Tough Times Ahead for This Coal Miner

Coal prices are under pressure, and so are shares of Arch Coal (NYSE: ACI  ) . The company, whose shares are down 42% this year, recently reported a third-quarter loss of $1.8 million. This is certainly an improvement from the $60.5 million second-quarter loss, but is it enough to attract investors?

Costs are down, but so are prices
Arch Coal has managed to reduce its operating cost per ton of coal from $21.90 in the second quarter to $19.37 in the third quarter. However, this was not enough to break even, as the company's average sales price per ton has dropped by 12.5%.

In addition to that, the company suffered from lower met coal sales, as mining conditions at its Mount Laurel mine were less favorable than in the second quarter. Arch Coal is optimistic about this mine and states that it expects these conditions to normalize over the remainder of the year.

As the company states, Arch Coal is transitioning into a met coal play in the Appalachia region. It is doing exactly what Alpha Natural Resources (NYSE: ANR  ) has been doing for a while. Alpha Natural Resources received 38% of revenue from met coal in 2012. In the second quarter, this number climbed to 50.5%. The company is yet to reap the benefits from this shift, but I think there's light at the end of the tunnel.

Alpha Natural Resources realized that thermal coal is going to be under continuing pressure from cheap natural gas and environmental restrictions. Peabody Energy (NYSE: BTU  ) shows another way to deal with the problem. Peabody is betting that the increase in demand from China, India, and Japan will allow it to profit from both met coal and thermal coal exports. It worked out for Peabody in the third quarter, as the company posted a surprise profit of $0.05 per share.

Strategically difficult situation
Arch Coal expects to produce 134 million–137 million of thermal coal this year, while met coal production is expected to range between 6.9 million and 7.3 million. As you can see, Arch Coal is heavily involved in thermal coal production. In current market conditions, this is the company's main weakness.

There is something else to consider as well: Costs can't be cut forever. When asked about further cost-cutting potential during the earnings call, the company has stated that it is already running pretty lean. You can expect small improvements here and there, but I would not bet on something big.

This means that Arch Coal's future is now in the hands of thermal coal prices. As natural gas prices remain well below the $4 mark, you cannot expect thermal coal prices to improve. Arch Coal has $5 billion of debt on its balance sheet, and this is something worth considering.

Although the first big payment comes in 2016, it's not as far off as one might think. After the sale of Canyon Fuel, Arch Coal's cash position has improved, and now the company has $1.4 billion of cash on its balance sheet.

This cash is very likely to remain there for liquidity purposes. It's clear that without major improvements in coal pricing Arch Coal would have to start refinancing its debt. Staying liquid would allow the company to get reasonable debt terms.

Bottom line
Arch Coal's future is dependent on thermal coal prices. You can expect neither significant cost-cutting nor major production increases. On the other hand, the stock trades at just a third of its book value. What's more, the company's cash will allow it to continue paying its dividend, which currently yields 2.88%. So, if you believe in the future of thermal coal, Arch Coal is an interesting yet risky investment.

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