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Coking coal project announced by Arch Coal 'highly attractive' to analysts

Arch Coal Inc.'s stock price has been slowly climbing since greenlighting a West Virginia metallurgical coal mine that analysts are expecting to fortify the company's post-bankruptcy strategy of directing free cash flow to shareholder value initiatives.

Executives are expecting the well-received project to generate some of the highest margins of any metallurgical coal mine in the U.S. While the company said it may consider debt financing in the future, it currently projects it can fund the new mine completely from internally generated cash flow, easing potential concerns about revisiting a wave of coal sector bankruptcies that followed a trend of debt-fueled metallurgical coal acquisitions.

"In our opinion, the project is highly attractive for Arch on multiple levels," wrote B. Riley FBR analyst Lucas Pipes in a note reiterating a buy rating on the company. "It strengthens and transitions the company's long-term met coal production profile, it expands Arch's high-quality coal product and lowers Arch's average cost structure."

Arch shares closed at $83.25 on Feb. 13, but opened at $90.92 on Feb. 15 following the announcement of the project. Analysts with Seaport Global Securities LLC, Jefferies Group LLC and B. Riley FBR have price targets on Arch Coal stock of $105.00, $110.00 and $125.00, respectively.

"While the company will continue to emphasize shareholder returns, Arch plans to build a new met coal mine in West Virginia and the renewed focus on organic investment differentiates the company from most of its peers," said Benjamin Nelson, vice president and senior credit officer at Moody's Investors Service. "Successfully completing the project using internally-generated cash flow would strengthen the company's credit quality."

Seaport Global analyst Mark Levin lowered EBITDA and free cash flow estimates to reflect the company's updated guidance but reiterated a buy on the company. He also warned about "low expectations" for Arch's first quarter, which is expected to be weak relative to the rest of 2019.

Arch is the top U.S. coal pick for Jefferies analyst Christopher LaFemina, who noted that the company's share buybacks have continued at a "frantic pace. The company has spent $584 million since early 2017 to buy back 29% of the initial shares outstanding.

"Arch is operating well, generating strong [free cash flow], and now investing in high-quality growth," LaFemina said. "Its shares are undervalued, and we recommend that investors buy these shares now. ... This is an excellent project, in our view, and the growth from this new mine will not be enough to materially affect seaborne met coal prices."

Potential downside risks to the project, LaFemina said, could include a global recession pushing metallurgical coal prices to well below $120/tonne. Even though Arch has been increasing its focus on metallurgical coal, particularly the high-vol A grade metallurgical coal that commands a significant premium in the market, it also remains significantly exposed to the U.S. thermal coal sector. With U.S. thermal coal demand already in secular decline, a U.S. recession, lower natural gas prices or decreased demand for electricity could weigh heavy on the company.

"In 2019, we anticipate coal producers will seek to add 20 million tonnes of additional seaborne export metallurgical coal mine supply," according to the Wood Mackenzie report. "Output growth will principally be derived from brownfield expansions and recovery of output from operating mines, with only 3 [million tons per year] coming from restarts at suspended mines, and less than [500,000 tons per year] from greenfield projects."

The global market for high-vol A coking coal is particularly tight, Levin wrote, and Arch's new project would capture a quarter of that market.

"This is a move we view positively. Why? It improves the company's met coal production profile, mix, and costs," Levin wrote. "It also has a quick payback, even under stressed coal price scenarios."