TOP CONTRIBUTORS

Avinash Gandhi

Geoffrey Jordan

ACI AT A GLANCE

P/E ► 36.4 HIGH EV/EBITDA ► 13.4 AVG ROA ► 4.4% AVG ROE ► 5.3% AVG Debt to Equity ► 1.27 AVG Current Ratio ► 2.82 AVG Interest Coverage Ratio ► 2.21 AVG

 

 

 

 

 

 

Arch Coal (NYSE: ACI) is the second largest coal dealer in the U.S. The company is responsible for 6% of the electricity generated in the U.S., a large amount when considering that above 48% of U.S. electricity comes from coal power.^[1] During 2008, the company sold approximately 139.6 million tons of coal, including approximately 6.1 million tons of coal it purchased from third parties, mainly to power plants, steel mills, and industrial facilities.^[2] As of December 31, 2008, Arch Coal operated 20 active mines at 11 mining complexes located in the United States.^[2]

Arch Coal reported a decline in net income of 62% in the first quarter of 2009. This significant decline was caused by sales volumes lower than the first quarter of 2008 by nearly 11%.^[3] Also, Arch's operating margin in the first quarter of 2009 declined by about 42% due to rising operating costs.^[3] Coal is a commodity good; though different coal from different sources can have different mineral contents, there is no real product differentiation between competitors, leading to competitive price cycles and, as a result, low profit margins. The global economic slowdown caused coal spot prices to plummet after July 2008, and slowing economic activity has limited the demand for electricity, and hence the demand for coal. Falling coal commodity spot prices have lowered Arch's profit margin since the company earns less revenue on each ton of coal sold to utility companies when spot prices are lower.

According to the Edison Electric Institute, overall electric generation has declined 3.4 percent year-to-date through April 18, 2009.^[3] Arch forecasts power generation to decline roughly 4.0 percent this year, which would represent the largest decline in power demand on record.^[3] Additionally, it expects U.S. coal consumption to decline more than 100 million tons in 2009.^[3] The decline in the demand for coal and also the price of coal has had an adverse effect on Arch's sales volumes and profit margin. At the same time, the dominance of coal power plants as the primary source of electricity is being threatened by the increased use of natural gas and nuclear and hydroelectric power.

Company Overview

Arch Coal is the second-largest coal company in the U.S.; its coal is responsible for 6% of the electricity generated in the U.S., a large amount when considering that about 48% of U.S. electricity comes from coal power.^[4] Arch Coal is not a utilities company; it sells its product to electric utilities, factories, and other coal-burning businesses. These customers then burn the coal to fuel their generators and produce electricity. Once a mine is empty of resources, Arch Coal uses land reclamation techniques to prep it for resale, in order to maximize returns.

In 2008, Arch Coal sold 140 million tons of coal. The vast majority of this coal was transported by an extensive U.S. rail network and delivered to 175 power plants across the U.S., powering the equivalent of 20 million homes.^[1]

Business and Financial Metrics

Second Quarter 2009

Shares of Arch Coal (ACI) posted a second quarter loss of $15.1 million, or 11 cents per share, in the three months ended June 30, compared to a profit of $113 million, or 78 cents per share, a year ago.^[5] ACI reported that revenue fell to $554.6 million, from $785.1 million last year, citing huge stockpiles of coal and soft prices for natural gas.^[5] ACI management expects coal industry fundamentals to improve as the year progresses. However, the company expects its 2009 sales volume to fall to between 114 million and 118 million tons, excluding coal purchased from third parties.^[5]

Jacobs Ranch Acquisition

On March 9, 2009, Arch announced its intent to purchase Rio Tinto's Jacobs Ranch mine in the Powder River Basin of Wyoming for $761 million.^[3] The transaction includes 381 million tons of low-cost coal reserves in the same area as Arch's Black Thunder mine, as well as a high-speed rail loadout, and an overland conveyor and near-pit crushing system.^[3] In 2008, Jacobs Ranch produced 42.1 million tons of high-quality sub-bituminous coal for sale to power generators located throughout the United States.^[3]

ACI Net Income and Revenue from 2005 to 2008 in millions of USD^[6]

World Electricity Generation by Source^[7]

