No Miracles From Arch Coal Inc in the First Quarter

When CONSOL Energy (NYSE: CNX  ) raised its annual coal production guidance back at the beginning of April, it was a good sign for Arch Coal (NYSE: ACI  ) . Back then, CONSOL Energy stated that thermal coal demand was strong, which must have certainly been positive for the thermal-coal heavy Arch Coal. However, such expectations did not turn into reality. Arch Coal reported an adjusted net loss of $126.5 million or $0.60 per diluted share, missing analysts' expectations of a loss of $0.42 per share. What went wrong for Arch Coal?

Cost increase pushes margins further into negative territory
Total operating costs per ton continued to rise. While it was $21.10 in the fourth quarter, total operating cost per ton was $21.70 in the first quarter, a 3% increase. What's more, total operating cost per ton was $20.82 in the first quarter of 2013. This means that costs rose 4.2% in a year, while the average sales price per ton declined from $20.45 to $20.09.

Surely, harsh winter weather contributed to this problem, as rail service issues lowered coal shipment levels. On the positive side, Powder River Basin pricing improved: average sales price per ton was up 3.7% from the fourth quarter. Yet, this was not enough to take the operating margin out of negative territory.

Operating margins are doomed to be negative throughout the whole year, unless something miraculous happens to thermal and met coal pricing. The company itself acknowledges that it is going to be cash flow negative this year. The issue of cash burn is common for most coal miners nowadays. At least, Arch Coal has sufficient liquidity with more than $1.1 billion of cash and short-term investments. The company will surely need this safety cushion in the coming few years.

Arch Coal joins the new trend
Arch Coal reduced its expected met coal sales volume by approximately 1 million tons in response to tough market conditions. With this move, Arch Coal joins the new trend started by Walter Energy (NASDAQOTH: WLTGQ  ) , which has recently decided to idle its Canadian operations. Yet, it's too early to state that these cuts will have an impact on met coal pricing in the short term.

During the earnings call, Arch Coal's CEO John Eaves estimated current oversupply of the met coal market at 15 million-25 million tons. This means that the market needs more production cuts in order to become balanced. As earnings season is under way, we could hear more about production estimates decreases from coal miners.

For example, Alpha Natural Resources (NASDAQOTH: ANRZQ  ) , which got 50% of its revenue from met coal in 2013, is a good candidate for met coal production cuts. The company, whose stock is down as much as 41% year to date, has already seen a significant decrease in met coal sales in the fourth quarter. What's more, Alpha Natural Resources did not commit and price 44% of its expected 2014 met coal production at the time of annual report filing, so it will be easy to cut production for the company.

Bottom line
Not surprisingly, problems for Arch Coal continue. However, I do not think that investors should be extremely disappointed with the company's first quarter earnings report. The report didn't reveal any negative news that was not already known. The rail issue likely caused the whole rise in costs, and this issue will probably be over by the end of the year. Met coal production cuts will have a positive impact on company's cash flow, as Arch Coal eliminated negative cash flow tons.

All in all, patience remains a virtue for Arch Coal investors. There's still a long road before the company returns to profitability.

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Vladimir Zernov

Vladimir Zernov believes that fundamental analysis works best with energy and materials stocks and covers them on Motley Fool.

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