Tag: ARCH

Arch Coal’s Q3-2021

ARCH is clearly a type of company where the analysts have most of the information well before the retail investor, which makes short-term trading of it a money-losing venture. You can see this in today’s trading action where pretty much most of the professionals got it right.

There is value, however, in making medium-range outcomes, where the playing field is a lot more level.

This is where it gets interesting today, specifically the question of how long this party in coal will last.

Putting a long story short, the demand for steel has increased since 2020’s Covid hit, while global supply of metallurgical coal has decreased. This is causing the current situation where steelmakers are forced to pay up.

Upon review of ARCH’s Q3-2021 conference call today, we have a company that is working like mad to sell both met and thermal coal. Indeed, they have pre-sold most of their 2022 thermal production at Powder River Basin at a margin that will likely net them about $10/share alone. On the met coal side, they are looking at spot seaborne prices of US$390/ton, and they have already been making sales for next year domestically in the US$200s, plus the added 3 million tonnes that gets produced in the Leer South project.

The majority of 2022 looks locked and loaded and will be incredibly profitable. It’s going to be, conservatively, about $600 million in free cash, probably more. Most of the capital expenditures will taper in 2022 as the last major construction project (Leer South) is done, and will clock around $125-150 million for the entity.

Mentally, this 2022 incoming cash flow can already be subtracted from the valuation as this is a known quantity. Factoring in Q4-2021, you can subtract about $50 of so off the stock price for the rest of 2022. The number might be even more, depending on how much high-priced met sales they can get off.

The question and value that an investor can bring to this point is what the heck is going to happen in 2023 and beyond (they’re already trying to sell 2023 production).

Right now, the stock is trading at a Price/2022 FCF of a low single digit multiple, perhaps around 2 and a half. Your valuation exercise, and what the sharps with the real information do not have, is what economic conditions are going to exist a year from now?

If things continue as-is, ARCH continues to be a dramatically undervalued stock – for each and every year these conditions are expected to continue, you can pack on another $50 or so to the stock price beyond what you currently see.

If you expect a crash in coal pricing (e.g. other international jurisdictions get their act together to ramp up supply, or steelmaking crashes), then you’ll take a hit. Depending on how bad it is, you could see a quarter of your investment evaporate.

Your typical spreadsheet analyst probably loves technology companies because their revenue curves fit really well to models. Earnings are predictable, and everybody is happy. However, the real value in investing is made in very jagged situations like this one.

Management is taking a very cautious approach with capital allocation. Their first priority is to pay down as much debt as possible (which they will be able to do in 2022) and then pre-pay some asset retirement obligations with the thermal business. They should be able to do both in the first half of 2022. They instituted a nominal dividend (25 cents/share/quarter) which will get some income ETFs in the mix, and then sometime in 2022, if the stock is still at their current levels and the commodity is still at highly profitable levels, will probably institute a buyback, although at a lesser scale than the overkill they engaged in 2019. I would expect the dividend to also increase in 2022.

Considering that costs on their met coal side is around US$60/ton and the commodity price is well into the triple digits, there would have to be a considerable crash before that business reverts back into a breakeven mode. It’s a pretty big cushion, albeit the coal market at this moment must feel like the conditions that traders of GME were facing at the end of January this year.

I think once the coal tourists get shaken off with the existing volatility and relative price disappointment (“Why isn’t this thing trading higher than 2 times earnings???”), the stock heads higher. The tough part, however, will be the day where you sell it at 4 times. Not today.

What do you do if you’re a steelmaker?

Steel factories at this moment must be facing a huge dilemma.

When your industrial process involves millions of tons of materials, you can’t exactly click a button on Amazon to get your feedstock – you need to order your inputs months in advance, if not years through a long-term supply contract.

So when prices are sky-high for metallurgical coal as they are, do you continue waiting and increase the risk that you will get no supply, or do you bite the bullet and secure a contract today?

At high prices, you are very unlikely to procure a long-term contract (who wants to lock in record-high prices on the buy side?). But you run the risk of not being able to properly price out your raw product to your own customers. It is a terrible situation.

We have a Q1-2022 pricing article that has the following:

US coal mining firm Arch Resources is offering a January-loading Panamax cargo of Leer high-volatile A coal at $410/t fob US east coast, with expectations of securing at least $400/t fob. The Leer high-volatile A coal continues to command a premium in the market, being particularly well-established in the Chinese market. “We are having trading firms chasing us pretty hard for high-volatile A coal into China,” said another US mining firm that said a European buyer was seeking 30,000t of high-volatile A coal last week. “We would be pushing for above $400/t fob ourselves.”