Coal

Coal is a highly cost-efficient source of energy - one of the cheapest in the world. When burned to produce electricity, coal-powered plants tend to have an average efficiency of 33% energy-to-electricity output; liquid forms of coal are even being touted as the next great way to power vehicles. A form of carbon, coal is a nonrenewable fossil fuel found in the Earth and is obtained using capital-heavy mining techniques; Arch Coal maintains mines in the Powder River Basin, the Appalachian Basin, the Western Bituminous, and more recently in the Illinois Basin. Coal is a commodity good; though different coal from different sources can have different mineral contents, there is no real product differentiation between competitors. This leads to competitive price cycles and, as a result, relatively low profit margins.

Coal is the most abundant fossil fuel resource in the United States.

^[8]

Breakdown of Production by Geography^[10]

Powder River Basin

Of all the mines in the U.S., the Powder River Basin is the most productive and the most abundant in coal resources. The geography of the basin facilitates mining in a way that eastern basins, like the Appalachian basin, do not; this allows coal extraction at much lower costs, though Arch Coal has seen margins drop in the region due to increased costs in the form of tire wear and diesel spending.

The coal from the Powder River Basin is also low in sulfur, and is therefore attractive to electric utilities who want to meet environmental regulations for sulfur emissions. On the other hand, the coal is also high in water, which makes it less efficient to burn, and the basin is so far from Arch Coal's main markets that transportation costs are a major factor in constraining profitability.

Trends and Forces

Due to the commodity nature of coal, Arch Coal's profit margins are closely connected to the overall demand for coal.

Arch Coal is investing in clean coal technologies

^[11]

By 2015, the U.S. government will require power plants to reduce sulfur-dioxide emissions nearly 60% below 2003 levels.^[11] Arch is helping power plants achieve these reductions by mining clean-burning, low sulfur coal for electricity generation. Nearly 82% of Arch's 2.8-billion-ton reserve base is low in sulfur content, with 73% meeting the most stringent requirements of the Clean Air Act without the application of scrubber technology.^[11]

Though Arch already mines low-sulfur coal, it has made investments in technology companies focused on making coal combustion cleaner. It has partnered with a coal-conversion company that plans to transform coal into domestic supplies of gasoline, with the potential to capture CO2 emissions during the conversion process for use in enhanced oil recovery.^[11] Furthermore, Arch Coal has invested $8 million in clean coal research through the Washington University in St. Louis and the University of Wyoming Clean Coal Technology Center.^[11]

The coal industry is pursuing several Btu-conversion technologies to transform coal into diesel fuel, gasoline, synthetic natural gas and hydrogen.^[11] These technologies would make the United States less dependent on foreign oil. Additionally, Arch supports the adoption of electric vehicles because if the nation's automotive fleet switched to electricity, coal demand would increase and also reduce carbon emissions since energy is more efficiently generated in large-scale coal-fired power plants than in internal combustion engines.

Falling coal prices have lowered Arch's profit margin and lower demand for electricity has driven down sales volumes

Coal is a commodity; there is very little that can distinguish Arch's coal from competitors' coal. Coal companies are price competitors; they attract customers by attempting to lower their prices below the competitions'. This makes it very difficult for companies to maintain high profit margins. When demand for coal is high, as could be caused by colder weather patterns or a rapidly expanding economy, prices rise for a period of time because of an undersupply to meet the demand; eventually, new companies enter the market to capitalize off of high prices and supply increases, lowering prices. Conversely, when prices are low for a period, due to high supply and low demand, companies leave the market, bringing down the supply and raising prices. According to the Edison Electric Institute, overall electric generation has declined 3.4 percent year-to-date through April 18, 2009.^[3] Arch forecasts power generation to decline roughly 4.0 percent this year, which would represent the largest decline in power demand on record.^[3] Additionally, it expects U.S. coal consumption to decline more than 100 million tons in 2009, based on data through February as reported by the Energy Information Administration.^[3] This expected decline in coal consumption reflects overall weaker power generation trends, stronger nuclear utilization, increased precipitation in hydroelectric power regions, fuel switching to natural gas, weak demand facing industrial customers, reduced need for coking coal from domestic steel producers, and the impact of lower coal exports.^[3] The shrinking demand for coal has already cut Arch's net income by over 62% in the first quarter of 2009 compared to the first quarter of 2008.^[3] Additionally, falling coal prices, which mirrored the fall in crude oil prices after July 2008, have lowered Arch's profit margin since the company earns less revenue on each ton of coal sold to utility companies when spot prices are lower.

