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Arch Coal (ACI) has been a wonderful growth story, making its way from 27.76 to as high as 77.40 over the past year. It recently sold off to the tune of 15%, closng Friday at 63.70, which raises the question whether this is a good time to try to catch the falling dagger - a question I would answer in the negative.
To complete my review, I browsed a number of analyst reports as well as the most recent 10-K and 10-Q, concentrating on management's discussion of operations. In addition, I visited the company's website and looked at their most recent investor presentations (impressive), and checked out coal on the Energy Information Administration website.
Coal, like oil, has had a tremendous price run as the energy and materials boom has developed. ACI management has done a good job positioning themselves for this boom and exploiting their new-found pricing power, particularly in metallurgical grade coal, where they have locked in prices at what appears to be the peak of the materials boom. The coal business operates on long-term contracts, and Arch sold most of their planned metallurgical production for the next year of so at very good prices.
The largest volume of Arch's prduction comes from the Powder Ridge Basin, out West, and is very low sulfer but also low in heat value. It sells for much lower prices than the metallurgical grade coal they mine in the Central Appalachia. However, management expects prices to increase, driven by international demand for coal for power generation, specifically in China and India. To make this thesis work, it is necessary to assume that Australia's current infrastructure and port congestion problems will continue unabated. Australia has ample supplies of coal and is nearer to the China and India markets. Arch is holding out for better long term pricing contracts on its Powder Ridge Basin production. EIA information shows Powder Ridge Basin prices declining for the past several months.
When projecting future earnings, I start with current year revenue, increase it by a growth percentage, and then get to earnings by using a net income percentage. My spreadsheet does this using historical averages, which I can over-rule if think I have good information about future revenue and margins. In the case of ACI, earnings estimates prepared this way are substantially less than analyst consensus figures. Using 5 year average revenue growth and the best historical year's margins, I get EPS of 2.67, while some analysts are getting around 5.50. It's about future margins.
It's about future margins and the sustainability of future margins. Steel is cyclical, and demand for metalurgical grade coal will be driven by this cycle. Whatever Australia's port congestion and infrastructure problems are, they will be solved when financial incentives become strong enough. So, if Arch earns 5 per share next year, P/E might be disappointing, based on concerns for sustainablity.
Arch is a wonderful company. Coal is the United State's most aboundant fossil fuel, a proven technology. ACI's Laurel Mountain facility in Central Appalachia is state of the art, a coal mine that is more like a factory. Injury rates have been low. Management was adroit in positioning themselves such that this facility came on line at a time of increasing demand. Future plans include a presence in the Illinois Basin, where they have a large contiguous area under control. They are working on Coal to Liquids (CTL), which is a viable technology, albeit one with a heavy environmental cost in terms of CO2 release. Mangement presents their story well.
Taking all of this together, I plan to add ACI to my watchlist and buy it if the prcie falls to an area I find attractive. As of this moment, that would be 40 per share.
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