ARCH - Arch Resources Vs. Alpha Metallurgical Resources

2024-01-14 04:05:42 ET

Summary

• Alpha Metallurgical Resources is the largest MET coal producer in the US, expected to produce 16M tons of MET coal in 2024.
• Arch Resources is another coal mining company in the US, likely to produce 9M tons of MET coal and 65M tons of thermal coal in 2024.
• Both companies are attractively valued, despite strong price performance lately, but Arch is the cheaper unless we see consistently very high MET coal prices.

Overview

Alpha Metallurgical Resources ( AMR ) is the largest metallurgical ("MET") coal producer in the United States. The company is expected to produce about 16M tons of MET coal in 2024 and roughly another 1M tons of thermal coal as a byproduct. The last thermal coal mine was closed last year, so AMR is now a pure-play MET coal producer.

Arch Resources ( ARCH ) is another coal mining company in the United States. The company has yet to provide official guidance for 2024, but did on the Q3-23 conference call provide some indications on what we can expect for 2024. The company is likely to produce 9M tons of MET coal and about 65M tons of thermal coal in 2024.

Purely based on production numbers, one might be fooled into thinking ARCH is more impacted by thermal coal sales. However, most of the thermal sales are done in the domestic market due to poor rail service to export terminals. The thermal coal margin is lower in general, but significantly lower in the domestic market.

The above figure on ARCH is constructive, where we can see that 74% of EBITDA came from the MET segment in 2022, even though most of production came from the thermal segment. In the chart below, we can also see that the adjusted EBITDA contribution from the MET segment has increased to 80-90% for ARCH in 2023, due to diverging MET and thermal coal prices over the last year.

So, in this article, I wanted to compare two of the largest MET coal producers in the United States, which have done very well over the last few years. I have covered these stocks a few times in 2023 and those articles can be found here .

Thermal Segment - Arch Resources

The thermal segment at ARCH gets relatively little attention. The expectation is that the local demand for thermal coal will eventually disappear. So, the company keeps the capital investments very low in this segment, but the sales volume have held up reasonably well over the years even if we have seen some declines compared to 5 years ago.

Most of the sales are done on slightly longer contracts, which makes the profit in the segment less volatile, and we have seen a small consistent positive margin over the years. I have in 2024 assumed 65M tons of sales and a margin of $1.5/t, which equates to about $100M in gross profit. So, the contribution to total estimated EBITDA or cash flow is low, but it is expected to produce a decent boost to ARCH's cash flows, which could be very welcomed if MET coal prices were to decline throughout the year.

MET Segments

ARCH and AMR have very healthy reserves and resources, the mines life is on average around 20 years for the various MET coal mines for both companies.

The types of coal is more diversified for AMR compared to ARCH, which primarily mines High-Vol A. However, despite slightly different types of MET coal, the realized sales figures in $/t have over the last few years been relatively similar for the two companies.

Both companies are at the current MET coal prices making extremely good margins, but ARCH has lower operating costs in the MET segment, despite some operational challenges with the Leer South mine over the last year.

Performance

ARCH has performed reasonably well over the last 6 months and over the last 5 years, as illustrated by charts below. That is due to a combination of a very low valuation, solid cash flows, increasing MET coal prices, and buybacks. However, AMR has dwarfed the returns of ARCH, over just about any time frame.

The stellar returns of AMR is due to the same factors as ARCH, but AMR has on top of that been much more aggressive with the buybacks. Both companies have distributed 100% of free cash flow to shareholders for a couple of years now, but AMR has used just about all of the cash flows for buybacks, while ARCH has also relied on dividends. From Q4-23, ARCH will use 75% & 25% of free cash flow to buybacks & dividends.

Another often overlooked point is that AMR has had a cleaner share structure and consequently been buying back common shares and directly impacting the free float.

ARCH has had warrants and convertibles that the company has instead focused on buying back recently. That was no doubt the right choice for ARCH, as it has decreased the diluted share count more than what the impact would have been buying back common shares, but the effect on the free float and consequently the share price has been less impactful. With that said, in 2024 and onwards, the ARCH buybacks will be directed towards the common shares as well.

Valuation

The following free cash flow estimates are based on the assumptions mentioned throughout this article, the 2024 guidance for AMR, and my estimates for ARCH in 2024. Diluted shares have been used for both companies and I have relied on financials as of Q3-23.

The chart illustrates free cash flow yields at various MET coal prices for the two companies, with ARCH in green and AMR in blue.

Both companies are cheap, with free cash flow yields in the 15-30% range, but ARCH is at least in my view the more attractive company based on valuations. The free cash flow yield is similar for the two companies at a realized sales price of $230/t in the MET segment.

Now, we did see both companies achieve a higher price than that in H1-22, as illustrated by figure 6, but that is a rather aggressive price assumption to use for the valuation. The Australian coking coal price index is presently at a very healthy level, but we are still some ways from the higher levels seen in 2022.

Conclusion

So, when it comes to the valuation, ARCH looks to be slightly more attractive stock here. The same can be said for downside protection due to somewhat more fixed cash flows from the thermal segment together with a slightly lower operating cost.

Both companies are effectively debt free and have plenty of cash, so there are no substantial differences with the financial leverage or liquidity.

For anyone that focuses more on momentum, it is hard to find a more appealing stock than AMR. I would also reiterate that the absolute valuation for AMR is far from excessive, with a double digit free cash flow yield even when a more conservative MET coal price assumption is used.

AMR was added to the S&P Small Cap 600 index a couple of months ago, which is likely part of the reason why the stock has outperformed so much over the last 6 months. This addition has led to even more buying in an ever shrinking free float. U.S. ETFs now own close to 33% of AMR, while only 22% of ARCH.

I tend to focus more on the valuation and use more conservative MET coal prices as my base case, which is why I favor ARCH slightly at this point.

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