After a 48% drop year-to-date, at the current price of around $38 per share we believe Arch Resources’ stock (NASDAQ: ARCH), a company with a market capitalization of $600 million, that owns and operates coal mines, looks oversold and it can offer significant upside. ARCH stock has moved from $73 to $38 since beginning of the year, compared to the S&P which is down roughly 3%, after a strong recovery following the Fed stimulus and resumption of economic activities as lockdowns are gradually lifted. ARCH stock is also down 57% from levels seen in early 2018.
Most of the decline of the last 2 years can be attributed to a contraction in the company’s P/E multiple, as the declining natural gas prices and other cleaner sources of energy continue to pose a threat for the demand of coal. Looking at fundamentals otherwise, the company has seen its total revenue stay around $2.3 billion between 2017 and 2019, maintaining its Net Margins of around 10.2%. Though a sharp decline of 31% in total shares outstanding due to share repurchases meant the earnings grew sharply from $10.05 to $14.42. Despite the earnings growth, the P/E multiple has contracted. We believe the stock is likely to see significant upside after the recent decline. Our dashboard, ‘What Factors Drove -57% Change in Arch Coal Stock between 2017 and now?‘, has the underlying numbers.
Arch Coal’s P/E multiple changed from 8.8x in 2017 to 4.9x in 2019. While the company ‘s P/E is 2.7x now, there is a potential upside when we compare the multiple with historical levels, 8.8x in 2017 and around 5.0x in 2018 and 2019.
So what’s the likely trigger and timing for further upside?
The global spread of coronavirus has resulted in lower demand for coal, which was drifting downward over the last few years with growth of cleaner forms of energy and favorable natural gas prices. In fact, half a dozen companies filed for bankruptcy in 2019 itself. 2019 also marked the year with the lowest demand for coal in over 40 years.
Last month, Moody’s downgraded Arch Resources corporate family Rating and senior secured rating to B1 from Ba3 citing the Leer South project which will result in higher debt levels after the completion of the project. We analyze the company’s survival in the current pandemic here.
Shifting focus to prospects, Arch Resources has been willing to tie up with Peabody, another coal mine operator in Powder River Basin to survive in the current environment by achieving economies of scale and lower costs, but the Federal Trade Commission is looking to block the joint venture alleging it would violate federal competition laws, given these two companies combined will control 60% of Powder River Basin coal mining.
For Arch Resources the prize is in the east with the company pivoting to a focus on metallurgical coal, given the weak outlook for domestic thermal coal sales. Metallurgical coal is a grade of low-ash, low-sulfur and low-phosphorus coal that can be used to produce high grade coke, which is essential in steelmaking. The demand for metallurgical coal can be directly linked to the demand for steel. Though given the pandemic, the global demand for steel is expected to trend 6.4% lower to 1,654 million tons in 2020, it is expected to rebound 3.8% to 1,717 million in 2021. In the long run, the demand is expected to remain steady, growing at a CAGR of a little under 1% over the next few years. For Arch Resources, metallurgical coal will likely be able to offset the decline in thermal coal demand going forward. However, a lot will depend on metallurgical coal pricing, which is higher, from sub $70 levels in early 2016 to around $115 per ton now, and it is roughly 20% below the levels of around $145 seen in early 2019.
Overall, from a valuation point of view, Arch Resources looks like it can see significant upside from the current levels. At the current price of $38, it is trading at 6x its 2021 average consensus earnings of $6.56. Looking at the broader economy, over the coming weeks, we expect continued improvement in demand and subdued growth in the number of new Covid-19 cases in the U.S. to buoy market expectations. Following the Fed stimulus — which set a floor on fear — the market has been willing to “look through” the current weak period and take a longer-term view. With investors focusing their attention on 2021 results, the valuations become important in finding value. Though market sentiment can be fickle, and evidence of a sustained uptick in new cases could spook investors once again.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
