Nerthuz/iStock via Getty Images
Nerthuz/iStock via Getty Images
Arch Resources, Inc. (NYSE:ARCH ) is a miner of metallurgical and (to a lesser extent) thermal coal. It goes without saying that the coal industry is viewed with disdain by many investors due to its negative environmental contributions as well as its history of capital destruction.
Arch itself emerged from bankruptcy in 2016 and has been winding down its thermal operations as the world becomes increasingly less tolerant of coal generated electricity (thermal coal is used to generate electricity). This will leave Arch as a pure-play metallurgical/met coal operator (met coal is also known as coking coal). Met coal is one of the primary materials utilized as part of the refining process to make steel. Below is a breakdown of the company's enterprise value .
Under normal circumstances, investors would have little reason to be interested in this unloved, unfollowed, mature, cyclical, and formerly bankrupt business. But 2021 has not been a normal year.
A variety of supply and demand factors have combined to create a perfect storm for both thermal and met coal prices in 2021, and we have reasons to believe that higher prices will persist into 2022 and beyond.
Unless you've been living under a rock, you've probably heard that the world is currently experiencing a global energy crisis. Simply put, nations have for years been working to curtailing the supply of "dirty" electricity feedstocks (e.g. coal and natural gas) in favor of "clean" electricity feedstocks. As demand has recovered post COVID, inventory levels and available production for "dirty" sources are low. As a result, Europe, Asia, and to a lesser extent, North America, have seen incredible surges in prices for "dirty" feedstocks.
A recent Bloomberg article stated that U.S. power plant coal stockpiles were at 24-year lows as power producers were on track to burn more coal this year relative to 2020, while in the meantime, miners have been curbing production capacity. The article notes that U.S. prices have surged 39% YTD.
The steel industry has also roared back into the post COVID world and supplies remain tight. According to this WSJ article, steelmakers expect demand to remain strong "deep into next year".
We are as bullish for the fourth quarter and going into next year as we ever have been,” said Mark Millett, chief executive of Steel Dynamics Inc
Similar to thermal coal, supplies of met coal have also been subdued in the face of the demand boom. While there are many different price indexes for met coal depending on the type/destination, they all exhibit the same incredible rise.
As coal companies have recently announced Q3 results, we've been provided a first glimpse of the prices that are already being locked in for 2022.
Regarding thermal, one can simply refer to this Bloomberg article: "U.S. Coal Miners Are ‘Sold Out’ for 2022". Some key excerpts:
Almost every lump of coal that U.S. miners will dig out of the ground next year has already been sold
[...] Arch Resources Inc., the No. 2 producer, has lined up deals with utilities for all of its 2022 output from the basin at an average price that’s 20% higher than current spot prices.
Peabody Energy even states that they only have a "small portion" of 2023 volumes left to sell.
In September, Goldman Sachs raised their outlook for 2022's average met prices to $175 per ton. While met sales aren't typically booked as far out as thermal, Australian based Coronado Global Resources (CODQL) recently reported that their "U.S. domestic annual contract negotiations for FY 2022 are largely complete", and that they anticipated an average price of $187 per ton.
Then there is fellow met coal producer Ramaco Resources (METC) who reported on October 26th that they had contracted 54% of their 2022 volumes at $196 per ton with North American steel producers.
Finally, Arch itself disclosed during their Q3 earnings call on October 26th that they had contracted select 2022 commitments at $230 per ton in North America. It's worth noting that Arch expects to export the majority of their met coal volumes and that seaborne volumes typically fetch even higher prices than domestic North American markets.
Every 2022 ton locked in today is one less piece of supply that will be available down the road. We have strong reason to expect pricing to remain robust.
We are now in a position to run these prices through a financial projection. Arch's thermal prices are almost completely locked in at this point. On the met side, I feel it would be conservative to lean towards Coronado's contracted prices of $187 per ton, and I frankly believe there is upside to this figure. Below are my resulting projections for 2022's cash flow.
Source: Compiled by author, historical figures represent segment results and will not match summary level financial statements.
