Arch Coal Inc.
/ (ACI-NYSE)/ Equity Research / ACI | Page 2
Current Recommendation / NEUTRAL
Prior Recommendation / Underperform
Date of Last Change / 09/11/2012
Current Price (09/10/12) / $6.59
Target Price / $7.00
SUMMARY
We upgrade our recommendation to Neutral from Underperform on Arch Coal Inc. We believe the company’s coal prospects look encouraging in the forthcoming quarters with a gradual increase in import demand for coal from the Asian, European and Middle Eastern markets. Other potential upsides include the company’s diligent effort in deploying capital to its core operations from the idle ones, maintenance of financial discipline and lesser coal mining cost in the US. However, these growth opportunities could be tempered by decline in global and domestic steel demand and environmental hurdles. In addition, increase in costs of input supplies and political risks associated with the company’s overseas operations remain as concerns./ Equity Research / ACI | Page 2
SUMMARY DATA
52-Week High / $20.3452-Week Low / $5.26
One-Year Return (%) / -63.40
Beta / 1.80
Average Daily Volume (sh) / 10,890,214
Shares Outstanding (mil) / 212
Market Capitalization ($mil) / $1,397
Short Interest Ratio (days) / 2.71
Institutional Ownership (%) / 80
Insider Ownership (%) / 1
Annual Cash Dividend / $0.12
Dividend Yield (%) / 1.82
5-Yr. Historical Growth Rates
Sales (%) / 12.7
Earnings Per Share (%) / -18.5
Dividend (%) / 1.7
P/E using TTM EPS / 28.7
P/E using 2012 Estimate / N/A
P/E using 2013 Estimate / N/A
Zacks Rank *: Short Term
1 – 3 months outlook / 3 - Hold
* Definition / Disclosure on last page
Risk Level * / High,
Type of Stock / Mid-Value
Industry / Coal
Zacks Industry Rank * / 221 out of 267
OVERVIEW
St. Louis, Missouri-based Arch Coal Inc. (ACI) is one of the largest coal producers in the U.S., operating 23 mines across the major low-sulfur coal basins of the country. It also owns a 42% interest in Knight Hawk Holdings, a coal producer in the Illinois Basin. In 2011, Arch Coal sold 156.9 million tons of coal, including 5.5 million tons of coal sourced from third parties. The company typically sells coal to power plants, steel mills and industrial facilities under long-term contracts. At year-end 2011, the company had overall proven and probable reserve of nearly 14 billion tons of coal. The company expanded its operations during 2011 by acquiring International Coal Group Inc. which operates primarily in the Appalachian region of the U.S.
Arch Coal primarily conducts its business through three operating segments: Powder River Basin (PRB), having operations in northeastern Wyoming and southeastern Montana; Western Bituminous (WBIT), having operations in western Colorado, eastern Utah and southern Wyoming; and Central Appalachia (CAPP), having operations in eastern Kentucky, Tennessee, Virginia and southern West Virginia. Coals mined from the PRB region have very low sulfur content and low heat value. Western Bituminous coals usually have a low sulfur content and varying heat value. Central Appalachia produces coals, which have low sulfur content and high heat value. However, Arch Coal sells a part of the coals mined in the CAPP region as metallurgical coal to steel producers. Metallurgical coal has low sulfur content, high heat content, low expansion pressure and several other chemical properties. Metallurgical coal commands premium prices.
Source: Company
REASONS TO BUY
Ø Arch Coal is focused on generating long-term shareholder value. It has the ability to emerge as a strong as well as an aggressive competitor while facing economic cycles. We expect the demand downturn in coal markets to reverse over the second half of 2012 with train traffic increasing out of Powder River Basin (“PRB”). Coal mining prospects look encouraging with the projected start-up of long-wall operations in the Leer mine in mid-2013. Besides, we project coal exports to follow an upward trend, reaching 270 million tons by 2016 with growing demand from the prime Asian markets of China and Korea. Also, import demand for coal is expected to surge by 10% in the European markets, as demand is gradually increasing in the UK, Spain and Italy as well as in the Middle East.
Ø We believe the company’s strategy to enhance its financial flexibility in the near term will strengthen its position for an eventual recovery in the coal markets. The company’s increasing effort to maintain a healthy balance sheet and deploy effective debt restructuring initiatives will ensure stable financials. It has available liquidity of $860 million as of June 30, 2012 which is expected to remain consistent in 2012. Also, it managed to increase its cash balance to $512.5 million at the end of second quarter 2012 from $138.1 million at year-end 2011.
Ø Arch Coal puts a lot of emphasis on the efficient utilization of its available resources. The company’s strategy to shift its resources to core operations is expected to reduce its capital spending on low return units. This will enable the company to divert the proceeds towards development of lucrative growth projects as well as for modernization initiatives. The company recently reallocated some of the input resources from its idled Left Fork mine in West Virginia to the Leer mine in Appalachia which will contribute to savings of $30 billion to $40 billion in the future.
Ø Arch Coal continues to operate its mines efficiently and a lot of stress is given to the safety of operations. The safety records of the mines operated by Arch Coal are four times better than the national average. This safety feature allows continuation of work without any hassles and hardly any production lost due to accidents.
Ø Arch Coal is expected to be a major supplier of seaborne coal in the near term. Spiraling cost of production of coal in countries like Australia, Indonesia, Canada and Russia will give a comparative advantage to U.S coal miners as mining costs are expected to be much lesser. This is projected to boost the company’s revenue and will aid in weathering the current downturn and strengthening its position in the market.
