One Person's Trash Is Another Person's Treasure: Arch Coal

Nearly two months ago, I announced my intention to create a portfolio composed of 10 companies that investors have unjustly cast aside. My goal in creating the One Person's Trash Is Another Person's Treasure portfolio is to highlight just how successful value investing and contrarian viewpoints can be, as well as uncover some great companies that have a good chance of turning their fortunes around. For a more thorough explanation of what I hope to accomplish and how I'll measure my success, I encourage you to visit my portfolio mission statement.

For reference, here are my previous six selections:

For my seventh selection, I've chosen thermal and metallurgical coal producer, Arch Coal (NYSE: ACI  ) .

Why traders have given up on Arch Coal
The main reason Arch Coal has been left in the dust in 2012 has to do with its reliance on thermal coal and what shaped up to be a once-in-a-generation warm winter. Weak natural gas prices caused electric utilities like Duke Energy (NYSE: DUK  ) to shift some of their coal-burning facilities to natural gas in order to save money (and produce fewer emissions) over the long run. As utilities made this switch, coal prices plummeted and supplies soared, causing Arch, CONSOL Energy (NYSE: CNX  ) , Alpha Natural Resources (NYSE: ANR  ) , and Walter Energy (NYSE: WLT  ) to reduce production or, in some cases, to shut mines down completely. Patriot Coal didn't even make it that far, declaring bankruptcy last July.

Another factor that squashed Arch and coal in general was President Obama's stance toward the coal industry during his reelection campaign. The president was very clear that clean coal will play a part in America's future, but was clearly more enthusiastic about supporting our huge natural gas and oil reserves, as well as potentially subsidizing alternative energies like wind and solar. Compounding these weak results, Arch was forced to drop its quarterly payout last year by 77% to just $0.03.

Why investors should trust Arch Coal
The way I see it, there are three primary reasons why Arch Coal deserves a big second chance in 2013.

Last time I checked, coal accounted for 42% of all electrical generation in 2011. Although this figure is down from its peak, coal is going to continue to play a vital role in helping to move the U.S. away from foreign energy dependence. Weak natural gas prices, which were paramount in pushing utilities away from coal, have risen significantly off of their lows set last year. Also, while the weather will always remain unpredictable, I feel confident in forecasting that another record-year of warmth in the winter isn't in the cards for 2013.

An equally important factor for Arch is that it's arranged long-term export contracts on the West Coast and in the Gulf of Mexico to ship some of its production overseas to emerging markets like China, which are starved for energy and building coal-powered facilities at a rapid pace. Arch is going to attempt to quadruple its coal exports by 2020 which will only help to solidify its cash flow.  

Finally, to a lesser degree, China's $156 billion infrastructure bill, as well as the passing of the fiscal cliff bill in the U.S., likely means that demand for steel is bound to pick up. That bodes well for Arch's metallurgical coal business which is used to strengthen steel.

What you'd get here
If there was a fourth reason as to why investors should trust Arch Coal, it'd be because of Arch's incredible value.

Like any downtrodden energy company, debt remains the biggest concern. With nearly $4 billion in net debt, Arch Coal skeptics wonder if the company is capitalized well enough to survive a continued downturn in coal prices. I'm here to tell you that Arch is indeed well-capitalized, and it's an extremely attractive value at just 47% of book value, while still producing $1.2 billion in EBITDA over the trailing 12 months. Despite the reduction in dividend payouts, Arch is still netting shareholders a nice 1.6% while it attempts to shift some of its production overseas and keep a tight lid on costs.

In 2013, I'll be looking for Arch to restructure its debt to record-low rates and to focus on ramping up its met-coal production to the max to take advantage of what should be a surge in steel demand. Although bottom line profits may remain elusive, I expect solid EBITDA growth to continue.

Check back next week, when I unveil the eighth in a series of 10 selections to the One Person's Trash Is Another Person's Treasure portfolio.

The coal industry in the United States has been in a state of flux since the arrival of a cheaper alternative for energy production: natural gas. Exports are becoming a much bigger part of the domestic coal landscape, and Peabody Energy has deals in place to get its cheaper coal from the Powder River and Illinois Basins to India, China, and the EU. For investors looking to capitalize on a rebound in the U.S. coal market, The Motley Fool has authored a special new premium report detailing exactly why Peabody Energy is perhaps most worthy of your consideration. Don't miss out on this invaluable resource — simply click here now to claim your copy today.


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