This Resurrected Coal Miner Is Set To Outperform

Richard Robinson's picture

Wednesday, May 31, 2017 - 2:30pm

by Richard Robinson

On a recent trip to Des Moines to teach a class for financial professionals, the weather didn't cooperate. This kept me from flying. 

So a road trip was in order.

Now, it's a 20-hour trip by car from Florida. While the plan wasn't to drive straight through, tunnel vision kept me going. 

By the 18th hour, I was just a couple of hours away from my destination. So I decided to stop and grab some sleep at a local hotel. Without even knowing it, I was in Hannibal, MO -- the boyhood home of author Samuel Langhorne Clemens (the real name of writer Mark Twain).

After a nap, I toured the area made famous by the fictional exploits of Tom Sawyer and Huck Finn, and then made my way to Des Moines.

Noticing the number of coal cars heading west got me to thinking about several articles written recently about the death of coal. I found the irony of the situation funny. 

You see, in 1897 the New York Herald proclaimed that Mark Twain was grievously ill and near death. A report followed that Twain died -- and legend has it that newspapers printed his obituary.

Of course, Twain didn't die for another 13 years. But when he learned of his "death" he said, the report of his death was an exaggeration.

It's the same for coal...

Now don't get me wrong, the coal industry will never be as important to the U.S. economy as it was in the early part of the 20th Century. But writing coal's obituary is nothing short of foolishness.

Here's Why…
By any standard, coal still fuels power plants in the United States. In fact, coal continues to produce about 30.4% of power generation in the United States. 

Still, those numbers will continue to decrease over time. But what is true in the United States just isn't so for the rest of the world.

You see, China is key to the future of coal. China burns 4 billion tons per year -- four times more than the United States and six times the amount the entire European Union burns annually. And it isn't slowing...

The use of coal will increase in China through at least 2040. There are 368 coal-fired power plants under construction with another 803 in various stages of planning. Even if the Chinese government takes steps to reduce air pollution by burning cleaner natural gas, it will take decades to build the infrastructure to accomplish this. 

In the meantime, the country will install scrubbing technology rather than permanently closing its coal plants. That means coal will remain in high demand for the foreseeable future. 

But China isn't the only country tied to coal. India will be the second-largest coal consumer before the end of this decade. They project to double their use of coal through 2040. They are currently constructing 297 coal-fired plants -- with another 149 projected. 

In total, there are more than 2,400 coal-fired power plants either under construction or in the planning stages globally. This means the capacity that India and other emerging Southeast Asian countries will build is nearly double the existing capacity in the United States today. 

So in short, no, coal is NOT dead. 

Profits In Coal
Nearly all U.S. coal-mining companies have gone through bankruptcy in recent years as domestic demand fell. But only one emerged from that process strong enough to rise to the top of the global coal business. 

That company is Arch Coal (NYSE: ARCH).

Arch Coal ranks among the largest producers of both thermal coal and metallurgical coal (used to make steel) in the United States. The company has mines in Wyoming, Colorado, Virginia, West Virginia, Kentucky, and Illinois. 

The table below provides information on the company's margins as reported in its most recent quarterly filing. Better yet, the company expects these margins to improve across each of the three segments.

Type of Coal Price per Ton Cost per Ton Margin
Thermal Coal $12.57 $10.33 21.68%
Metallurgical Coal $90.84 $57.67 57.51%
Other Thermal Coal $35.51 $23.82 49.07%

In fact, the company's operations have been so good the company reinstituted a $0.35 cash dividend beginning in the second quarter. This, combined with the company's share-repurchase program of up to $300 million, should drive share prices higher.

A Value Play?
Based on the ratio of current enterprise value (EV) to estimated EBITDA, Arch Coal is undervalued compared with its peers. Today, Arch has an EV/EBITDA multiple of just 3.7, while its competitors trade at roughly five times EV/EBITDA. 

Now, it's true that these EV/EBITDA numbers are for some of the most hated companies on earth. Still, any company producing profits with such low multiples isn't fairly valued. 

Speaking of profits, the company's results have exceeded Wall Street forecasts. In the fourth quarter of 2016, its adjusted earnings per share (EPS) came in at $1.65, compared to street estimates of $0.19 per share. Yes, that's 8.7 times higher than expected -- a massive surprise by any standard. 

In its most recent quarter, the company reported EPS of $2.55, compared with estimates of $2.19 per share.

The Bottom Line
There is nothing stopping natural gas from permanently surpassing coal for power generation in the United States. But in developing countries, coal is the only game in town. And Arch Coal is in the driver's seat for meeting global demand. 

That means rumors of coal's death are greatly exaggerated. 

Risks To Consider: While Arch Coal is an efficient company with a now-squeaky clean balance sheet, its future success hinges on Chinese and Indian demand for foreign coal. Should coal producers in China pick up steam (which for now seems unlikely given recent production curbs and unfavorable weather), Arch could be left with only the dwindling U.S. market to fuel its growth. 

Action To Take: Buy ARCH on a dip in price and hold for the long term. 

Editor's Note: John D. Rockefeller amassed the largest fortune in contemporary history because he understood one simple fact about commodities. This "secret" transformed his approach to investing and turned him into America's first billionaire. What can it do for you?

does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.