December 10, 2020 - 12:36am EST by
2020 2021
Price: 42.00 EPS 0 0
Shares Out. (in M): 15 P/E 0 0
Market Cap (in $M): 630 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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  • Coal
  • Commodity exposure


ARCH is a metallurgical coal producer (ie: not the bad kind).  And for those that can overcome the "reverse greater fool psychology" (ie: no one/the market will ever buy this investment from me at a higher level) around the coal sector, I think there are multiples of invested capital to be made in this very uniquely positioned commodity producer.  Of course, since we are in one of the most buoyant "greater fool" markets of all-time, I think there is an excellent chance that eventually the market will in fact pay fair value for this company, similar to the "buoyancy" witnessed in other old economy businesses, such as FCX, CLF, and TECK, all of which have similar macroeconomic exposures as ARCH.

If you take 15 minutes to read this, I think you will get it (you can easily/quickly verify every underlying point to the thesis).  If you don't like the idea, please explain/poke holes in the comments.

To be clear, I am not arguing that coal isn't dying.  However, that argument is most legitimately made for thermal coal (ie: power plant coal), not metallurgical coal used in steel-making.  In fact, metallurgical coal has a fairly "holy grail"-like commodity industry backdrop, in that for certain high quality/specification coal, it is very geologically scarce (unlike thermal coal), has no available substitutes, and has a relatively steep cost curve.  This is why if you look historically at met coal prices, you will see they have a clearly defined trough, around variable cash costs, and are prone to spikes every few years, to 2-3x new-build/full-cycle cost curves... call it $100 to $300/ton range.  again, sort of the holy grail in commodity investing setups.

I think we are very far from steel/metallurgical coal demand plateauing or entering secular decline, and since this is a heavy depletion-oriented industry, even if you disagree/are concerned with this demand assumption, your risks of demand plateau are still mitigated insomuch as the production cost curve still drives full-cycle pricing due to the replacement capital requirements of the depleting production.

On top of this industry backdrop, ARCH has the "holy grail" characteristic within a commodity sector of an irreplicable technology/geology-driven, structural cost advantage, which allows it to generate modest cash from operations at the troughs when competitors are EBITDA/variable contribution margin negative, and earn excess returns "through the cycle," namely due to fully capturing the scarcity value pricing scenarios, that are caused by those negative EBITDA competitors falling out of the market.

Today you can buy this asset base at or below replacement cost, almost unheard of for world-class production assets in commodity industries.

The details are as such:

1) ARCH's key assets are Leer, and the under-construction sister mine, Leer South, in Northern West Virginia.  These mines produce High-Volatile A met coal, which is both the most scarce quality of met coal (<10% of US production; note the US is a key global producer of this quality), and irreplaceable in coking coal blends, which are ultimately used to make coke, which is then used in blast furnace steel-making.  For these reasons, High-Vol A coal trades at a consistent price premium to other met coals.  For context (you can Google the details), steel produceres/coke makers are trying to minimize coal costs, while still meeting certain CSR/hardness requirements of steel blast furnaces, and High-Vol A coal's key quality is "fluidity"/plasticity, which helps "bind" the other hard and semi-soft quality coals together at high temperatures, therefore enabling steel makers to substitute out expensive Low Vol/Mid Vol coals, into lower-priced High-Vol B coals, by splashing in a blend of (expensive) High-Vol A coal, thereby optimally minimizing total coal costs.

2) Not only does ARCH have a structurally premium-priced product, but it has a structural cost advantage as well.  Because high-quality (low vol/mid vol/high vol A) coal is so scarce, oftentimes coal producers will mine smaller, or thinner-seamed, deposits to access this premium-priced coal.  ARCH has a unique deposit in Northern West Virginia (which it owns vs competitors lease, a separate and distinct cost advantage), which is able to be mined using longwall methods.  This is equivalent to "sweeping" back and forth across long (mile+) coal deposits, rather than the "room and pillar"/continuous miner method of "punching holes" into small blocks of mineable coal deposits.  This mining technology (which requires larger upfront equipment investments), creates the advantage of allowing for more tons/man-hour to be mined, and since labor is the largest mining expense, the hours/ton is lower, thereby creating a structurally advantaged ongoing cost structure.  You can verify this statistically through various data sources, but these longwalls (of which there are only 4 metallurgical mines in the US, 10+ thermal mines), can achieve .5hr/ton+ advantages over peers, or $15-30/ton.  This leads to ARCH's all-in cost structure at these mines to be ~$45-50, vs. continuous miner competitors at $65-100/ton, depending on productivity.  Note that longwalls make up <25% of US met coal production, and the US is the 2nd largest exporter of met coal globally (~15% of global supply), meaning the cost curve is steep.

3) High-Vol A coal prices have peaked ~$300/ton, 3x in the last 12 years, on the aforementioned supply scarcity, and re-occuring issues with Australian supply (~65% of global export supply).  This $300 price "nets back" (to compare to the above cost structure) at $300 less $20-30 ocean freight, less 10% discount for metric ton conversion = ~$250 priced at the East Cost port, less $25-35 rail freight = $210-220/ton at the mine, for a $150/ton+ variable cash margin.  Prices consistently trough ~$115/ton, which nets back to ~$60/ton, still allowing longwalls to generate cash flow even, even while all continuous mine competitors are EBITDA negative.  The forward curve is ~$150/ton currently (Australian low-vol futures contract).