Coal commodity spot prices plummeted after July 2008^[12]

Inputs

The only way coal companies like Arch Coal can control their profitability is by keeping their costs down. This is also very difficult, however, because the majority of coal inputs are also commodities - steel, natural gas, diesel. As the prices of these products fluctuate, the cost of coal production fluctuates, making the profitability of coal a function of an output cycle and a number of input cycles. Thus, even if coal is in high demand with high prices, rising steel costs can crimp profit margins, if not revenues.

Production Constraints

Production constraints can have a powerful, positive effect on coal price and, thus, Arch Coal's profitability. Limited transportation resources, like port space and rail capacity, can artificially limit the supply of coal may cutting down the amount that can be moved from one place to another, thereby pushing prices up. Further constraints, like labor or capital, can limit the amount of coal being produced at a mine, again limiting supply and pushing prices up. While this has the potential to limit coal companies' potential revenues, it also tends to make coal more profitable. Limits on labor, port, and rail capacity in foreign markets have contributed to the profit boom in the American coal industry, as well as to the rise in coal prices to above $100/ton.

Worldwide Energy Demand and the global economic slowdown

Coal is the most cost-efficient source of energy for the production of electricity in the world; currently, coal is abundantly found, cheaply harvested, and burns with a relatively high efficiency of 33% energy converted to electricity. Because of this, many developing countries have and may turn to coal as an economically viable source of energy to power their expansion.

Global demand for coal remained weak in the first quarter of 2009, driven by low capacity utilization at steel mills and a fall in the demand for electricity. Global steel production decreased 23 percent in the first quarter of 2009 from the prior year due to low demand.^[13] Of the major steel-producing nations, China is the only country outpacing prior-year steel production levels, with all other nations running 38 percent below 2008 on average.^[13] Operating levels at U.S. steel makers are just 40 to 45 percent of 2008 capacity.^[13]

Weakening demand for coal and the economic contraction has an adverse effect on Arch Coal's sales volumes and revenues. Already coal-based electricity has declined 5% (15 million tons) in 2009 from 2008 levels.^[13] The coal industry has seen more than 60 million tons of announced production cuts in the U.S., and U.S. production has declined 8 million tons year-to-date.^[13]

While the global economic contraction has had an adverse effect on the demand for coal in the United States, China continues to be a significant importer of coal, and China is predicted to be a net importer of coal by the end of 2009.^[13] Also, India continues to be a significant importer of coal. State forecasters predict that thermal coal imports to India will more than triple over the next four years to more than 100 million tons.^[13]

Though falling electricity demand globally limits the demand for coal, legislation is spurring the development of low carbon technology. In the U.S., economic stimulus legislation is accelerating low-carbon technology development with $3.4 billion in funding and tax credits of $10 to $20 per ton of carbon dioxide for carbon capture and storage.^[13] Another $11 billion has been approved for smart grid and transmission upgrades in the United States that would enable improved utilization of current coal-fueled generation.^[13]

The overall trend of falling energy demand does not bode well for coal because falling demand means lower prices, lower revenue, and lower profit margins on coal sales.

Government Regulation

Because of the nature of coal power, as well as the nature of coal harvesting, government regulations could play a part in raising production costs and lowering Arch Coal's profit margins. One of the major regulatory hurdles for the company involves the difficulty of obtaining permits to mine; as coal mining has highly detrimental effects on the ecosystems around mine areas, as well as on the air and water quality for human developments in the vicinity of mine areas, government permits to mine are handed out on a case by case basis. A March 2007 court decision made it more difficult for the company to expand its Central Appalachian holdings, and since no new mining permits have been given out in the past nine months, the company faces increasing challenges to expanding operations.

