Arch Resources (ARCH): A Soft Q2 But Weak Share Price Makes Risk Reward Compelling

VaselineAugust 12, 2024

0 4 minutes read

Arch Resources (ARCH): A Soft Q2 But Weak Share Price Makes Risk Reward Compelling

Coal miners on the coal pile — Monty Rakusen

Overview

Arch Resources (NYSE: ARCH) is a publicly traded US-based coal mining company that they have owned since the summer of 2023. The share price has seen some weakness recently, but is still well above minimums observed last year.

I’ve covered Arch several times over the past year, and previous articles can be found here. The company released its Q2 2024 result on July 25th, which this article will focus on along with my overall thoughts on the company.

Figure 1 - Source: Koyfin — Figure 1 – Source: Koyfin

The company has large thermal coal production, much of it in the Powder River Basin, but most of its EBITDA normally comes from the metallurgical (“met”) coal segment. So I see Arch primarily as a known coal producer.

Figure 2 - Source: Arch Annual Reports — Figure 2 – Source: Arch Annual rEPORTS

In 2024, the thermal coal segment is expected to break even due to low domestic thermal coal prices, which are closely correlated with natural gas prices that have been lower recently.

Less-than-ideal domestic thermal coal conditions may have contributed in part to the weakness in Arch inventory in 2024, but the weakness is likely more related to lower coking coal prices globally and possibly also due to disruptions in Baltimore exports during the second quarter of the year. Exports for Arch in Baltimore now work normally.

Figure 3 - Source: TradingView — Figure 3 – Source: TradingView

Result Q2 2024

Arch reported quarterly revenue of $609 million in Q2 2024, and adjusted EBITDA was $60 million in Q2 2024, down 42% from $103 million in Q1 2024. Net income was $15 million, in down 74% from the previous quarter. EPS for the quarter was $0.81, which missed the consensus EPS estimate of $1.99 by a decent margin.

Figure 4 - Source: Arch Quarterly Reports — Figure 4 – Source: Arch Quarterly Reports

The thermal segment operated, similar to last quarter, at roughly breakeven, but the segment was affected by excessive stripping in the first half of 2024, which will benefit the result in H2 2024 when stripping levels will be below transportation levels . So we should expect some margin improvement in the second half of the year.

Figure 5 - Source: Arch Quarterly Reports — Figure 5 – Source: Arch Quarterly Reports

The met segment had a sales volume of 2.2Mt in Q2, on par with Q1 and in line with annual guidance. This was relatively impressive given the outages at the export terminal for much of Q2. Costs were also relatively competitive at $91/t, but the selling price fell significantly in Q2 to $132/t, which is the main reason for the weaker quarter. The $41/t margin in the met segment is the lowest we’ve seen in three years.

Figure 6 - Source: Arch Quarterly Reports — Figure 6 – Source: Arch Quarterly Reports

Arch reported operating cash flow of $59 million and discretionary cash flow of just $12 million during the second quarter, which was the weakest we’ve seen in a long time. It’s important to remember that Arch is a low-cost producer, so if the company is barely making a profit here, we can expect to start seeing negative results elsewhere in the industry if current coal prices persist as contract prices settle smaller.

Figure 7 - Source: Arch Quarterly Reports — Figure 7 – Source: Arch Quarterly Reports

Arch is committed to returning 100% of its discretionary cash flow to shareholders. 25% of distributions are in the form of dividends, while the remaining 75% will be in the form of buybacks. The next dividend payment in September will be $0.25 per share. The company repurchased 94,000 shares during the second quarter, but continues to have a net cash position of $146 million that can be tapped if we see more weakness going forward.

ASSESSMENT

The figure below uses the latest share price, Q2 2024 financials and the company’s latest guidance for 2024. Note that the thermal coal segment is expected to make a very minimal positive contribution to EBITDA in 2024.

Figure 8 - Source: My estimates — Figure 8 – Source: My estimates

The historical free cash flow yield is currently around 13%, using both enterprise value and market capitalization as the denominator. If current low coking coal prices persist for the remainder of 2024, the free cash flow yield in 2024 is likely to be around 10%.

Conclusion and risks

It is important to remember that coal prices are cyclical, and if current prices continue for an extended period of time, we may begin to see supply cuts. I also expect to see an improved margin from the thermal coal segment over time as well, which is not accounted for if we just focus on the 2024 numbers.

As a result of Arch’s recent weakness, I see it as a very compelling buy here and have added to my holdings recently. The valuation is reasonably attractive using low coal price assumptions, the balance sheet is excellent, operating costs are in the lowest quartile for the met segment, and the company continues to distribute 100% of discretionary cash flow to shareholders. So, apart from the recent price action, there is a lot to like.

Can coking coal prices get any lower? Always, but given that Arch is a low-cost producer, I’m not that worried about the company making substantial losses for any extended period, and the balance sheet is robust enough to handle any short-term losses.

In 2024, Arch was added to the S&P SmallCap 600 index, which substantially increased the percentage of ownership from ETFs to 39%. So the company very likely became more sensitive to the market movements that followed. There is also potential oversold risk if the company were to pull out of any of the larger ETFs, where I’m thinking specifically of the Pacer US Small Cap Cash Cows 100 ETF (CALF) which invests in the top 100 companies in the S&P. SmallCap 600 Index based on free cash flow yield.