The numbers speak for themselves. 2022 is shaping up to see an exponential surge in free cash flow, which should conservatively approach $1.3B. Has the market woken up to this potential? Given ARCH currently trades at a fully diluted ~$1.6B market cap and a ~$2.0B TEV, I'm going to say "no". The stock has merely recovered to levels last seen when the company's average met prices barely touched $100 per ton.
How is this possible? I chalk it up to the fact that coal names are utterly unloved and left for dead. Additionally, I'd wager that 99% of investors don't even know what coking coal is used for, much less have any idea what the commodity price has actually done over the past 6 months. Coking coal prices are much more difficult to find relative to more commonly discussed commodities such as oil, gold, or lumber. In some cases, pricing details even require paid subscriptions.
But now we will turn to the question of what management is likely to do with all of this cash once it materializes. We have reason to expect good things.
Management has been very clear on their immediate plans for the use of free cash flow. From the Q3 2021 earnings call:
We intend to pay down debt and/or build cash in order to return to a minimal net debt position. At the same time, we plan to maintain our sharp focus on simultaneously reducing and diffusing the long-term closure obligations at our thermal assets through the establishment of a sinking fund.
The industry is painfully aware that financial institutions are increasingly reluctant to serve as a provider of capital. Management teams are likely expecting that there is a strong possibility that operations will need to be largely self-funded in the near future, i.e. these business must become largely debt free.
To that end, management is looking to aggressively reduce debt ahead of current maturities as well as set cash aside for existing mine asset retirement obligations (AROs). These AROs currently stand at $170M, and below is a break-down of Arch's $602M in debt.
Given Arch is highly unlikely to pre-pay equipment leases, this leaves their Term Loan as the primary vehicle to pre-pay. I estimate that combined Q4 '21 and Q1 '22 should see between $450M and $500M in FCF for Arch. Combining this with the existing cash balance of ~$210M implies that Arch should easily be able to fully cover their ARO liability and payoff their term loan by Q1 2022.
Arch made a very prescient move when they issued their convertible bonds. While the bonds were issued at a conversion price of $37.32/share, Arch completed a separate capped call transaction which effectively capped the dilutionary impact up to a share price of $52.56. This move significantly limited the amount of dilution that would take place at today's share price and the dilutionary impact of the convertible bonds is already included in Arch's reported diluted share count.
A second important point on the convertibles is that they should be directly related to Arch's optically large short interest of 25%. A short interest this large would typically spook investors as the assumption would be that the "smart money" knows something detrimental about this business. But purchasers of convertible bonds often simultaneously short the underlying stock to hedge movements in the share price (this is known as convertible arbitrage). Given the bonds are more than 150% in the money, it's a fair assumption that a significant portion of bondholders have locked in these gains, and indeed the 4.16M shares issuable for the bonds neatly coincides with the ~4M shares sold short.
Arch has stated that they plan on redeeming the principal portion of the convertibles with cash while issuing shares for the value above par.
Investor's biggest concern would typically be that management might squander these cash windfalls by using the cash to chase after potentially destructive M&A activity. Management's actions and statements post bankruptcy emergence should put these fears to rest. They've repeatedly stated that while they will kick the tires on opportunities, they have an extremely high bar on M&A and prefer to return capital to shareholders.
We're going to be very careful as we assess any opportunity out in the marketplace and meanwhile are quite comfortable continue to run the assets we have and returning cash.
I mean at the end of the day, Lucas, our fallback is for the next 20 years effectively, which these four mines are set up to do, we're just going to generate cash and return to shareholders.
"We're just going to generate cash and return to shareholders". Music to my ears. Immediately before the COVID crash, Arch paid out an annualized $2.00 dividend per share. As of Q4 2021, they've reinstated the dividend at an annualized $1.00 per share. But Arch's 2019 and 2018 dividend payouts paled in comparison to the $245M and $280M in share buybacks that were completed during these respective years. I would similarly expect Arch to now allocate residual cash flows towards repurchasing common stock.
So once management has right-sized the balance sheet, how much can we expect in shareholder returns for 2022? Based on my previously presented FCF projections, I'd estimate that Arch could buyback an incredible $800M worth of stock after paying off the term loan, setting funds aside for the ARO, achieving $50M in net cash after debt, and paying a $2.00 dividend.
This amount represents more than 55% of Arch's current market cap at today's stock price.
