Description

Thesis

ARCH recently emerged from bankruptcy with a pristine balance sheet and meaningfully improved cost structure. In a richly valued market we believe ARCH is an attractively valued security operating in an industry with a more favorable outlook under a Trump administration. Importantly, ARCH is under owned as the stock is not currently in any ETFs post its emergence from bankruptcy. We expect the stock to be added to the Russell Index this summer which should be a positive catalyst. ARCH currently trades under 4x EBITDA – attractive on a relative and absolute basis, in our view.

Background

Arch Coal is a low-cost coal producer with mining operations in Appalachia, Powder River Basin, Colorado and Illinois Basin. The company is the largest US producer of metallurgical coal (1/3rd sales) and the second largest producer of US thermal coal (2/3rd of sales).  

Arch Coal filed for bankruptcy in January 2016 as a result of a prolonged period of weak coal prices and the company’s burdensome debt level. On October 5, 2016, Arch announced  that  it  had  completed  its  restructuring  and  emerged  from  bankruptcy with net cash on its balance sheet and an improved cost structure - taking nearly 25% of cash costs out of their coal business.  

Over the same time period the US coal industry has shrunk by 30% given cheaper alternatives and Obama era regulations. We believe Arch has emerged from bankruptcy at an ideal time with a strong balance sheet, high quality assets and an industry on the mend.

Coal Market Dynamics

With a pro fossil fuel administration in the White House looking to exert their mandate we believe the noose around the collective necks of the coal industry has loosened considerably. The total annual demand for US coal peaked in 2008 at 1.1b tons and has settled at roughly 750b tons in 2016. In the U.S, the share of coal used to generate electricity has decreased from 48% to roughly 30% primarily due to the abundance of cheap natural gas. With natural gas prices posturing higher we believe coal could be increasingly favored for incremental electricity capacity recapturing lost share. This dynamic will ultimately put upward prices on coal and benefit Arch who has strong operating leverage even in a flat pricing environment. Further strengthening Arch Coal’s position, has been the overall industry’s plight which has seen many bankruptcies and deep cuts to investments and capex. This has led to a structural deficiency in production increases keeping supply and prices relatively stable, benefitting low cost, high quality asset holders like ARCH coal.

The current met coal supply demand picture is also showing signs of improving.  On the demand side, Met coal which is used in steel production, has seen prices stabilize and demand for steel is positioned to pick up, specifically in the U.S. where a pro-growth infrastructure heavy agenda is set to be proposed. PMIs in the US are signaling strong growth which is also supportive of demand. As shown in the table below China Steel demand is also tracking well providing a natural tailwind for met coal demand.

Supply has been driven by Chinese production and steel demand in recent years. China accounts for over half the world’s steel production at 1.13bn tons and consumes approximately 85% of its production. Furthering the point, Wilbur Ross who has had many steel interests as a private investor and is the Commerce Secretary under President Trump has said recently that Chinese overcapacity is the biggest problem for the steel industry, with Chinese steel makers selling their wares overseas "often at dumping prices." He recently signed a new round of steel tariffs on Chinese steel as one of his first measures. We are watching his actions closely to help gauge real steel supply and thus met coal demand. Importantly China has recently moved to curtail coal production during what amounts to be high season for steel production which should further pinch supply of metallurgical coal.

Morgan Stanley: “In our view, the National  Development  and  Reform  Commission (NDRC) will adjust coal supply based on seasonal demand for thermal coal. We expect coking coal to benefit as it follows different cycles during the year. Coal production is likely to be constrained during spring and autumn due to a lull in power demand; however, this is typically the more active season for steel production. As a result, we expect coking coal prices to be better supported at the current high levels compared with thermal coal prices.

Thermal Coal Supply and Demand: Making up 2/3rds of Arch coals revenue. Thermal coal is primarily used to generate electricity. 2016 saw of the tightest thermal coal markets is recent years pushing prices near $80 per metric ton. 2017 is set to weaken slightly mainly due to softening demand. However as we just laid out for met coal, economic growth is back on the table and with China and Brazil inflecting higher after soft periods we believe the drop off won’t be as severe and supply increases could be further hampered as a rebound in Chinese production will likely slow at current elevated prices which keeps thermal coal prices elevated helping support Chinese coal miner profitability.

Structurally improved balance sheet and free cash flow generation

Operating with a net cash balance sheet ARCH is a well-positioned FCF generator. Given the high hurdle rate for capex on new projects ARCH will selectively deploy cash into high ROIC projects or establish a capital return profile either in the form of dividends or buybacks. Given the industry dynamics and baring a sharp increase in demand or coal prices our bias is towards capital return relative to investing in projects aimed at organic growth. Analyst’s estimate that Arch will return half of their $900M or 11% forecasted cash flow yield. One of the benefits of Arch growing its dividend is it keeps management disciplined on future cash flow decisions in addition to providing a volatility buffer for its share price given the inherent cyclicality of their business.

Valuation/Sentiment: Arch Coal is trading under 4x EBITDA and a double-digit free cash flow yield – both of which we find attractive in the wake of the company’s improved financial profile.  In addition, the company is not on the radar of all the major bulge bracket sell-side shops, nor has it been included in any of the large capital flows that accompany ETFs. We have observed this dynamic distort Arch’s trading volatility relative to its peers who consistently have a bid from passive flows. This headwind is set to change as we expect it will be included in the Russell 2000 Index reconstitution in June that we estimate will account for at least 1.5M shares of demand and nearly $115M in value to trade nearly 6%-7% of its market cap. The constant investor flows to passive vehicles have had a significant and growing impact for stocks on investor awareness and multiple re-ratings in the recent past. We expect it to continue in the near future and be a benefitting factor for Arch Coal.

Recap: We believe Arch Coal who recently emerged from bankruptcy is uniquely positioned in a challenged but improving industry to emerge as the high quality operator, whose cost structure, budding capital return story and prospective index inclusion make for a compelling value stock position. In addition we believe the imminent inclusion in indices and subsequent ETFs will create a perpetual tailwind as those vehicles continue to gain assets.

Catalyst

Risks:

·         Global coal demand falls due to weak economic growth

·         Supply shocks from China and EM countries

·         Global coal prices fall to levels seen in recessions

·         Natural gas remains perpetually cheap relative to coal

·         Falling U.S. demand for electricity