(fob US east coast, for those unfamiliar with shipping, means that once the coal is loaded on the east coast ship, the buyer pays and it is the buyer’s risk in the event of any catastrophe).

US$400/ton is a lot of profit, especially on a company with a US$50-60/ton cost structure. How long will this party last? Will any producers be able to supply long-term contracts at these prices, or will demand for steel plummet?

Teck / Metallurgical Coal

The rumour mill has Teck (TSX: TECK.B) looking at selling or spinning off their metallurgical coal unit for $8 billion.

In the 3 months ended June 30, Teck’s metallurgical coal unit did $1.1 billion in revenues and generated $191 million in profit.

However, since June 30, metallurgical coal prices have exploded. Teck is going to be making a lot more money from this unit in the near term future. Hard coking coal, shipped to China, is nearing US$500/ton. Domestic is approaching US$300/ton.

Realized sales in Q2 was US$144/ton with 6.2 million tons sold. Costs were $64/ton plus $42/ton for transport (moving 6.2 million tons of anything, let alone across the Pacific Ocean is going to be expensive).

While the coal volume will drop slightly in Q3 (due to BC wildfires and such), the realized price is going to increase dramatically, especially with Teck having two points of egress (they are no longer hamstrung by having Westshore Terminals (TSX: WTE) being their only exit point for coal).

If Teck manages to get $8 billion out of this unit, they will be able to eliminate their debt and become that much closer to being a pure copper play.

I also thought they were going to get rid of their energy division, but clearly management is waiting for higher prices before pulling the trigger on that (likely in the form of a sale back to Suncor of its division).

This would be an interesting turnaround for Teck – their coal division was primarily acquired through the Fording River acquisition in July of 2008, and they paid US$14 billion for them, with the lion’s share (US$12.5 billion) in cash.

We all know what happened in late 2008 – the economic crisis really hit the fan. The acquisition was possibly the worst-time acquisition in Teck’s corporate history and it nearly bankrupted them.

So now we fast-forward 13 years later, and Teck is looking at getting rid of their coal division.

My question is – who would buy this? There’s no logical strategic buyer for the entity. Financially, perhaps some hedge funds want to make a gamble that coal pricing will be excessively high for a longer duration of time than the markets anticipate. One financial combination that would make some sort of faint sense is one of the British Columbia crown corporation pension plans (think about the regulatory protection that would afford the company), but one could imagine the political outrage of taking over a coal company in the era of climate change consciousness.

A spinout would be more likely, but I would see the Teck umbrella affording the coal entity much more regulatory protection than being a standalone entity.

As such, I do not believe they will take any real action on the coal entity. I could be wrong.

If they were able to dispose of the coal unit on acceptable terms, the financial engineering motive is pretty simple – by being seen as a more pure copper play, the company would receive a higher valuation. I know how my cautious investing colleague John Cole is feeling about Teck, but this commodity cycle is not at the point of peaking yet. Unlike lumber (where starting up and shutting down is a way of life and can be done with relatively quick frequency), other commodities have much longer cycles and activating coal/copper supplies is a matter of years and not months.

The other observation is that Teck is exporting 6 million tons a quarter, Arch (NYSE: ARCH) is going to do about 2.5 million tons of met coal a quarter now that Leer South is opened. While Arch has a geographical disadvantage (more difficult to ship the material to China from West Virginia), ton-for-ton would give them a US$2.6 billion valuation, which is about 60% higher than their current stock price, accounting for the moronic convertible debt financing they did a year back.

Short note – Coal

Market pricing for metallurgical coal is going nuts in China – right now it is north of US$400/ton cfr (and given how gong-showed marine transportation logistics are these days, freight is not a trivial expense). However, the point is that even with freight these are very, very, very high prices. This has impact on prices that Teck will receive on their met coal production (a good chunk of their met coal production goes over the Pacific). In addition, my briefing note and financial forecast I wrote on Arch Resources in June (cash generation of $15-20/share) is looking increasingly conservative.

In the current commodity price environment, both Teck and Arch will be cash machines. While both companies aren’t going to make US$400/ton on all of their sales (the North American market is much less pricier), the overall impact on pricing across the geographical spectrum is clearly up from where it was 18 months ago.

