When there is a shortage of an economically important commodity and its price is up significantly, you want to invest in the producers of that commodity, right? Well, it's not always that simple. While the price of coal has gone up considerably as production has lagged demand, it doesn't automatically follow that coal companies are still perennially attractive investments.
Looking at Arch Coal's (NYSE: ACI ) third quarter, we see more of the kind of results we've been seeing from the coal sector lately. Revenue was up 24% as both volume and pricing climbed nicely. Although production costs are also rising rapidly, margins improved a bit, and the company posted 30% higher operating income for the quarter.
For now at least, the basic thesis on coal looks very much intact. Although coal prices are higher, it is still a cheaper fuel than oil or natural gas on a per-BTU basis. What's more, production difficulties are causing supply to lag demand, and that in turn means lower inventory stocks at customers.
Turning to cash flow, you see that it's not a perfectly rosy picture. Although operating cash flow is up strongly over last year, the company is still not in a positive free cash flow position. Look back a bit into the company's history, and you also see an odd pattern of somewhat erratic free cash flow. Part of the problem is the high cost of maintenance for this industry -- it takes a lot of money to keep the production assets in production.
And that makes gauging the future of the coal sector challenging. Arch Coal isn't alone in having a high-maintenance capital-expenditure burden and a somewhat dicey history of free cash flow growth; the same could be said to some extent of Peabody (NYSE: BTU ) , CONSOL Energy (NYSE: CNX ) , and Massey Energy (NYSE: MEE ) as well. So, while the company stands to benefit from higher prices as old below-market contracts roll over, I'm not sure you can draw a straight line between profit growth and free cash flow growth.
In the short run, you can often get away with ignoring cash flow and going with stories where the earnings growth is impressive. Over the course of time, though, I think cash flow becomes increasingly important in separating the winners and losers. So while I think Arch is a good coal company and I think the outlook for coal should be strong for a few more years, this stock might have a bit more risk to it than seems the case at first blush.
For more carboniferous Takes:
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Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).
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