Wouldn't Mimic This Insider Buy

 | Feb 26, 2013 | 11:00 AM EST
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Arch Coal's (ACI) shares have slid 60% in the past year amid weak demand in both metallurgical and thermal coal. Metallurgical coal is used in steel production, so demand here has been heavily affected by poor macroeconomic conditions, most notably in Europe. Meanwhile, the burgeoning natural gas market over the past year or two has grabbed market share from thermal coal, a leading fuel for power plants.

Still, company board member Douglas Hunt recently bought 8,000 shares of Arch at an average price of $5.54, upping his direct stake to 30,000. On average -- though not always -- insider buys tend to be bullish signals, since insiders thereby increase their exposure even further to any company-specific risks. As a result, these moves would seem to indicate the potential for high returns ahead. With Arch closing in on its $5.26 low from July, Hunt apparently believes the market is not correctly anticipating the likelihood of a recovery.

Business certainly was poor for Arch in the fourth quarter. Revenue dropped 21% year over year and operating income was barely positive, even after we add back goodwill impairment and a special item related to Patriot Coal's bankruptcy. While the company fared better in the first nine months of the year, operating income was still very low after add-backs. Adjusted earnings before interest, taxes, depreciation and amortization came in at about $690 million for the year -- down 25% from 2011 -- with most of the decline having come in the fourth quarter. That figure makes for a trailing EBITDA multiple of 7.8x, which is high for a low-margin business such as Arch Coal, unless it is able to improve its operations. That number also, of course, excludes substantial costs: Last year interest expenses were about $320 million, or nearly half of adjusted EBITDA.

Unsurprisingly, Arch Coal reported a significant net loss for the year, and analysts expect a loss of $1.15 per share for all of 2013. The sell side anticipates an improved performance in 2014, though most forecasts call for the company to remain unprofitable. Further, with the share drop -- which still leaves the stock at a high EBITDA-based valuation, as noted above -- the company has a highly leveraged current capital structure. Market capitalization totals $1.2 billion, and large cash holdings help bring its enterprise value to $5.4 billion, but Arch also carries long-term debt of more than $5 billion. Cash flow from operations was positive last year, though there was a large percentage decline from 2011.

Arch Coal stock carries a beta of 2.1, likely due to both the company's leverage and the fact that the metallurgical coal business depends on general economic activity. The most recent data show that 17% of the outstanding shares are held short. So, contrary to what this insider purchase seems to indicate, a number of market players believe the stock price has further room to fall.

The metallurgical coal business is tough for us to predict, but Arch Coal's situation is certainly in line with those of steel companies -- so watching their performance over the coming years could serve as an indicator for metallurgical coal as a whole. At least some of the switch to natural gas is likely temporary, driven by a supply glut in the U.S. and extended by the lack of sufficient export infrastructure. However, we believe some of the shift is permanent.

Quite simply, new technologies have unlocked a new source of energy that stands to be a major player in the U.S. energy mix for decades to come. Coal, as the previously dominant player, will pay the price amid the onset of new natural gas capacity. Given also this particularly poor fourth quarter for Arch, we think buying at this point would be too speculative, and we would prefer to see the company gaining traction before we'd consider an investment.

-- Written by Matt Doiron

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