Undervalued Report: Arch Resources
All I want for Christmas is a sack of coal
“Santa honey, one little thing I really need
The deed to a platinum mine
Santa baby, so hurry down the chimney tonight”
– Santa Baby, Eartha Kitt
This Christmas, a lump of coal – or certainly a sack – is suddenly not looking like such a bad Christmas present. I’ve bought myself 250kg of the stuff for Christmas – to use combined with wood on my open fire, particularly in case of power cuts or another cold spell. I’ve got briquettes made from anthracite (coal with a high carbon content that is more efficient and produces little smoke).
Not only that, I’ve also bought shares in a coal miner: Arch Resources (ARCH) is the second largest supplier of coal in the US.
Yes, I’m now in the coal trade:
The investment case for ARCH is simple. Its 2022 free cash flow (FCF) is at around 50% of its enterprise value (EV), and its expected 2023 FCF yield is over 30% of EV. This is a long-term investment for collecting high capital returns: hopefully an increasing slice of the dividends as the company buys back shares at a low valuation.
If we are bullish on coal further out than 2023, we could potentially get 100% capital returns within 2-4 years. And, in the short term, it seems to me China reopening could be seriously bullish for coal demand.
Contents
ARCH stats
Met coal: brief market outlook
Arch Resources: overview
Financials
Capital returns
Investment thesis
Risks
Conclusion
ARCH stats
Share price: $147.25
Share count: 18.4 million
Market Cap: $2.7bn
Net cash: $323m
EV: $2.4bn
Met coal: brief market outlook
Before some of you think I’ve gone completely bonkers, Arch produces primarily metallurgical (met), or coking coal, as opposed to thermal coal for power generation (although the fundamentals for both look strong).
It’s expected that met coal will be needed for steel production for decades to come, or at least until the middle of this century. Steel is one of the “four pillars of modern civilisation” according to energy expert Vaclav Smil. It’s critical for construction, transport and infrastructure (including that for the energy transition such as wind turbines).
Global steel demand is expected to continue to rise, supported by growth in India and Southeast Asia.
Electric arc furnaces are projected to take some market share in North America and Europe, but this should be offset by new steel capacity coming online in Asia.
And, at the same time as demand for coking coal is likely to increase, supply is constrained. As met coal has largely been lumped in with thermal coal, investments in supply have been few and far between.
US exports lag pre-pandemic levels. Australian exports have fallen in recent years, down 11% in 2021 versus 2016, as underinvestment bites. Capex is being directed to transition minerals such as lithium and copper, amid regulatory pressure, and therefore depletion is setting in. Russian production is expected to fall ~4% in 2022, according to the Russian Ministry of Economic Development, and by ~10% in 2023, due to import bans and challenges associated with redirecting product to eastern markets.
The longer term fundamentals look attractive; the met coal price could also benefit in the short-to-medium term from China reopening.
Arch Resources: overview
Arch resources supplies around 30% of the world’s High-Vol A coking coal, used to produce good quality coke for steel making. Approximately 80% of the company’s output is High-Vol A coal, with the other 20% being thermal coal.
Arch’s four metallurgical (met) coal mines are in West Virginia and its three thermal mines are located in the Powder River Basin, in Wyoming, and Colorado.
The company has been pivoting from thermal to metallurgical markets, as it sees coking coal as having a better future due to the energy transition and phase-out of thermal coal for power generation in many markets. Arch has reduced its EBITDA from thermal coal from 75% in 2010 to 20% expected in 2026.
Arch’s mines are relatively low cost, with ~80% of output coming from lower cost longwall operations, as opposed to an average of ~30% for the US industry as a whole. And it has a long reserve life of ~20 years in all four of its met coal mines.
Arch sells the vast majority of its coal abroad on the seaborne market. The company has rail and terminal agreements as well as a 35% interest in the DTA export facility in Virginia.
Financials
At the end of Q3, Arch had a $323m net cash position and $174m of total debt, after paying down its debt and repurchasing nearly all of its convertible debt securities year-to-date.
