ARCH - Arch Resources: A High-Quality Metallurgical Coal Producer Still Waiting For The Dip

2023-07-17 04:26:24 ET

Summary

• Arch Resources is cheap with a forward-looking price/earnings ratio of around 4, even if that is up somewhat from last year.
• The net debt is now negative, so the balance sheet has improved drastically for the company over the last couple of years.
• ARCH stock is committed to returning 100% of discretionary cash flow to shareholders in the form of dividends and buybacks.

Investment Thesis

Arch Resources ( ARCH ) is a U.S. coal mining company, which produces metallurgical and thermal coal. The company has historically had more exposure to thermal coal but does today get most of the adjusted EBITDA from the metallurgical coal segment. The vast majority of CAPEX is also spent in the metallurgical coal segment, so the contribution from thermal coal will continue to decrease in the future.

Metallurgical ("coking") coal is often used to create coke, which is a fuel used in blast furnaces when making steel. So, the demand for metallurgical coal is relatively closely linked to the industrial demand for steel.

The stock price of Arch has had an impressive runup from the lows in the 2020 but has lately declined from the highs seen in early 2023, due to lower thermal coal and metallurgical coal prices.

A part from lower energy prices, the slower growth in China and certain industrial segments globally has likely impacted the sentiment for Arch Resources. However, the stock is still attractively priced based on forward earnings.

Quality Characteristics

There is a lot to like about Arch Resources, where the company has deleveraged substantially over the last few years. The net debt is now negative, and the debt-to-equity ratio is only at 11%.

Arch has, despite the focus on deleveraging, also managed to return substantial amounts of capital to shareholders in the form of regular & special dividends, and buybacks. The company is currently committed to returning 100% of discretionary cash flow to shareholders, where 50% is expected to be in the form of dividends and 50% in the form of buybacks. Discretionary cash flow is defined as cash flow from operating activities after contributions to the thermal mine reclamation fund and less capital expenditures.

CAPEX is relatively modest for the company, which means a substantial portion of operating cash flow is distributed to shareholders.

The figure below is rather instructive, where we can see that while Arch has much of the production volume coming from thermal coal segment and almost half of revenues in 2022, the better part of adjusted EBITDA is coming from the higher margin metallurgical coal segment.

This is not just in 2022, the percentage of adjusted EBITDA coming from the metallurgical coal segment has consistently been above 70% over the last 5 years.

Coal Prices

Both metallurgical and thermal coal prices have been declining lately, where the chart below illustrates the price for Newcastle Coal over the last 5 years, where we are far off the highs seen during the peak of the energy crisis last year.

However, Arch has locked in prices for most of its thermal coal production during 2023, at a level which will generate a healthy margin, as illustrated in the figure below. The company does however, as of Q1-23, have much of the production from the metallurgical coal segment exposed to market fluctuations.

Valuation & Conclusion

Most coal producers do today have strong balance sheets following the good prices lately and are trading with very low valuations. The low valuations are likely partly due to the cyclical nature of the business, but primarily because of the perception coal has today. Many have the same perception of metallurgical coal as thermal coal, even if the use case is somewhat different.

When it comes to thermal coal, which is typically used for electricity generation, I certainly prefer natural gas to be used over thermal coal and nuclear to be used over natural gas. However, there is very little doubt that electricity generation will continue to grow in the future and more of all sources are likely to be needed, at least in the near term.

The below figure illustrates the historical and forward-looking Price/Earnings and EV/EBITDA ratios for Arch Resources and a few peers. Here we can see that they are all cheap, with forward-looking Price/Earnings ratios in the 3-4 range, but none of them stands out substantially.

I have a slight preference for Arch Resources due to the high percentage of earnings coming from the premium priced metallurgical coal segment, where at least the long-term demand picture has the potential to be better than for thermal coal.

While I like Arch Resources following the recent retracement in the stock price, I would need to see even more downside before adding it to the portfolio, given the somewhat precarious global economic situation and consequently the potential demand for metallurgical coal.

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