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Arch Resources (NYSE:ARCH ) is a miner of coal, both metallurgical (used in steel production) and thermal coal (used for electricity generation). Presumably due to general hatred for coal stocks and cyclical commodities, it is currently available for purchase near its expected FCF for FY22. Almost 1x FCF sounds crazy? Let’s dig in.

ARCH operates world-class High-Vol A mines in West Virginia, at Leer and Leer South, along with the Beckley and Mountain Laurel metallurgical mines, and thermal mines in the Powder River Basin and Colorado. The thermal mines are being wound down and reclamation costs are being accrued for these locations, but the metallurgical mines are the future for Arch.

One of the reasons I was drawn to Arch is their history of returning capital to shareholders. Prior to 2020, Arch paid almost $2/share in annual dividends and bought back over $800m worth of stock between FY17 and FY19. With the terminal value of coal production in question, particularly for thermal assets, any cash generated by operations that is reinvested in the business is riskier than a dollar returned to shareholders.

As of their most recent filing, Arch had 15,316k shares outstanding.

Add 1,845k outstanding warrants (and $105m cash from exercise)

$155.3m of convertible debt converts at $37.325 (may get adjusted for dividends) - 4,161k shares. Arch has stated they plan to settle the convert in cash and may be able to somewhat mitigate this amount, but I’m working with a max dilution perspective.

Capped call limits dilution up to $52.255 - $14.93 per convertible share - $62.1m cash offset to the dilution.

$500m Asset Retirement Obligation - ARO (bonded value, balance sheet amount sits at only $211m in Q3-21)

$450m of debt ex-convertible, including equipment financing

Resulting fully diluted share count is 21,322k, for a $2.45B market cap at $115/share, and $593m net debt. Total Q3-21 EV is ~$3.0B.

Arch provided detailed information to determine what you need for FY21 FCF estimates on their Q3 release .

For the year, Arch expected to sell 7.2-7.6m tons of met and 63-67m tons of thermal coal, with the majority of it already priced.

Actual MSHA data suggested Q4 met production was up 7% Q/Q - so Q4 Met should be ~2.1m tons, or 7.8m for all of FY21, and thermal for Q4 should be 18m tons, or 64m for the year. About half of the Met was unpriced seaborne, and essentially all the thermal was priced. We will assume unpriced coking coal sold for a bit over $300/ton in Q4, and committed volumes were around $110/ton. The remaining 18m thermal should come is around $15/ton. Costs for Q4 should be $75/ton for met and $12/ton for thermal.

Gross Profit = 2.1m*(220-75) + 18m*(15-12) = $358m. Drop $28m for corporate cost and interest and $20m for CapEx, and you get to ~$310m FCF, reducing our EV estimate to $2.7B. These numbers above tie out fairly closely to the $715m revenue and ~$13 EPS street estimates for Q4.

Taxes are ignored due to >$1B of NOLs.

The killer question becomes, what will FY22 realizations look like? We should get some pricing guidance with the Q4 release tomorrow, but I'll do my best to layout the current high-level market environment.

With Leer South fully ramped in Q122, I expect 10m tons of met coal production for FY22, and around 80m tons of thermal given Q3 call commentary . Arch has already contracted a small portion of domestic coking coal for $230/ton, and the forward pricing curve sits above $300/ton for FY22, and is even better for their premier High Vol A assets. ( Good thread on different ways to look at FY22, and a Substack bull case ). I’m sticking with $230 net realizations and increased costs of $75/ton for met, and $18/$13.50 cost/realization for thermal (West Elk pricing pulls up PRB contracted volumes):

10m*(230-75) + 80m*(18-13.50) = $1.9B FY22 gross profit

With Leer South CapEx behind them, I’m expecting closer to $100-150m of maintenance CapEx instead of the $200m+ each of the last two years. We can use $150m (street estimates are a bit under $130m).

Interest expense should be minimal, given Arch’s stated goals in Q3 of deleveraging, which should be mostly complete after Q4. We can use $25m for FY22 to be safe.

Cash SG&A will likely be ~$75-80m with another ~$20m non-cash.

All in, this gets us to $1.65B of FCF in FY22, putting ARCH at 2.7B/1.65B= 1.64x EV/FCF.

Street estimates for Arch’s FY22 FCF average less than $800m, which it is possible Arch will exceed in just the first 6 months of FY22. With volumes already contracted for FY23, it is possible Arch will announce they have close to their entire EV in contracted cash flow between FY22-23.

I tried to build in some conservatism with pricing coming down in the second half of 2022, bonded ARO values, and maximum dilution, so if pricing remained where it is now and shares are bought back at low prices, 1x FCF is possible. If Arch looks to divest their thermal assets to a producer that is looking to expand (Alliance Resource Partners (ARLP) indicated as much on their latest call) they could possibly offload their remaining ARO and remove any remaining thermal pricing exposure.

Thermal demand has skyrocketed at the moment, but the pricing modeled above may also quickly come back to earth. With 70m PRB tons already contracted at $16, Arch should earn enough from the segment this year to essentially cover their entire ARO. Management also indicated the contracted volumes in 2023.

Guidance for 2022 could be lower than what I have above, especially if they locked in pricing below my estimations.

Arch could have a significant accident at a location, though their longwall mines and surface mines are lower risk than some styles of coal mining.

The convertible note is closely tied to the short interest in the stock, which has some impact on how the stock trades. I expect the resolution of the convertible and closing out of the short shares to be a significant positive for trading dynamics going forward.

I expect Arch to return capital to shareholders given their track record, but if Management were to pursue M&A or further develop new mining assets, there would be more coal pricing risk to shareholders.

Ramaco Resources (METC) has some good pricing and industry CapEx information in their recent investor deck, strongly suggesting pricing could remain structurally positive for more than a few months. However, one must always be careful with commodity stocks.

With Arch set to earn the majority of their current enterprise value during 2022 based on current coal pricing, and given Management’s history of returning capital to shareholders and their low-cost assets, Arch looks like a “safer” way to play the coal boom in the event pricing starts to come back to earth. We are looking forward to Arch releasing Q4 results and giving a clearer picture of their FY22 targets.

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Disclosure: I/we have a beneficial long position in the shares of ARCH either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.