Coal may be a dirty word in social circles, but the fact remains that coal is still the preeminent natural resource on the planet and used in every day products ranging from steel, water filters, energy generation, computers, and even in the glass on cell phone screens. So, when we find a fast-growing company with a stellar management team and a very tightly held float, how can we not get excited? After all, our job is to try and find good investment opportunities for our audience, and we believe we’ve done just that with American Resources Corp. (“American”)(OTCQB:AREC).
American opportunistically acquires companies that have undervalued physical assets, and a bounty of resources in the ground that management is able to restructure in short order. Typically, the target company’s financial troubles were the direct result of prior mismanagement. American is therefore able to acquire very good mines and logistic complexes at bargain prices. Once purchased, American will then get to work on rightsizing the business by stripping out redundancies so the company can operate efficiently. The company will also upgrade machinery and acquire new mining licenses (or shed excess licenses), so that the mining complexes can produce high quality coal at an optimal level. When the turnaround is complete, the operations are put back into production and run as efficient, cash-producing enterprises.
Though the company has been operating under this paradigm for less than three years, thus far the business model seems to be extremely effective. To date, American is on a run rate to generate over $28.0 million in revenue in 2018, which is up from $19.2 million in 2017 and $5.3 million in 2016.
No doubt the company’s tremendous growth is in large part due to the management team. Chief Executive Officer Mark Jensen, has spent a career building and turning businesses around and he has 12 years of experience in the coal industry. Mr. Jensen has brought on board a highly skilled team of professionals that have executed this same turnaround strategy time and again, with great effect.
Coal Industry Primer
Before we dive further into American business, we want to cover some coal industry basics. Coal is used to produce a variety of products, but the main two being metallurgical coal for steel making and thermal coal for energy generation. The quality of the coal, chemical characteristics and the infrastructure to clean and process the coal is what separates the various qualities. The amount of energy that coal can produce is determined by its makeup in carbon; the higher the presence of carbon, the more energy coal can produce. However, to measure heat that can be produced, the British thermal unit (BTU) is used, which is usually where the value lies. There are four types of coal: lignite, sub-bituminous, bituminous, and anthracite. Lignite is approximately 30% carbon (6,900 BTU per pound), sub-bituminous coal contains about 40% carbon (9,000 BTU per pound), Bituminous coal is the most abundant, containing about 70% carbon (10,750-14,340 BTU per pound) and represents about half of the coal used in North America. Anthracite has highest carbon content and is 95% carbon (close to 13,200 BTU per pound), but is hard to light and expensive, making it unsuited for consistent production. This leaves bituminous coal as the ideal coal for usage due to its accessibility and its position as the top heat producer.
For a coal producer, the typical target industries are production of thermal coal and metallurgical coal. There are two distinct usages of coal: coal suitable for coking, and those that are not. Coking is the ability for natural coal to be converted into coke, which is one of the key required components in the steelmaking process. Coal that does not possess the chemical characteristics to create coke is generally dedicated for thermal and energy production. Coal with strong coking ability is usually converted into metallurgical coal for making steel, including the supplemental pulverized coal injection (PCI) coal. Therefore, metallurgical coal sells at a significant premium to thermal and PCI coal, which typically makes metallurgical coal a higher margin product.
Coal production in the United States is geographically regional in nature, with the coal west of the Mississippi generally being of lower-quality than the coal in the Central Appalachian region (Kentucky, West Virginia, Virginia and Pennsylvania). Central Appalachian coal is some of the highest quality of coal for both electricity generation and the steel making process.
American’s operations are concentrated in the eastern Kentucky area, which accounts for the company’s ability to mine high quality coal.
Why the Opportunity Exists
A number of coal companies are operated based on a legacy mentality. “We do it this way because it’s always been done this way,” is a common refrain in the industry. The problem is, the old way isn’t always the best way, in fact it can sometimes be terrible. As a result, some coal companies have become distressed because they have too many employees, too much debt, and/or they’re not mining anywhere near as much coal as they could be either because the machinery is old or they don’t have the proper permits.
The mines that American has acquired all possess the capacity to produce far more coal than when they were producing under previous ownership, and at a lower cost. In addition, their mines can produce both high quality, metallurgical coal as well as premium quality coal for thermal use. The range in coal quality allows for American to target a blend of metallurgical and thermal coal customers, providing broad diversification of revenue while also maximizing margins from such properties.
Today, American’s metallurgical output accounts for approximately 60% of their business. The increase in production from their McCoy Elkhorn complex could result in a material increase in metallurgical coal output, and corresponding increase a percentage of the company’s revenue. American’s Deane Mining complex can produce Metallurgical coal, PCI coal and currently produces premium thermal coal. Due to the company’s operating efficiencies, all of these coal products can be mined at very favorable rates.
Another example of the way in which American implements operating efficiencies is the manner in which they have turned some single section mines into super or walking super section mines. In a super section mine, by adding an additional continuous miner, the company can double the production from the mine while increasing the labor by less than 35%. The end result is typically more coal for less money.
American has acquired major complexes from some of the largest players in the industry at that time, such as Arch Coal, James River and Rhino Resources. American currently has six mines producing and over 33 additional coal permits to put into production, leaving substantial room for organic growth. In the past year, the company has restarted production at four new mines, all of which are in the process of ramping up and expanding production. The Company has slated a number of additional mines that will be brought into production over the next year which should further augment the company’s acquisition strategy.
This past week the company announced that it had entered into a processing and transloading agreement with a global energy and commodity trading company. This is yet another example of how American can increase margins through operating efficiencies. Running a coal processing facility is typically a fixed cost, regardless of how much coal is processed. Therefore, American will be able to generate additional revenue without increasing their cost of goods or operating expense.
Over 95% of the company’s shares are owned by management and insiders. Such a tightly held float means that once Wall Street figures out what’s happening with this company, it will probably be very difficult for investors to get enough shares; it also means that management’s incentives are aligned with outside shareholders’. In our view, both are significant positives. Additionally, the business is clearly poised to grow organically, even if the company doesn’t make any further acquisitions – but more acquisitions are probably on the horizon anyway. The current business model allows the company to benefit from both organic growth and accretive acquisitions, another significant positive.
American isn’t on Wall Street’s radar just yet, but if management continues to execute, we think it’s just a matter of time before it is. Once that happens, it will be very interesting to see how aggressively investors fight to purchase such closely held stock.
This is definitely one of our favorite stories of the year, and it’s a company that investors should be watching.
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