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Introduction
After years of capital-starvation and underinvestment, both metallurgical and thermal coal are experiencing a bit of a renaissance. Coal prices over the past 18 months have reached all-time highs, and remain exceptionally elevated compared to historical averages. However, despite this boom in the underlying commodity, the story for the major U.S. producers remains under-appreciated. In particular, the story of Alpha Metallurgical Resources (NYSE:AMR) has 3 main components: the currently low valuation, the supply/demand set-up that could lead to “higher for longer prices”, and its capital allocation strategy. Let’s take each part in turn.
Earnings Potential
At first glance, AMR seems like a value trap. The first impression of most investors could be summed up as follows: “yes, it’s extremely cheap on a P/E basis, BUT it’s a commodity producer. It has boom and bust cycles. And, commodity stocks appear most attractive, by traditional valuation metrics, precisely when the cycle has peaked. What makes this situation any different?”
Before we address these general concerns, let’s look at the specifics: how much cash flow AMR will generate in the current pricing environment. In Q1, AMR sold 3.78mm tons of met at an average price of $240. Their margin on these tons after all costs was $137, resulting in EBITDA of $513 million for the quarter. For shareholders, this meant $20.52 in EPS. We expect that Q2 earnings will come in hotter than Q1, due to the extremely elevated pricing for AMR’s spot seaborne tons during the quarter. We estimate that AMR realized an avg. $300 on 3.7mm tons, with margins of ~$190. This would result in an EBITDA of ~$700 million for the quarter. That seems like a lot for a debt-free company with only a $2.7 billion market cap, especially considering its high-quality assets and 350 million tons of proven reserves. With the latest share count figures, this would equate to ~$30 in EPS for the quarter.
If this Q2 forecast is correct, then we have a company that has already earned ~$50/share just in the first half of the year and has no debt. Met has sold off dramatically in the past month due to global recession fears. But, after a rapid decline, the futures curve has flattened going out for many years. This suggests that the price has stabilized and the pain may be over. The Australian Coking Coal futures curve remains above $250 through 2024. At a $250 price level on the index, AMR would continue to earn exceptional profits, roughly ~$400 million in EBITDA per quarter. Based on the futures curve, in FY ’22 we can expect AMR to have a FCF yield greater than 60% and ~40+% in 2023.
Valuation
Based on the met futures curve and its high operating leverage, we expect AMR’s free cash flow through 2023 to come in at ~$2.4 billion. Given its current enterprise value of $2.75 billion, the market is implying close to 0 terminal value for the business beyond 2023. However, we believe AMR’s high-quality mining assets will be active for decades. We think placing a 4x EBITDA multiple on AMR’s business for 2024 and beyond is very conservative. What could this terminal value look like? Let’s start with the bull case: the long-term avg. price of met coal is $200. With AMR’s current cost structure, that implies a run-rate EBITDA of $1.15 billion and a post-2023 terminal value of $4.6 billion. The bear case is a LT avg. price of $150 (historical average), this implies EBITDA of $433 million and a terminal value of $1.73 billion. Prior to applying a discount rate for the 17 months from the end of 12/31/2023 to today, we have a range from ~$4.1 billion to ~$7 billion in enterprise value. Based on our supply/demand outlook, and the current futures curve that have prices at $230 through 2027, we believe the LT avg. sales price will come in closer to $200 (or higher) than $150. In the coming months, we expect market participants to re-rate the stock and place a more reasonable post-2023 terminal value on its business.
Supply/Demand Outlook
Let’s first touch on the demand side. As you are likely aware, steel is one of the main pillars of the industrial economy. Modern economies could not grow, nor even function, without constant steel consumption. It’s needed for everything from buildings, cars, appliances, reinforced concrete, oil pipelines, even wind turbines. In 2021, 1.95 billion tons of steel were produced, and around 2/3 of that steel production is “net-new”, rather than recycled steel. Producing 1 net-new ton of steel requires roughly 0.9 tons of high-quality, met coal.
We need a lot of met coal to produce all the things needed by a modern economy. As the developing world grows economically and becomes wealthier, they will need more steel. Unless decades-long trends of economic growth and urbanization reverse, the demand for steel is in secular growth. After a year of slow-growth in 2022 (.4%), the World Steel Association forecasts that steel demand will resume it’s uptrend and grow 2.3% in 2023 And in the U.S. domestic market, the EIA predicts that met coal demand will grow by 8% from 2021 to 2023.
Now, let’s take a look at the supply situation. Are high-prices going to “cure” high-prices, as your dusty, old economics 101 textbook suggests? In this case, that seems unlikely in the next few years. The biggest exporters of met coal are the U.S., Australia, and Russia. Due to sanctions, Russian supply is not going to find its way to the Western world anytime soon. In the U.S., the supply response has been muted. This can be blamed, in part, on ESG investment mandates that have starved the coal industry of capital for years, resulting in minimal new mine development. It would take years before new investment would meaningfully increase supply from the U.S. In Australia, they have gone a step further – last month, Queensland’s government imposed massive royalty taxes, 40% of sales at the highest price thresholds, on all coal exports in that territory. 90% of Australian coking coal is produced in Queensland, and this new tax greatly reduces the incentive for miners in the region to expand capacity.
The supply response in the developed world has been anemic, and it will likely continue to be anemic. We could be heading into a very different long-term pricing environment for met coal with a much higher floor than the historical averages.
Capital Return
The market has not appreciated the “higher-for-longer” inflationary scenario outlined above, and AMR has not re-rated (as evidenced by its insanely high FCF yields). This creates a tremendous opportunity for the company to buy back stock. This is the only responsible way for them to deploy capital – they are not going to find any organic projects with equivalent FCF yields (~40+%) as their own equity currently offers.
AMR’s management has been very clear about their plan to allocate excess FCF to buy back stock. In addition to paying off the entirety of their term loan balance and becoming debt-free last month, AMR expanded their buyback program to $600 million. ~$126 million of that buyback had been used by June 3, at an average price of $146.
CFO Andy Eidson responded as follows to a question in the Q2 earnings call (when the stock was trading at ~$144):
When you look around the options available to us and the discussions with the Board, at the current market levels where futures are currently sitting the valuation of the company feels a little bit off. And so it’s hard to argue that there’s any better investment right now than picking up our own shares.
Other than the $1.50 annual dividend, you can be sure that management will use most of its excess cash to buy back shares. We think that AMR management’s clear stance on buybacks is one of the best reasons to own it in the current operating environment.
At today’s price and projected earnings, AMR can buy back ~15% of its float per quarter. Only one of two consequences can result from this activity – either the share price goes up, or AMR is going to rapidly reduce its share count over the next 12 months. The latter is the better outcome for long-term shareholders, and they should hope that the stock remains at these very cheap valuations for as long as possible.
With the existing buy back authorization($474 million remaining), AMR could buy back 3.25 million shares at today’s price, bringing the total float down from 18.2 million to ~15 million. They could likely complete this buy back with the excess cashflow from Q2 2022. If the excess cash in Q3-4 2022 (~$700 million) is also deployed this way, they will be able to buy back another 4.8 million shares.. This scenario would bring the float to 10.2 million shares by end of year. That would be a 44% reduction in the share count. So, if the price does not move up from here, you will be left owning much more of a business that is already spitting out absurd FCF yield based on the current pricing environment.
Even better, AMR put in place an automated buyback program in March. This means that they have been buying during the recent sell-off of the stock (which got as low as $103 intraday). We will find out how many shares they were able to accumulate when they next report – but, it is possible that they have reduced the share count substantially below 18 million already. That would be a welcome announcement to all shareholders during their Q2 earnings call.
Tail Risks
There are a couple of risks to our thesis that are worth stating. The first is a geopolitical risk – if the Ukraine war ends in a negotiated peace, and Europe / U.S. lift their planned sanctions on Russian exports, that would put downward pressure on the price of seaborne met coal. However, we view the sanctions as sticky, and do not anticipate that NATO countries will be eager to reestablish trade relationships with Russia, even in the case of a negotiated peace. Further, the geopolitical events of this year emphasize the need to re-shore critical supply chains, including steel production, which is supportive of seaborne met coal demand going forward.
The second risk worth mentioning is related to rail. Two weeks ago, 115,000 rail workers were on the verge of striking. Like many industries, coal shipments depend on functioning rail – and a strike of this magnitude could significantly lower the sales output of U.S. met producers (and impair their ability to take advantage of high prices in 2022 and 2023). If the railroads and the workers unions aren’t able to agree to a contract in the next 50 days or so, and a strike ensues, that would be disruptive to AMR’s operations. It would result in far fewer tons sold until the strike is resolved. We think that the dispute will be resolved before a strike occurs – whether by the two parties themselves or by extraordinary Congressional action. The consequences of the strike on supply chains and inflation would be too severe. But, it remains a notable tail risk.
Conclusion
In summary, AMR presents a unique risk/reward opportunity for the value investor. It produces a commodity that is essential for the modern world, and that is in short supply. It has high-quality assets that will operate for decades. Yet the market values it like a melting ice-cube. We believe that AMR’s exceptional earning potential, cheap valuation, and capital allocation strategy set it up for success in the coming months (and years).
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