Description

Arch Resources (ticker: ARCH) is the pre-eminent metallurgical coal (using in steelmaking) company in North America.  I believe it has the combination of the best assets, capital structure, and growing free cash flow generation.  It also boasts a nearly free option on the current energy shortage persisting in the form of its thermal segment.

Manny had an excellent writeup almost a year ago to which I would refer you: https://valueinvestorsclub.com/idea/ARCH_RESOURCES_INC/8573216930.  

Rather than rehash the thesis, I will primarily focus on what has changed since then.  While the share price has slightly more than doubled, I believe ARCH remains a compelling long today.

Cutting to the chase, I project ARCH to generate $25 per share of FCF (or $477mm) in H2’21, pushing ARCH into a net cash position before year end 2021.  We should find out soon how much of fy22 tonnage has been committed and priced so far, but for now I project an additional $50 per share of FCF in fy22.  I naturally assume that met coal pricing declines from current record high market rates back toward industry cash cost levels.  This drives my FCF projection to decline from a peak ~$19 per share in Q4’21 down to $6 per share in Q4’22 and ~$14 per share for fy23.  

Even then, I project ~$75 / share of FCF in the next 6 quarters and ~$89 by the end of 2023 on ARCH’s $95 share price.

Here is a summary of my assumptions for the Metallurgical Segment:

Here is a summary of my assumptions for the Thermal Segment:

Here is a summary of my FCF build assumptions:

Next is a summary of my build to the fully diluted market cap, net debt, and enterprise value:

Here is how I am treating the convertible bonds and the dilution implied:

For conservatism, I simply assume a cash payout on the capped calls that reduces net debt in the above net debt build:

Here are my calculations for the dilution from the warrants:

Having laid out a summary of my numbers, I’ll now move on to a more qualitative discussion.  And I’m happy to entertain questions / pushback in the Q&A thread.

Focusing back on what has changed here since Manny’s excellent writeup last December, the concerning element is that now we are at the point where the relevant spot commodity prices have completely mooned, especially met coal – meaning the commodity price will necessarily fall hard from all-time record highs, the only questions being when and how rapidly.

What was nice about last December is that met coal prices were close to trough, so the future direction of the key spot commodity price was going to be higher.  Now that the future direction of the key commodity price is going to be lower, many investors will necessarily believe that ARCH cannot possibly work as a long.

My belief is that the magnitude of the windfall profits in the short term relative to the share price already account for that concern and then some.  

Last year an ARCH long had to believe (based on logical reasoning, etc.) that the commodity price would likely move up.  The challenge back then was to guess how far it would actually move up, how rapidly, and for how long it would stay elevated.

A year later, the magnitude of the current all time record high spot prices are so much higher than even the most wildly bullish prior projections as to seem absurd.  For perspective, prior record peaks for benchmark LV HCC FOB Australia had briefly touched ~$300 per metric ton several times before falling back down sharply.  Today that benchmark is ~$400 / mt despite China’s import ban on Australian met coal.  Last year, CFR China prices generally reflected the incremental logistics costs from Australia to China (let’s call it ~$350 / t all-in delivered to China for simplicity).  At the moment, CFR China prices are over $600!  And US East Coast HVA (most relevant for ARCH) prices are nearly $400 / metric ton today, an even greater incremental all-time record relative to the Australian benchmark.  

To state the obvious, it is clear that episodic shortages can/will continue to occur.  More importantly, the extent of the windfall cashflow production when such episodes occur can be game-changing.  This is not theoretical or possible, but rather happening in real time.

Historically, ARCH has often sold ~20-30% of its met coal to domestic steelmakers on fixed price annual contracts, with the remainder exported (generally on a spot basis or with very short term contracts).  On the Q2 earnings call, ARCH talked a big game with respect to the upcoming domestic contract negotiations for fy22, suggesting the price had better be right or ARCH would happily export 100% of its met production in 2022.  We will likely find out where such negotiations ended up on Tuesday’s earnings call.  For now, I am assuming essentially an identical result to what Coronado just reported last week ($187 per metric ton or ~$170 per short ton).

Another critical milestone now is that ARCH’s free cash flow is sharply inflecting.  The $400 mm capex Leer South project has been completed, so forward capex is massively reduced, right as EBITDA is exploding higher too.

I suspect that the timing of Leer South coming online may prove to be especially fortuitous.  Often, new capacity is commissioned near peak market conditions and finally comes online at the worst possible time in the next trough.  But as mentioned, met coal pricing is at the highest levels ever observed.  So presumably ARCH found itself in a disproportionately beneficial position relative to peers, with the most open tons at a time of peak pricing with competitors sold out and customers suffering shortages.  (I don’t believe that much of any Leer South tonnage was pre-committed based on the contracted tonnage disclosure overall in the Q2 release and the fact that ARCH never sought a JV partner or offtake agreement for Leer South.)

Moving on from the core met coal business, ARCH also seems to find itself in a very fortuitous position on the thermal coal side today.  Recall that ARCH in recent years has aggressively repositioned itself to being almost a pure play met coal company.  That was especially true in recent years with thermal coal pricing so weak.  ARCH not only changed its name from ARCH Coal to ARCH Resources, but more importantly it downsized its thermal operations via both divestments and production declines.  Relative to peers, ARCH made it particularly clear that its thermal business was in long term (but rapid) decline and would be harvested for cash rather than invested in.  A year ago, it wasn’t clear there was any positive value to ARCH’s thermal business whatsoever, with EBITDA barely exceeding maintenance capex and reclamation costs and pricing continuing to trend ever downward.  Today the thermal business appears it will generate material FCF far in excess of capex and reclamation costs for the next few years.

