ARCH - Arch Resources: Burned Out Ahead Of Q4 Earnings

Summary

• Arch Resources is set to report its Q4 earnings on February 16th and we highlight the themes to watch for 2023.
• The stock has been a strong performer, although declining coal prices more recently may limit further upside.
• In our opinion, it's a good spot to take profit or move to the sidelines with risks tilted to the downside.

Arch Resources Inc ( ARCH ) was a massive winner in 2022, returning more than 70% over the past year, benefiting from strong coal pricing amid global supply chain disruptions. We last covered the stock with a bullish article back in 2021, highlighting the early financial momentum and its new production capacity coming online supporting a positive outlook. Indeed, many of those themes will be featured in the upcoming quarterly report, likely capping off a record year for cash flow and profitability.

We're believers that the coal industry resurgence is real and view ARCH as one of the best in class. That being said, we also see shares as stretched at the current level with a sense that a correction lower is in the cards. Notably, the price of coal has declined sharply in recent months with many of the tailwinds from last year effectively losing steam. The expectation here is for renewed volatility with risks tilted to the downside.

ARCH Q4 Earnings Preview

ARCH is set to report its Q4 results on February 16th. The current consensus is for EPS of $12.36, a decline of -6.7% compared to the period last year. The setup here considers several moving parts with the period last year representing particularly tough comps with record margins at the time. On the cost side, Arch has faced inflationary pressures on labor and materials over the past year. along with logistical challenges as a recurring theme in 2022

The forecast for total revenue this quarter at $828 million this quarter, if confirmed, would be 3% higher than Q4 2021. Here the theme is that the company is beginning to lap the early ramp-up period from the "Leer South" mine that went online in 2021 meaning slower production growth momentum.

There is also the dynamic of an ongoing shift in the operation away from thermal towards metallurgical or steel markets as part of a long-term strategic plan which has added some volatility to the result on the operating side. Keep in mind that ARCH is also active with hedging activities that have created some swings to its bottom line, both positively and negatively in recent quarters.

Overall, it's important to recognize what has been a very solid cash flow generation environment. In Q3, the metallurgical cash margin per ton at $81.07 was up 35% compared to $59.93 in Q3 2021. The spread on the thermal side was even greater with a Q3 margin of $5.18, up 93% y/y. These trends are expected to continue into the Q4 report. Management offered Q4 guidance suggesting a modest climb in coking coal shipments.

The other update has been the company's generous shareholder distribution policy. In addition to a regular $0.25 per share quarterly dividend, the company expects to distribute 50% of the quarter's "discretionary cash flow", as a separate variable dividend. This is incremental to the other 50% of free cash flow directed toward share buybacks.

In the last quarter, the amount translated to a total payout of $10.75 per share, or $206 million against Q3 discretionary cash flow of $413 million based on EPS of $8.68. It's unclear the level of the Q4 dividend will depend on the final accounting. As an approximation, assuming a similar EPS breakout from Q3, investors can expect a Q4 dividend of above $14.00 with payment data likely in mid-March. Keep in mind that the stock price would naturally adjust on the ex-dividend date.

The effort has been facilitated by a strengthened balance sheet. Arch ended the quarter with $501 million in cash and investment against just $178 million in total debt, which has been reduced from $570 million at the end of 2021.

What's Next for Arch?

For income investors, ARCH is a unique stock where its distribution policy allows it to stand out. At the same time, the setup is hardly a secret suggesting the share price rally over the past year has already incorporated much of the dynamic.

With all indications that Q4 will be another solid quarter, we can start looking ahead for the 2023 trends with the early signs suggesting full-year cash flows and earnings will be lower. Even as the company contracts for deliveries out into the future, in addition to its hedging activities, changing spot coal prices ultimately translates into top-line results going forward.

In this case, the key has been the market volatility, particularly in recent weeks. For context, Appalachia region coal commodity prices , tracked by the U.S. Energy Information Administration are down between -17% and -31% depending on the benchmark just since the end of 2022.

The global themes at play include slowing winter demand from Asia and the easing energy crisis out of Europe. In China, reports suggest the country is resuming imports from Australia, reversing a ban that had been in place since 2020 which has helped supplies. Stepping back, even as global coal pricing benchmarks remain well above the historical average and pre-pandemic levels, it's fair to say conditions are no longer the bonanza that defined most of 2022.

From there, the way we're looking at ARCH is that the company will be challenged to repeat its windfall from 2022 as market conditions normalize. We make a case that there is a downside to current consensus estimates among 2023 EPS of $42.30 the revenue forecast at $3.2 billion.

Even assuming coal pricing can catch a bid and just stabilize at current levels, ARCH loses that backstop of d financial momentum with an expectation for declining earnings going forward.

ARCH Stock Price Forecast

We rate ARCH as a hold but leaning towards the bearish side. The stock is fine, supported by overall solid fundamentals in the near term, but we believe it will be difficult for shares to break out significantly higher without coal prices rebounding sharply.

Into the Q4 earnings, guidance will be closely followed on current market conditions. Cash margins are the key monitoring points. On the downside, the level to watch is around $125 at the stock price which represents an important area of technical support.

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