Teck will also have the supplement of its 70% owned QB2 project when it is completed in 2022. QB2, at US$4.00/pound of copper, will generate about US$1.7 billion EBITDA on a 100% basis and after baking in 40% taxes, Teck should be able to generate an incremental US$700 million/year in cash out of this project. Every 50 cents of copper above this will be about US$125 million more. On a consolidated company basis, it is foreseeable they will be able to pull in about $3 billion a year in cash. Once the capex on QB2 is finished (which is the primary cash drain for Teck at the moment), they will be able to begin a simultaneous debt paydown and dividend increase at the same time – my guess is they will ramp up their existing $0.05/quarter dividend to around $0.25/quarter once QB2 is finished and dump the rest into debt repayment. My guess is they’ll want to get below at least $5 billion net debt.

Arch’s net debt probably peaked out at Q2-2021 and at this point forward, it will be generating significant sums of cash. When examining coking coal statistics, the Leer South mine (pretty much finished) will be positioned to grabbing the lion’s share of this market. It takes years to get a coal project out of the ground and mal-investment has finally taken its course. In 2022 they will likely be able to pay off their net debt and then re-institute a dividend or share buyback (offsetting their near-disastrous capital allocation decisions of previous years post-Chapter 11).

The virtual investment prohibition (fueled by ESG and other environmentalism) has created an environment of impossible-to-get capital for coal projects – a perfect formula for elevated prices for those that have incumbency rights. Both Teck and Arch fit the bill for metallurgical coal in North America.

The question is when the party will end. As long as worldwide demand for steel remains red-hot, not anytime soon.

Briefing note on Arch Resources

For historical context, read my December 2019 post on Arch Coal where I give a primer on coal mining and discuss Arch Coal.

This is a short briefing update on the renamed company, Arch Resources (NYSE: ARCH).

My timing from the December 2019 post was a bit botched up – indeed, at one point I exited the entire position (during the Covid crisis) but later took a very healthy position at lower prices than they are trading at today. It is a large but not gigantic position currently. I am expecting it to get larger by virtue of appreciation.

Between then and now, other than Covid-19, the other major setback they hit was the regulatory blocking of the merging of their Powder River Basin thermal coal operation with Peabody Energy. This probably cost the company tens of millions of dollars a year in synergies.

It also turned out that they engaged in poor capital allocation. They bought back way too many shares in the 2017/2018 coal boom and were forced to tuck their tails behind their backs when doing some subsequent debt and convertible debt financings to fund the $390 million Leer South Project, but it appears that path is now clear and the need for future capital is gone.

The reason for this is that the Leer South project is due to be operating in Q3-2021 and this project, at current met coal pricing, is going to make a ton of money. The project is anticipated to generate 4 million tons of High-Vol-A coking coal a year for the next couple decades.

Right this very second (partially instigated by the trade war with Australia), prices to China are around US$300/ton. Indirectly, demand from China will continue to suck supply from other suppliers of the world.

Because shipping tens of thousands of tons of material is not an easy feat, transportation logistics became a ‘weighty’ issue. There is a limited capacity to transport from an eastern inland mining area (West Virginia) to the west coast (typically Long Beach, CA), and then onto a freighter across the Pacific Ocean. The opportunities for westward export are limited (indeed, Teck is making a fortune doing this from Elk River mines in southern British Columbia). As a result, the prices that ARCH will be receiving will be well less than US$300/ton, but it will be significantly higher than the averages received in 2019-2020.

High Vol-A, from what I can tell, is around US$190 spot currently. At that price, Leer South, once completed, will contribute an incremental US$500 million or so at existing pricing to the entity, in addition to the existing metallurgical operation. This is crazy amounts of money. Also, by virtue of the entire coal industry being decimated, competitors will have to take their time to open up more met operations (looking at Warrior Met Coal (NYSE: HCC) here), so Arch will eat up the lion’s share of marginal met coal dollars.

There is a lag effect between when coal is mined and when it is sold – contracts and deliveries have to be signed quarters and years in advance, so the pricing seen on GAAP statements will not be see until well after the economic substance of such transactions is actually performed. You can sort of see this being factored in the existing share price (which is the highest it has been since the Covid crisis) but my question will be what sort of valuation the market will ascribe to the company when they generate around $15-20/share next year (current analyst estimates are $7.63). Ultimately it depends on how much this boom for steel production (the primary driver of metallurgical coal consumption) continues world-wide.