Suddenly, the outlook for ARCH’s thermal business looks much brighter (albeit only temporarily).  The remaining thermal business is almost entirely in the Powder River Basin (PRB) at the Black Thunder operation.  ARCH had been more disciplined than peers, aggressively reducing its production in the PRB in the face of persistently weak pricing.  Meanwhile, most of the competition was still focused on trying to maximize volume (in the context of being strapped for cash) and to lock in whatever customer contracts they could to try to keep the lights on.  

Today, ARCH is one of the few domestic thermal coal producers in a position to ratchet volume back up and to do so especially profitably as thermal coal pricing has exploded higher in sympathy with natural gas prices (and seaborne thermal coal pricing).  Having proactively reduced its production schedule when pricing was weak, ARCH now has more slack than PRB peers to ramp up.  And relative to producers in the Illinois Basin and Appalachia (generally underground mines that utilize much more labor and are struggling mightily to increase volumes due to labor constraints), Black Thunder is a massive surface mine operation with a much lower relative labor need.

In fact, production data suggests Black Thunder production volumes in Q3’21 are up ~3.7 mm st from Q2 and 4.0 mm st from Q3’20.  In theory, at a time when customers are scrambling to procure coal in advance of the winter season and global energy shortage, ARCH should be able to drive a tough bargain.  Specifically, while ARCH’s open tons in the short term should achieve strong pricing, ARCH ought to be able to demand multiple future tons of contracted volume in exchange for every incremental ton it can supply during the current shortage.  If so, that ought to translate into stronger profitability for ARCH’s thermal operations for the next couple years.

I hesitate to get too excited about the thermal business, especially given its far more challenged intermediate and long term outlook relative to the met business.  With that said, I think ARCH’s thermal business has particularly asymmetric upside if the current energy shortage is sustained for any length of time.  The primary reason is that the starting margin per ton is so incredibly thin in the PRB.  Historically, the delivered price to a domestic customer of a ton of PRB coal might have been ~$40 / st.  Yet the netback to the producer might be just $11 / st – barely over a quarter of the delivered cost, with the rail taking the remainder.  With transportation cost representing so much more of the delivered cost of PRB coal relative to ILB or NAPP coal, and with the remaining netback to the coal producer in the PRB being so much smaller relative to the delivered cost of coal or dispatch cost to the utility customer, incremental upside in pricing should represent massively greater % price and EBITDA increases in the PRB relative to ILB or NAPP, all else equal.  (That said, all else is not equal – considering that a far, far smaller % of PRB production can be exported than ILB or NAPP production.)

In the last period of strong met coal pricing, ARCH returned cash to shareholders aggressively – primarily in the form of share repurchases that shrank the share count nearly 40% from its emergence from Chapter 11 in 2016.  (Unfortunately, they were a bit too aggressive on the buybacks in concert with the Leer South expansion and impact of Covid.  That is what drove the convertible bond issuance in 2020, with its resultant dilution).

While ARCH has suggested they want to return to a net cash position before restarting the capital returns, we should be there by year end.  So if ARCH doesn’t articulate its plans on Tuesday’s call, it almost certainly will on the Q4 earnings call, if not sooner.

ARCH also boasts major tax attributes, with an implied pretax income tax shield exceeding $2 billion.  I’m not certain of the pace of its usage.  While prior fy21 guidance was for a cash tax rate of 0%, the real question for me is fy22 cash taxes.  For now, I assume ~10% of pretax FCF goes to cash taxes.  After all, I believe ARCH tripped Section 382 with its Chapter 11 process, subjecting its prior NOLs to an annual limitation.  However, I believe that post-emergence NOLs are not subjected to limitation.  Moreover, ARCH benefits from tax depletion and should also enjoy major cash tax benefits from the $400mm in capex it has just finished spending on Leer South.  I also would note that prior years of high met pricing and strong profitability post Chapter 11 emergence did not result in cash taxes of any materiality.  Finally, I note that much of ARCH’s deferred tax asset derives from “Investment in Partnerships” rather than NOLs per se.  I need to consult with a tax expert, but I wonder if the DTA from “Investment in Partnerships” could be utilized without limitation before bumping up against any annual NOL limitations from Section 382.  If so, it would seem plausible that fy22 might also have de minimis cash taxes.

In conclusion, I think it is unusual to find what seems to be the best, highest quality name among its peers that nonetheless enjoys similarly explosive upside to its peers in a potential in a bull case – despite those peers having much more financial leverage on the balance sheet or operating leverage from being higher on cost curve.  But in contrast to those peers, being lowest on the cost curve and also among the least financially levered, ARCH should also benefit from having among the least downside relative to peers in a bear case.

Risks

Met prices crash much faster than expected

ARCH does not secure material high priced met contracts before met prices crash

ARCH does not secure material high prices thermal contracts before thermal prices revert to prior levels

Catalysts

Contracted prices for met and thermal positively surprise

Positive revisions to earnings estimates

Balance sheet moves to net cash position in coming months

Capital returns announced

Capital returns executed

Upside potential to my projections

Met pricing takes longer to crash than I’m projecting

Perhaps ARCH manages to contract pricing on seaborne met further out than a single quarter or so

PRB volumes ramp up further if pricing is strong

Upside to PRB pricing beyond what I model

Perhaps tax attributes enable cash taxes to be 0 in fy22 and beyond

Catalyst

Contracted prices for met and thermal positively surprise

Positive revisions to earnings estimates

Balance sheet moves to net cash position in coming months

Capital returns announced

Capital returns executed