Given all that has been laid out, what should our price target expectations be? For this, we will need to look beyond 2022 and bear in mind two critical points.
Below are my projections beyond 2022.
Source: Compiled by author, historical figures represent segment results and will not match summary level financial statements.
Now I will apply a 4x EBITDA multiple to Arch's $486M in run-rate met EBITDA while adjusting the share count for buybacks from the near term FCF.
While this analysis is dependent upon what price Arch would ultimately be able to buy the stock back at, it should also demonstrate that if my projections play out, a significant share price appreciation would almost become self-fulfilling as buying demand from the company inevitably came into the market. The above analysis also carries an element of conservatism in that I am not including the benefit of 2023's thermal EBITDA.
We could go a different route and apply a DCF valuation and still arrive in the same valuation ballpark.
What could possibly go wrong with this apparent slam dunk? We can rule out a decline in thermal coal prices. As previously mentioned, Arch has largely already sold their entire 2022 production volumes and has even locked prices going into 2023.
This leaves a rapid decline in met coal prices as the primary risk to this thesis. Lets consider this risk from both a short term and long term perspective.
In my opinion, China is the largest wild card with respect to the supply/demand balance for met coal and steel. The country is currently attempting to orchestrate a soft landing for its residential/commercial property sector as major developers have been forced to reign in debt. Other immediate focuses for politicians are managing a energy shortage as we head into winter while also attempting to reduce CO2 emissions ahead of the winter Olympics in Q1 2022.
To these ends, the country has been actively stepping into the market. China recently sent local coal prices tumbling as the country effectively moved towards imposing price caps on local coal producers in response to skyrocketing electricity costs. But as economics 101 would tell us, price caps are likely to be a very temporary band-aid for the country as they inevitably lead to an even worsened shortage. China has also been imposing caps on local steel volumes (thus freeing up badly needed electricity capacity and temporarily reducing CO2 emissions). How much of an economic slowdown China will tolerate while working to meet the Party's objectives is an important question.
Outside of China, global steel supplies remain tight as the world is still experiencing a shortage of cars and appliances. If a U.S. infrastructure bill ever does indeed pass, this would serve as a further tailwind for global steel demand.
Putting aside 2022, we must also consider the outlook for met coal prices in the years beyond. Steel producers will continue to make limited efforts to reduce their reliance on met coal, as all industries and businesses make efforts to reduce their carbon footprints, but as we're seeing across many industries, supplies of these carbon intensive commodities are dropping much more rapidly than end demand, an unintended and paradoxical phenomenon that has been dubbed "greenflation".
New government-directed spending is driving up demand for materials needed to build a cleaner economy. At the same time, tightening regulation is limiting supply by discouraging investment in mines, smelters, or any source that belches carbon. The unintended result is “greenflation”: rising prices for metals and minerals such as copper, aluminum and lithium that are essential to solar and wind power, electric cars and other renewable technologies.
And in met coal's case, look no further than windmills themselves. According to the American Wind Energy Association, it takes 200 to 230 tons of steel to make a single wind turbine. Given it can take 770 kg of coal to make a ton of steel, that works out to 182 tons of coal for a single wind turbine. Quite a paradox.
In the meantime, it's becoming increasingly difficult to obtain approval for new coal mines. The example of a proposed new mine in Cumbria, UK (highlighted here by the BBC) is typical. The British PM is opposed to the mine despite the fact that it would reduce carbon emissions from the need to import coal from Australia or North America.
While my financial projections for Arch assumes a return to pre COVID level prices, I personally believe met prices will (to an extent) remain permanently higher over the business cycle as the "greenflation" phenomenon has now taken hold.
I believe Arch's current stock price has utterly failed to price in 2022's bullish outlook. By January 2022, we'll receive Q4 results from Arch along with an update on 2022 met prices that the company is contracting at. By the time we get Q1 2022's results in May, I believe that there is a strong possibility that Arch will:
At this point in time, even the most translucent cloud of uncertainty should be removed. And if this is not enough to catalyze the share price higher, buybacks themselves should do the trick. My price target for Arch is $175/share and I would expect to see this price sooner rather than later in 2022.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of ARCH either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.