This is part three of a three part series on Arch Coal Inc (NYSE:ACI). At present, Arch Coal is trading significantly below book value and appears to be somewhat of a value play. However, there are numerous headwinds facing the company, which could turn Arch from a value-turn-around-play into a value trap. In this series I’m trying to arrive at suitable conclusion as to whether or not Arch Coal Inc (NYSE:ACI) a value play or trap.
In part one, which can be found here, I covered the bull argument for Arch. Within part two, found here, I covered the state of the coal industry; possibly the biggest headwind facing Arch. And in this final part I’m going to take a look at how the rapidly declining price of coal is affecting Arch and if this is set to continue.
Arch Coal faces profit margin crunch
The problem is that the falling price of coal is compressing Arch Coal Inc (NYSE:ACI)’s profit margin to a level where it is becoming increasingly hard for the company to turn a profit. In particular, during the third quarter of this year, despite ramping up coal output to 38.3 million tons, an increase of 9.4% from the previous quarter and 2.4% year-on-year, Arch’s operating margin per ton slid to a minuscule 0.87%.
What’s more, based on numbers supplied by Arch Coal Inc (NYSE:ACI), the average price the company received per ton of coal sold during the third quarter of this year was $19.54, down from $25.57 during the same period the year before and down from $22.34 during the second quarter.
This is in sharp contrast to peer Peabody Energy Corporation (NYSE:BTU), the largest U.S. coal producer, which reported a surprise third quarter profit of 5 cents per share, excluding one-time items. Peabody benefited from high thermal coal prices, from which the company derives most of its income. Thermal coal prices averaged $10.29 a metric ton in ICE Futures trading during the third quarter, up 23% from a year earlier.
However, Peabody Energy Corporation (NYSE:BTU) also reported that the prices for metallurgical coal declined 36% year-on-year at the end of the same period, most due to a supply glut. Metallurgical coal will be the main product of Arch Coal Inc (NYSE:ACI)’s new Lear mine, which the company is relying upon to turn its fortunes around.
Still, Arch Coal Inc (NYSE:ACI)’s management has been working had to get its operating costs down. Unfortunately, the company has not been able to slash costs fast enough. Indeed, the company reported an operating cost per ton of $19.37 for the third quarter of this year, down approximately 20% year-on-year but during the same period, as shown above, the average sales price achieved by the company declined 24%.
All in all, with cost prices falling and costs staying stubbornly high, Arch Coal Inc (NYSE:ACI)’s operating margin per ton declined to $0.17 for the first nine months of this year, down 92% from the $2.07 reported during the same period of 2012. The company’s operating cost per ton includes depreciation, depletion and amortization but excludes items such as interest, which, when included pushes the company into a loss on a per-ton basis.
But after taking all of this into account, there seems to be a significant amount of uncertainty surrounding both Arch Coal Inc (NYSE:ACI) and the market for coal. It is this uncertainty that makes me highly cautious about reaching a conclusion on Arch Coal Inc (NYSE:ACI)’s potential value. On one hand, the company’s profit margins are collapsing, on the other the new Leer mine should lead to increased output and possibly profits. However, with the price of metallurgical on the decline will the Leer mine only add to Arch Coal Inc (NYSE:ACI)’s woes?
There are also questions to be asked about the global coal market, which is likely to be in oversupply during the next few years.
So all in all, with so much uncertainty surrounding Arch Coal Inc (NYSE:ACI) I feel that the company is a value trap. fn investors are interested in the company, perhaps they should wait to see how the company’s Leer mine adds to the bottom line during the next few quarters.