Is Arch Coal a Buy After Strong Earnings?

With shares of Arch Coal (NYSE:ACI) now trading around $8.15, is ACI a Buy, a Wait and See, or a Stay Away? Let’s analyze the stock with the relevant sections of our CHEAT SHEET investing framework. Let’s analyze the stock with the relevant sections of our CHEAT SHEET investing framework:

C = Catalyst for the Stock’s Movement

Arch Coal posted third quarter 2012 earnings on October 26 that came in at $0.20 per share, beating estimates by $0.36. Revenue dropped 9.2 percent year over year, at $1.09 billion. The company shipped 37.5 million tons of coal in the quarter, a 6 percent decline year over year, but a 19 percent increase quarter over quarter.

In the press release, president and CEO John Eaves said, “Looking ahead, we believe global coal markets are in the process of correcting with the domestic thermal market building some momentum while metallurgical markets are bottoming out.”

EVP and COO Paul Lang added, “We are prudently matching our production levels to market demand, reducing costs and lowering capital spending.”

Shares jumped over 11 percent in afternoon trading,

T = Technicals on the Stock Chart are Weaker Than Desired

As of October 26, 2012, the stock price is 12.83 percent above its 20-day simple moving average, or SMA; 15.66 percent above its 50-day SMA; and 11.06 percent below its 200-day SMA.

Since the beginning of the year, the stock price has been in a downward trend, falling 52 percent this year through October 25, and 51.97 percent year over year. Stock price is down 68 percent over the last two years, and 79.2 percent over the last five years.

The stock is trading in a 52-week range of $5.16 and $20.37 per share.


E = Earnings are Increasing Quarter over Quarter

After experiencing what could politely be called as a massacre to its share price in the middle of 2008, Arch Coal fought to regain value into the middle of 2011. However, the prevailing winds of a down economy and steep competition from cheap natural gas have brought the company back to new lows. It is only in the past three months that we have seen something of a rally for the company, as relative performance looks strong versus the first two quarters of the year.

Fiscal Year 2007 2008 2009 2010 2011
Revenue ($) in millions 2,414 2,984 2,569 3,186 4,284
Basic EPS ($) 1.21 2.45 0.28 0.97 0.74

(Fiscal year is January-December.)

Quarter Sept. 30, 2011 Dec. 31, 2011 Mar. 31, 2011 June 30, 2012 Sept. 30, 2012
Revenue ($) in millions 1,198 1,228 1,039 1,063 1,090
Basic EPS ($) 0.10 0.31 0.01 -2.05 0.20

E = Excellent Relative Performance to Peers

Many investors favor return on equity as a key metric to diagnose how well a company is performing. Arch Coal’s return on equity is -10.66 percent, compared to Alpha Natural Resources (NYSE:ANR) at -43.57 percent and much larger CONSOL Energy (NYSE:CNX) with a ROE of 17.29 percent.

Operating margins are also critical for stock evaluation. Arch Coal still suffers from a margin of -7.50 percent, which is much better than ANR’s margin at -40.34 percent, but looks pretty bad compared to CVX at 12.92 percent.

It is important to keep in mind that Arch Coal has a market cap of about $1.70 billion, while CNX caps at $7.84 billion. Sometimes, size helps. CNX also plays in both the coal and natural gas industry, in many ways hedging its losses as coal suffered against a high supply of cheap natural gas. It’s a position that has panned out pretty well, illustrating the relative strength of a mixed operation.

T = Trends Support the Industry in which the Company OperatesCoal Mining

According to the U.S. Energy Information Administration, coal was the fuel for 42 percent of the electricity generated in the U.S. in 2011. Natural gas accounted for 25 percent of the power, nuclear for 19 percent, renewable for 13 percent, and petroleum for less than 1 percent.

For a number of reasons, it is unlikely nuclear power will grow to provide any more than one fifth of America’s power. The tangible threats to thermal coal are natural gas and renewable sources. As we have seen over the past year, cheap natural gas prices stomp on domestic coal use. Coal stocks have come up about 30 percent across the board in the past three months as natural gas prices climb, but initiatives from companies like Chevron (NYSE:CVX), British Petroleum (NYSE:BP), Exxon Mobil (NYSE:XOM), and ConocoPhillips (NYSE:COP) will continue to ramp up natural gas production. While prices may come to a competitive level in the near future, the coal industry is fighting an increasingly difficult fight. The weight of the oil and gas giants, plus typically stricter regulations, is taking its toll.

That being said, massive growing economies like India and China are rapidly industrializing. The recent coal rally is due in part to speculation that foreign energy demand will increase. It’s clear that the coal market is not going to vanish. However, headwinds suggest that it may slowly evaporate in the face of natural gas and renewable energy.

ConclusionKeep Away

According to the EIA, the U.S. exports about 7.5 percent of coal produced. If a recovery is imminent, that number will need to rapidly increase. Domestically, there may also be a shift how much of coal produced is used for electric power versus industrial purposes. If natural gas edges coal out of power plants, we could see a higher percentage of the production mix going to coke plants.

Based on the metrics, Arch Coal is a Stay Away. Despite surprising investors across the board Friday with solid earnings, there is no guarantee that the company can make a healthy comeback. If the coal industry does come back, it is more likely that larger players like Peabody (NYSE:BTU) will take the lead. Going long, growth will come from natural gas an renewable sources.

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