sept. 30), Arch’s reorganized equity value is $290-$590 million. At the high end of that range, I estimate that the stock was anticipated to be worth about $23.60 and so the package of cash and securities received by unsecured bondholders represented a recovery of about 2% of their claims.
In fact, the stock was worth much more than that original estimate. It opened on Oct. 5 at $70 and fell steadily throughout the day, closing just off its low at $63. Since then, the stock traded between $60 and $80 until Nov. 9, when it spiked higher after the company filed its 2016 third quarter 10-Q. (That filing provided additional information, including up-to-date financial statements and details about the specific terms of securities issued under the bankruptcy plan that were not in the court documents.)
As a result of the higher-than-anticipated share price, the recoveries to unsecured bondholders have improved over those given in the bankruptcy plan. I estimate the old and new recoveries as follows: (Please note that I am estimating the value of the warrants because they are not traded on an exchange and I do not have access to quoted prices from broker-dealers.)
Subsequent to the 10-Q filing, the stock reached an intra-day high of $86.47 on Nov. 14 and then sold off sharply. It closed the week (on Nov. 18) at $72.67, down nearly 16% from the recent high.
Since emerging from bankruptcy, daily trading volume in new Arch common has averaged just over 800,000 shares or about 3.8% of its outstanding float of 24.6 million shares. Average daily trading volume for most stocks is well under 1% of shares outstanding, so the heavier trading in Arch most likely represents liquidation of shares by distressed investors. At Friday’s closing share price, I estimate the recovery of investors in Arch’s bank debt exceeds their claims. Likewise, I estimate that the package of cash, stock and warrants received by unsecured bondholders is now worth about 6 cents on the dollar, much higher than the 2 cents estimated in the bankruptcy plan.
Consequently, it is not surprising to see liquidation by investors, many of whom probably bought their bank loans and unsecured bonds at much lower prices. These distressed investors would be looking to cash out of their investments at a nice profit in order to move on to the next distressed investing opportunity, even if Arch’s stock still has good long-term upside potential.
This week’s decline in the share price, however, was not due simply to exiting distressed investors. Like the share prices of all coal producers, Arch’s share price has been driven recently about optimism of a recovery in the coal sector, both from rising prices for coal (especially metallurgical or met coal) in overseas markets and also by the election of Donald J. Trump who has promised to end the war against coal and put the industry back on its feet.
The chart above shows the price for the May 2017 contract for Newcastle (Australia) coal, as quoted on NYMEX. The Newcastle price moved steadily higher during most of 2016, but it has fallen precipitously over the past seven trading sessions, from a peak of $74 per ton on Nov. 9 to $58.05 on Nov. 18.
This year’s price rise was driven by increased buying by China and a temporary shortage of supply, since coal producers could not easily meet a sudden sharp increase in demand after scaling back operations to cope with the industry downturn. I wrote about this issue in a previous post on Oct. 31. Futures prices in all major overseas markets now expect prices to fall over time.
Trading volumes in many of these contracts are light or non-existent and a correction should be expected after such a big run-up in prices, so it is possible that the setback could prove to be temporary. However, the primary driver of the industry downturn has been low natural gas prices. Recent optimism about a potential recovery in natural gas prices has faded at least temporarily in the past few weeks as the price of natural gas has fallen from a peak of $3.37 on Oct. 13 to $2.84 on Friday (11/18).
In an article released on Friday, the U.S. Energy Information Administration predicts that coal’s share of electricity production will exceed natural gas’s share in December, January and February. The author bases that claim on a return to normal temperatures this winter (following last year’s unusually warm winter weather). Last year, when heating demand fell, so did natural gas prices; so power producers opted to run proportionately more of their natural gas-fired power plant capacity. Thus, natural gas-fired power plants increased their share of the electric power production market.
With the recent declines in natural gas production and the start of LNG exports, natural gas prices are expected to rise back above $3.00 per million BTU. Along with a return to normal weather, power producers will begin to switch proportionately more of their production to coal-fired plants.
Yet, the EIA expects that this will be a gradual process. Despite a projected 25% rise in the Henry Hub benchmark price to $3.22 per million BTUs, the EIA forecasts that coal production will rise only 2.8% in 2017 and coal consumption will increase only 1.9%. This would be disappointing in my view, considering that decline in coal production in 2016 is likely to be about 17%.
Coal consumption will continue to run ahead of production, however, so inventories are projected to fall to the low end of their long-term historical ranges by the end of 2017. If inventories hold steady, production would increase by 5% rather than the 2.8% in EIA’s current forecast.
Despite the modest anticipated improvement in industry demand, Arch should see a meaningful boost in its performance next year as well as a return to profitability. According to my projections, the company will report a fourth quarter loss of $0.52 per share, excluding fresh start accounting adjustments, which is a big improvement over the previous year’s estimated $8.50 per share loss, excluding impairment charges. My 2016 fourth quarter projection does not include fresh start accounting adjustments, especially an estimated non-cash net gain of $2.6 billion (or more than $100.00 per share) from the cancellation of liabilities and write-down of assets due to fresh start accounting.
That write-down of assets will lower Arch’s depreciation, depletion and amortization expense going forward, which will allow it to return to profitability. For 2017, I am projecting that Arch will earn $5 per share, mostly from a $200 million reduction in DD&A expense. My projection also assumes a 3.5% increase in revenues and a 350 basis point increase in cash operating margin to 18.6%, mostly due to operating efficiency gains from higher selling volumes.
I also anticipate that Arch will generate EBITDA of $144 million in 2016 and $216.5 million in 2017, which is well above its April 2016 forecast of $102 million and $140 million, respectively. Arch generated EBITDA of $81 million in the 2016 third quarter and $53 million (after deducting $10 million of cash mine closure costs) for the nine month period, so I do not believe that my EBITDA projection of $91 million for the 2016 fourth quarter is much of a stretch.
If my forecast is on target, then Arch’s stock, at its current price of $72.67 is trading at 14.6 times projected 2017 earnings and its market capitalization is equal to 10 times projected 2017 EBITDA. Its valuation is therefore below the market average, but not dirt cheap. It is also attractive considering the long-term upside earnings potential, as natural gas prices move back toward (and above) $4 per million BTUs. Although the stock fell sharply this week, I would be surprised if it fell significantly from here.
November 20, 2016
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
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