Environmental Degradation and Regulation

Coal is one of the dirtiest forms of energy production. It's burning releases a number of pollutants that contribute to smog, acid rain, and higher instances of respiratory problems in the general populace. Furthermore, coal power releases greenhouse gases, which are causing the global warming induced global climate change. This hot-button environmental problem, aside from being a major election issue, will have massive economic, political, and social effects in the future. For this reason, many governments around the world are being pressured by their citizens to regulate greenhouse gas emissions. From mandatory emissions caps to Carbon trading markets to subsidies of alternative, clean, and Renewable energy sources, these legislative regulations are making coal a less attractive energy source by forcing companies to limit coal power production or by making coal expensive relative to other power sources. While coal producers like Arch Coal are attempting to regain public support by developing "clean coal" technologies to reduce pollution emissions, the fact that burning coal will always release greenhouse gases keeps clean coal from being an environmentally viable form of energy, at least until carbon sequestration techniques are perfected. Overall, this trend will either lead to lower demand and, therefore, lower prices for coal or higher costs - either ways, contributing to lower profit margins.

Safety Regulations

Mines are dangerous places to work; perils ranging from falling debris to accidental explosions to dust-induced respiratory illness. Unions and citizens movements are always working for better mining conditions, which means higher production costs; the U.S. location of Arch Coal's mines means that labor cannot be exported to less-regulated parts of the world. The recent Coal Mine Health and Safety Act of 2006 is an example of a government regulation that has the potential, by taking time and energy away from production, to raise costs and, therefore, lower profitability.

Mine Divesture

Recently, the company has been selling off more and more of its holdings, in an attempt to retain high-capacity, low-cost mines and acquire new, more profitable ones. Arch Coal sold the majority of its Appalachian holdings in 2005; in the process, it got rid of many of its liabilities, including future employee health-care and pensions. The shrinking supply of coal in the Appalachian mines has been leading to higher costs of extraction, making the region less and less profitable. Other companies, like Peabody Energy (BTU), got rid of their holdings in the region only recently, giving Arch Coal a head start to gain back its losses. All in all, divesting resources from the region should be a positive move because it would allow Arch Coal to divert resources to more profitable locations like the Powder River Basin.

Competition

As a form of energy, coal faces most of its competition from natural gas, a cleaner burning source of power. If natural gas prices fall, the entire coal industry could face a drop in revenue as power consumers turn to the cheaper form of energy.

Arch Coal faces increased competition during times of high coal demand, and decreased competition during times of low demand. Because of the company's size and well-established industry position, there is very little risk of its collapse during a period of low demand. Arch Coal's major competitors include Peabody, Massey Energy Company, CONSOL Energy (CNX), Rio Tinto PLC, and a number of Chinese entrants such as Yanzhou Coal Mining. To compete effectively, Arch Coal must control its costs; controlling prices is very difficult because product pricing is a function of the market.

Notes

1. ↑ ^{1.0 1.1} Arch Coal Annual Report 2008
2. ↑ ^{2.0 2.1} Reuters: Arch Coal, Inc.
3. ↑ ^{3.00 3.01 3.02 3.03 3.04 3.05 3.06 3.07 3.08 3.09 3.10 3.11 3.12}
4. ↑ ACI 10-k 2009 "The Coal Industry" p. 3
5. ↑ ^{5.0 5.1 5.2} Dividend: Arch Coal Shares Edge Higher Despite Q2 Loss (ACI)
6. ↑ Google Finance: ACI Income Statement
7. ↑ Arch Coal Annual Report 2008, p. 3
8. ↑ Arch Coal 2008 Annual Report
9. ↑ ACI 10-K 2009 Item 7 "Results of Operations"
10. ↑ ACI 10-k 2009 "Our Mining Operations" p. 11
11. ↑ ^{11.0 11.1 11.2 11.3 11.4 11.5} Arch Coal: Annual Report 2008, p. 6
12. ↑ Energy Information Administration: Coal Commodity Spot Prices
13. ↑ ^{13.0 13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8} Peabody Quarter 1 2009 Earnings Release: GLOBAL COAL MARKETS AND PEABODY’S POSITION, p. 2
14. ↑ BTU 10-k 2009 "Results of Operations"
15. ↑ ACI 10-k 2009 "Results of Operations" p. 52
16. ↑ MEE 10-k 2009 "Results of Operations"
17. ↑ Consol Energy 10-k 2009 "Results of Operations"