REASONS TO SELL
Ø Given the recent stress laid by the U.S. government on adoption of pro-environment measures regarding emission volume and resource use, Arch Coal’s operations could be severely affected. Energy producers are seeking other resource options to switch from coal to natural gas, nuclear, and hydroelectric for generation of electricity. Gas-fueled generation has the potential to replace coal as the primary source of electric production as these are cheaper to construct and also have low emission profile. Besides, clean renewable energy sources are also being tapped for meeting the increased demand for electricity. In the long run, substitution of coal with natural gas could drive down coal prices affecting the company’s margins.
Ø Arch Coal’s mining operation requires key industrial supplies which include steel, diesel fuel, explosives, and rubber tires. Any increase in prices of these input supplies will lead to higher operating costs and impact margins. Besides, the failure to timely procure input materials could result in disruption of mining activities and even delay the production process. This might hamper the profitability of the company.
Ø Arch Coal’s profitability is heavily influenced by its ability to mine and process high quality coal reserves in a cost efficient manner and provide affordable and reliable services to its customers. In the course of mining, resources get depleted leading to shrinking reserves. Failure to add economically viable reserves could significantly affect the company’s operational results. This might lead to a vicious cycle of negative profitability as lower financials will restrict further financing of coal operations.
Ø Global and U.S. demand for steel utilization from coal companies are expected to soften which will impact the company’s top-line results in the following quarters. In view of this, the company trimmed its met coal sales to 7.5 million tons from 8-8.5 million tons earlier. This will be compounded by increase in stockpiles owing to the bleak thermal market which will adversely affect Arch Coal’s production and hence its profitability. Coal inventories at the end of August 2012 stood at 175 million tons which is 20 million tons above the normal.
RECENT NEWS
Arch Coal Reports Loss, Revs Grow - July 27, 2012
Arch Coal Inc. reported pro forma loss of $0.10 per share in second quarter 2012, in contrast to earnings of $0.44 per share in the year-ago comparable period.
This was primarily due to lower sales volume related to decline in shipments from Powder River Basin (“PRB”) operations. The reported loss was, however, narrower than the Zacks Consensus Estimate of a loss of $0.18 per share.
Second quarter 2012 GAAP loss was $2.05 per share versus earnings of $0.04 per share in the year-ago quarter.
The variance between quarterly pro forma and GAAP loss was the result of a gain of $0.02 per share related to amortization of acquired sales contracts, tax adjustment gain of $1.15, charges of $2.48 associated with mine closure and asset impairment, goodwill impairment charges of $0.55, and other non-operating charges of $0.09 per share.
Total Revenue
Arch's total revenue in the reported quarter was $1,063.5 million, up 8% from $985.5 million in the year-ago quarter. Quarterly revenue surpassed the Zacks Consensus Estimate of $1,020 million.
Operational Update
Arch Coal sold 31.5 million tons of coal in the reported quarter, down 14.2% year over year from 36.7 million tons. This decrease in sales volume was due to a 22.1% year over year decline in PRB operations and a 15% dip in Western Bituminous Region sales volume, partially offset by 36.8% year over year growth in Appalachia mining operations.
Despite a reduction in the coal sales volume in the reported quarter, total revenue increased on the back of 15.3% year over year growth in the sales price per ton of coal.
Arch’s adjusted earnings before interest, tax, depreciation and amortization (“EBITDA”) in second quarter 2012 were $181 million, a decline of 27% from $248 million in the year-ago period.
Interest expenses were $77.6 million as of June 30, 2012 compared with $41.5 million in the year-ago period.
Financial Update
Cash and cash equivalents of the company as of June 30, 2012 were $512.5 million versus $138.1 million as of December 31, 2011.
As of June 30, 2012, Arch’s long term debt was $4.5 billion compared with $3.8 billion as of December 31, 2011.
Capital expenditure in second quarter 2012 was $202.1 million, up from $107.7 million reported in the year-ago period.
Guidance
In 2012, the company expects to sell 135.5–141.5 million tons of coal, which includes 128 – 134 million tons of thermal coal and 7.5 million tons of metallurgical coal.
Selling, general and administrative (“SG&A”) expenses are expected to be in the range of $125 – $135 million in 2012. Interest expenses are expected to be in the range of $305 – $315 million in 2012. The company’s capital expenditure in 2012 will likely be in the range of $410 – $430 million.
VALUATION
Arch Coal is a well-positioned in the U.S. energy market. We believe escalation of coal demand from the prime Asian economies of Korea, India, and China and from the European as well as Middle Eastern markets will act as growth drivers. In addition, continued focus on achievement of financial flexibility and efficient allocation of capital resources are expected to elevate the company’s growth prospects.
However, we are cautious of a downturn in global and domestic steel demand, political and economic risks associated with its operations in the international sphere and regulatory obligations. Rise in prices of input supplies and failure to augment economically viable reserves could further add to the company’s woes in the future.
Arch Coal’s current trailing 12-month earnings multiple is 28.7x, compared to the 10.6 average for the peer group and 14.7 for the S&P 500. The trailing 12-month EV/EBITDA multiple is above the industry average. Our target price is $7.00, based on 2.2x trailing 12-month cash flow per share.
Key Indicators
Earnings Surprise and Estimate Revision History
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DISCLOSURES & DEFINITIONS
The analysts contributing to this report do not hold any shares of ACI. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts’ personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts’ compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1032 companies covered: Outperform - 16.3%, Neutral - 76.3%, Underperform – 6.4%. Data is as of midnight on the business day immediately prior to this publication.
Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company’s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock’s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively.