Monday, January 11, 2010

Arch Coal (NYSE:ACI): Upgraded to Overweight at Morgan Stanley

Morgan Stanley is upgrading Arch Coal (NYSE:ACI) to Overweight from Underweight and raising their price target to $35 (prev. NA). Firm EPS estimates are raised significantly.

Morgan Stanley notes they are getting more constructive on a recovery for US thermal coal as the timing for an inflection in utility coal stockpiles may come sooner than expected. ACI is one of the most leveraged names to play a bullish thermal coal theme, in firm's view. The stock underperformed in 2009 as the market penalized it for having a significant unpriced thermal coal position in a weak environment, and Powder River Basin (PBR) exposure. Morgan believes the market will reward these very characteristics in 2010, and have lifted their 2011 EPS estimate by 59%, to $2.80, or 57% ahead of consensus. ACI trades at 5.5x their 2011 EBITDA estimate, and our $35 price target offers 30% upside.

Market to reward PRB exposure. For now, the market views Central Appalachian (CAPP) producers as a better leverage play to a cyclical recovery in thermal coal demand. But PRB producers have managed supply well through the downturn, and a combination of improving power demand and supply challenges in Eastern US coal should translate to higher market share and pricing power for PRB miners. Longer term, the economics of PRB coal make it a key fuel source for the utility industry.

Western Bit segment improvement not appreciated. Operating rates are improving, costs are falling, and below-market contracts are rolling off in 2011. Morgan Stanley thinks Arch’s Western Bit segment can expand margins, driven by significant unit cost reduction this year and a repricing to market of 50% of production next year.

Opportunity in met coal. They now model ACI’s met coal sales at 5 mmtpy in 2010, up 67% from their prior forecast. Firm believes the current scarcity of premium hard coking coal will create opportunities for Arch to increase its mix of higher margin, high-vol met coal.

Investment Debates Summary:

1. How leveraged is the Powder River Basin to a recovery in thermal coal demand?

Market’s view: Central Appalachian producers are a better leverage play to a cyclical recovery in thermal coal demand. Excess regional capacity and weak demand will weigh on PRB coal prices.

MSCO view: PRB prices should rise with Central App Historically, PRB prices have lagged CAPP, but they expect PRB prices to rise in tandem in this cycle. PRB prices could be sluggish near term, but should benefit as Eastern US coals are pushed toward being the marginal fossil fuel for electric power. Longer term, the firm thinks PRB volumes will grow as it increases share of the US thermal coal market at the expense of Eastern US coal, which faces significant structural challenges.

2. Timing of return of thermal coal pricing power

Market’s view: A late-2010 or 2011 event at best

MSCO view: Favorable weather has accelerated drawdown; supply may lag potential utility term coal demand growth they had expected a turn in the utility coal inventory cycle in 2H10. A favorable winter burn has accelerated the winter stockpile drawdown, and we believe may bring utilities back into the market to secure term contracts. Given the amount of supply currently idled, contract prices could move higher.

3. Western Bituminous margin expansion

Market’s view: Fundamentals could remain depressed

MSCO view: Operating rates are improving, costs easing, and 9 mmt of below-market contracts are rolling off. Firm sees significant Western Bit margin expansion taking place in phases. First, they expect significant unit cost cuts in 2010 as mine operating rates recover. Second, 9 mmt of below-market contracts will roll off in 2011; despite weak thermal coal markets, pricing today is still +20% above the average contract.

Notablecalls: MSCO looks to be somewhat late with their ACI call. Yet, the stock looks uber-strong in the very short term, helped by economic news out of China & the upgrade.

I'm guessing this one will trade above the $28 level today with $28.50+ not out of the question.

PS: Careful out there. We may get some surprise selling in the n-t. Just a gut feel.

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