4) These longwall mines cost ~$400mn to build a 4mn ton mine, assuming you already own the minerals/land (which is where the real economic value is extracted/priced).  ARCH's 4mn ton Leer mine has been running flawlessly for ~6 years (the youngest longwall in the US) and Leer South's 4mn ton mine should start up in 3Q21.  You can see the payback math at various commodity prices, but it's

5) You can buy this business for <$800mn today, or the equivalent newbuild cost, ignoring the other assets (discussed below).  Market Cap ~$780mn (assuming convertible bonds are equity), plus Gross Term Loan Debt ~$350mn, less Cash ~$375mn (including $155mn convert issue), plus Leer South completion capex ~$100mn, less Operating Cash Flow to fund Leer South over the next 9mo ~$75mn (conservatively) = ~$780mn Enterprise Value.  It's probably not a coincidence that management is essentially running the business in a zero net-debt position, accounting for the Leer South growth capital, as they are conservatively-oriented, after having filed for bankruptcy 4 years ago. (Note the $155mn convert is just in-the-money, so it's irrelevant ffrom a valuation perspective whether you count it as debt or equity).

6) The Leer complex has 200mn+ tons of engineered, mineable reserves, and so will have a 20+ year mine life. These 200mn tons could easily generate $20/ton+ in economic profit on an undiscounted basis, or >$4bn, for a 5x+ MOIC (undiscounted multiple of invested capital) vs. cost through the stock today.

7) ARCH has a number of other met and thermal coal assets, namely A) two met coal continuous miner operations (1 low vol "Beckley" mine, 1 high vol B "Mt Laurel" mine) ~$0-150mn of value; B) Viper/Knighthawk Illinois Basin mines, ~$50mn of value due to a long-term sales contract (~$10mn+ EBITDA/yr); C) West Elk Colorado longwall thermal mine $50mn+ value, at $20mn+ avg annual EBITDA, albeit volatile; D) Powder River Basin surface, thermal coal mines - the wildcard in the equation, as no-one will pay you cash for them (unlike these other smaller mines) so value is theoretical, however they are massive (50mn tons/yr), low-cost, and cash generative ($50mn+/yr contracted EBITDA), albeit with ~$200mn asset retirement obligations, so valuation-wise they could theoretically have zero value, though would generate a healthy MOIC over time; E) 35% stake in DTA Coal export terminal in Virginia - unclear value, though theoretically meaningful - they run it as a cost-center currently, but it has value on a market-oriented commercial basis.

To keep it simple, I'll round all these associated values to somewhere between zero and $200mn NPV;  Most importantly, ARCH is vocally committed to divesting/separating/closing all of these thermal assets, in order to isolate the metallurgical coal assets, and gain market recognition for the trophy Leer complex.  However, in the meantime these assets are highly cash generative and provide significant cash flow to fund both the Leer South expansion capital, as well as share buybacks.  Note that these assets generated ~$150mn/yr of free cash flow, net of capex, over 2017-2019, so I think this valuation assumption/range could prove to be conservative, even if salable market values are non-existent today.

Note that there is some optical "asset retirement obligation"/surety bond risk, which may explain the opportunity set here to a degree;  I think this is demonstrably manageable (~$200mn on a cash flow of $50-150mn/yr), though it explains some of the risk premium in the stock.

8) Looking at valuation from a top-down perspective, I think the met coal business (High Vol A Longwalls + Beckley Low Vol) generates ~$300mn/yr of asset-level cash flows at $150/ton mid-cycle pricing (10mn tons at a $30 margin), which translates to $250mn of corporate, unlevered cash flows, net of G&A. Taking out $5/ton, or $50mn, of maintenance capital leaves ~$200mn of unlevered free cash flow.  So you're creating this for 4x sustaining FCF, unheard of in almost any sector, let alone a trophy asset in a scarce commodity sector.  Cash interest is ~$25mn/yr.

9) Management doesn't suck (like most public company managers).  Upon exiting bankruptcy, they used excess cash flows to repurchase >35% of the shares outstanding over a 3yr period.  While these share purchases appear poorly "timed" in hindsight, I am much more encouraged by their willingness to return capital to shareholders, and I believe more of this is in store for equity owners once Leer South starts up in 3Q21.

10) I don't think it's unreasonable that this business will trade at 2x new-build value, or a low single-digit unlevered FCF yield, which triangulates to ~$1.5-2bn of enterprise value, or $100+/share (15mn shares).  It's awkward/aggressive-sounding to claim 100%+ upside, especially for a non-levered business (ie EV is off by 100%), but I don't think the math itself is aggressive.  It's also awkward to say it could be worth a greater price per share than at any point in the last 3 years, but again you can look at CLF or FCX as clear examples of old economy commodity companies that are currently trading well beyond last 5 years peak share prices.  Further, you can look back at history to the 2000s all the way to just a few years ago, and see that these types of met coal assets traded at 3-4x+ replacement value in the public markets.  Apollo/Blackstone/KKR all made a killing in 2016, buying/converting these met coal bonds through bankruptcy, and the beauty of this situation is that you can achieve the same "create" price they did without any of the bankruptcy risk/friction.  It's a fascinating valuation point in time to create these assets, relative to history, and relative to basic industrial logic in commodity market asset investing.

Note that this thesis is not particularly macro/cyclical/commodity price-oriented in nature, and there are a lot of moving pieces in the short-term that are creating negative and now positive noise (Chinese-Australian political disputes, import restrictions/relief, etc) but this thesis is very much a geological/technology driven opportunity in my mind, whereby low-cost assets, with good balance sheets, will earn significant excess returns through the cycle.

Any and all disagreement/pushback is welcome.  I can't wait to hear where you think I'll be wrong on this.  Thanks for reading.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


China imports met coal again, and prices rip in Feb 2021.  Leer South doubles production at exactly the right time, and the company is in a position to buyback 20% of it's shares per year.

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