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– Coal is a hated industry. Arch Coal valuation near lows; 20% or better bounce seen – Coal a necessary commodity in U.S. and especially overseas; sentiment hurts stock – Rival Peabody draws growing interest from Elliot Management.  Could ARCH do same? The skyrocketing price of Tesla (TSLA) shares in recent weeks is seemingly pointing to a future for energy related stocks that reduces or excludes fossil fuels.  Today I want to discuss coal.  Wait, come back. Hear me out for a moment. Coal is not dead, despite the efforts of large institutional investors to delegitimize it. Coal is still used for producing electricity (thermal) and making steel (metallurgical) all around the world, especially outside the U.S. The more that the consensus is anti-coal the bigger the opportunity for the contrarian if, as I believe, the consensus is wrong. While coal use has been reduced over the years, I think that economic reacceleration in the U.S. and the global economy, which we expect, is going to help improve the worldwide coal demand later this year. A stock that has been battered beyond what I believe the fundamentals justify is Arch Coal (ARCH), a low-cost producer and one of the largest coal miners in the world, with operations in Appalachia, Powder River Basin, Colorado and Illinois Basin. ARCH emerged from bankruptcy in 2016 with net cash on its balance sheet and having removed 25% of cash costs out of their coal business.  Since last April, the stock dropped nearly 50% from over $100 per share to as low as $50 this week.  It has since bounced to $59, but the shares still look inexpensive. I think ARCH’s future is better, perhaps 20% or better, than the stock price would have it. On a fundamental basis, coal prices are down, in some cases sharply. A drop in other energy prices, like oil and natural gas, has hurt as well.  Metallurgical coal fell about 30% last year, mainly on the global economic slowdown. Thermal coal has fallen on the growth in renewable energy sources and increasing regulations supporting moves away from coal energy production. The average price of coal has dropped from about $100 per ton to near $70. That plus worry about a slowing global economy has hurt ARCH stock and other coal producers. It’s hard to argue with the weak fundamentals as a reasonable concern. We think the global economy will reaccelerate. If it doesn’t, coal prices should remain roughly where they are. Despite this, I’d argue that much of the drop in ARCH stock is unjustified and emotionally based, due increasingly to poor sentiment, in particular to negative comments about “dirty” coal.  For example, the headlines blared last month that the world’s biggest institutional investors, BlackRock, plans to cut exposure to coal stocks, in order to address climate change. That was followed by a statement from the New York State Common Retirement Fund, the third largest U.S. public pension fund, that it might divest from coal mining companies that aren’t ready to move away from relying on thermal coal for profits.  What the headlines left out is that since much of BlackRock’s coal investments are in passive ETFs, it has little scope to change its coal holdings, which are pretty minimal anyway.  Nevertheless, the sentiment damage to the coal industry was done. ARCH is the largest US producer of metallurgical coal (1/3rd sales by volume) and the second largest producer of US thermal coal (2/3rd of sales). However, here’s another fact the headlines don’t mention: ARCH gets 44% of its revenue and over 80% of Ebitda from metallurgical coal because Met coal prices are higher. Climate activists are on the warpath against thermal coal. “The stock drop reflects more behavioral than market-fact forces,” avers Peter Andersen, who runs Andersen Capital Management, which owns ARCH stock.  Despite soft fundamentals, I believe there will be a normal cyclical reaction to improve results.  There is some worry about Australian coal capacity increases, but, as in the past, the industry will eventually lower production to bring supply and demand into balance.  At that point, which might take a year, coal prices should rise.  I also expect that lower 2019 Chinese demand is a temporary cyclical slowdown. Moreover, despite the worry about thermal coal, utility stockpiles are at lows. (See nearby chart.) The value of coal to the rest of the world is much higher than the average investor might think, Andersen adds. The world is far behind the U.S. in the use of alternative energy and that won’t change soon. “Coal is a basic fuel. Some might hate it but it is not going away.” Many countries cannot do without both thermal and metallurgical coal, and the supply/demand dynamic will always adjust prices to reflect that with time, he says. Besides the rising market, ARCH stock jumped Wednesday, probably on the following news: rival Peabody Energy (BTU) agreed to let Elliot Management  appoint  several new members to the  board. By the way, Elliot has been upping its stake in BTU for months, now around 19%.  This supports the idea that perhaps coal stock prices have fallen to a level that could attract outside interest. Andersen agrees. ARCH would seem a strong candidate to take private, after which it would no longer be subject to the latest whims from BlackRock and other large institutional funds.  I don’t know of any interest in ARCH, but the moves by Elliot are suggestive. At one point, when the stock hit $50, the shares were down 50% from May 2019, even as consensus EPS for 2020 had fallen 21%. That disproportionate drop suggests that much of the gap derives from more from sentiment than fundamentals. After the nearly 20% jump this week, ARCH stock still trades at about five times expected 2020 EPS of $11.10, significantly lower than its historical average P/E of seven to eight times. I’m heartened by the trading action this week, though it’s stolen some of my thunder. Still, I think investors should wait until after the company reports fourth quarter results tomorrow, Feb. 6. If, as many expect, it will be a weak quarter, the stock could give up recent gains and offer investors a chance at a lower price. I think 20% or more is still possible if the global economy improves. ARCH, which has no net long term debt, has repurchased some $890 million in shares over the past three years, roughly equivalent to the current market cap. It won’t take much in the way of good news later this year to move the stock upward inordinately. Where could I be wrong: Bears are expecting a poor global economy in 2020. That would hurt coal prices. Bottom Line: Poor sentiment is mostly responsible for a large part of the downdraft. We expect the U.S. and global economy to improve and with it coal prices and stocks like ARCH. 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After Sentiment Plunge, Arch Coal Stock Looks Inexpensive
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