Net income was $860m in the first nine months of the year, or $41 per diluted share, on a market cap of $2.7bn. On an annualised basis, this is a 43% earnings yield on the equity or 48% on the enterprise value (EV) for 2022. What is more, just about all the earnings are free cash flow, which can be returned via the capital return programme.
Capex compared to earnings is minimal and is focused on the met segment. The thermal segment has generated 10x the EBITDA vs capital invested since Q4 2016. In Q3 2022, it generated $97m EBITDA vs $5m of capital spending.
The key question is what numbers are going to be like going forward. Coal prices for 2023 are expected to be lower than for 2022, but the fundamentals for coking coal, as discussed, remain attractive, particularly with China’s reopening, and there are some strong earnings drivers.
In the Q3 earnings call, management forecast a 15% increase in coking coal shipments in Q4 2022, combined with a 10% reduction in costs, and further improvements with regards to both productivity and cost savings in 2023. In Q4 ‘22, Arch anticipates selling over 200,000 tonnes of coking coal to thermal markets – this could create more interest in their high BTU products for thermal use and provide optionality to sell them in both markets.
As for the thermal segment, the company has sold forward contracts for 2023, during 2022 at attractive prices, and is optimistic of repeating 2022’s strong thermal segment performance in 2023.
Capital returns
The capital return framework is very attractive, returning close to 100% of discretionary cash flow (which the company defines as “cash flow from operating activities after contributions to the thermal mine reclamation fund and less capital expenditures”).
50% of discretionary cash flow is pledged to dividends, and the other 50% will be spent primarily on share buybacks. The second 50% can also be spent on repurchasing convertible debt securities and warrants, on maintaining a $300-350m cash target and on special dividends.
In Q3, discretionary cash flow was $413m and half, $206m, was paid as a dividend in December, resulting in an ~8% yield in just one quarter!
2.3% of share outstanding, ~400,000 shares, were repurchased in Q3, and management said on the latest earnings call that they could more than double the amount of buybacks in Q4, buying back 1 million shares, which would be 5.6% of the equity.
Arch has a strong record of delivering on share buybacks, as it repurchased 40% of its shares in less than three years prior to April 2020. Going into 2022, it has focused on shoring up its balance sheet to position itself for increasing capital returns. Since the end of 2021, it has reduced total debt from $605m to $178m, and has built the balance of its thermal mine reclamation fund to $130m. It has already deployed $678m in phase 2 of the capital return programme since launching it in February.
Investment thesis
Analyst estimates forecast $777m of free cash flow (FCF) in 2023 and $330m in 2024.
If we take those numbers at face value, that’s a 46% return on our investment over two years. The dividend over those two years (at 50% pay out) would average ~11.5% per year, and another 11.5% could be expected via buybacks, to create a total 23% annualised yield of capital returns.
I’m not going to provide a DCF valuation as I usually do here, as I feel it would give a false sense of precision, due to uncertainty over coal prices, where none is required.
This is a simple investment idea. The plan is that we get around half our money back via capital returns within two years, which should de-risk the investment somewhat. Then we are left with half our money plus a high-return business with a powerful option on the coal market, with ~20 years of reserves.
Risks
The key risk is clearly in met coal prices. A global recession combined with further lockdowns in China and Southeast Asia, for example, could send prices lower. In that case, there could be significant downside for the stock. However, I believe the longer term case for met coal still applies.
Conclusion
This is a long-term investment for collecting capital returns: hopefully an increasing slice of the dividends as the company buys back shares at a low valuation, compounding our returns. If we are bullish on coal further out than 2023, we could potentially get 100% capital returns within 2-4 years. And, pivoting to the short term, it seems to me China reopening could be seriously bullish for met coal demand.
Thank you for supporting The Undervalued Newsletter!
With best wishes,
Timothy Lamb.
Blog: www.retailbull.co.uk
Twitter: @theretailbull
Disclosure:
The writer owns shares in ARCH at the time of writing.
Disclaimer:
This article is for informational purposes only, does not offer investment advice and does not recommend the purchase or sale of any security or investment product. Please see the full disclaimer on the About page.