Amid Energy Pullback, Coal Chugging Ahead

Over the past 12 months, Arch sold $2.3 billion worth of coal and earned $42.7 million. Net margins are low, at 1.8%, and so is the debt load, at 0.87% of equity. But naturally we are much more concerned about what's ahead.

At the risk of sounding like a coal-mining Pollyanna, the outlook continues to be strong: Powder River Basin coal has fetched increasingly higher prices this year, and metallurgical coal, in particular, is fetching record prices.

Input costs of things like diesel and labor are undoubtedly higher, too, but with inventories at record lows, contracts for 2006 and 2007 delivery continue to improve, at $20 a ton for the hottest-burning nonmetallurgical coal, while the best "met" coal comes in at $100 a ton. Jim Rollyson, an analyst at Raymond James, said he believes these prices "bode extremely well" for increasing earnings results over the next three to four years.

The key driver is demand for steel, and the rebuilding effort in New Orleans, Mississippi and the Gulf of Mexico appears to be helping. As steel demand and prices rise, so too will coal demand and prices. It's a virtuous cycle, as long as it lasts.

Friedman Billings analysts note that coal stocks, now near highs, should be volatile in the face of a softening economy and rising inflation. Yet Friedman said they should make good purchases on pullbacks, since, in fact, the sector is less sensitive to a weakening economy. Why? Subdued demand for energy would abate the industry's key costs while cutting down on the rail-transportation bottlenecks that now are a big affliction.

Most brokerages are rolling their 2006 target prices on Arch Coal forward to reflect 2007 estimates and multiples, and they're coming in at around $78 to $82. While consensus estimates for the September quarter are 29 cents, 94 cents for fiscal 2005, and $3.85 for 2006, the new thinking is that 2007 will come in around $5.50. Put a 13 times multiple on that and you get the target price.

Now here's something to worry about: The last two quarters, Arch has missed estimates by 2 to 3 cents. So you may wish to wait for another quarterly disappointment to buy into the long-term story. Figure on being able to pick up shares in the $63-$66 area after Monday's report.

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