I continued to be pleasantly surprised by what's available for our high-yield Extreme Portfolio in the structured product market. At a time when volatility is dominating the investing landscape, we are able to put our money in short-term instruments benefiting from certain mega-themes that are paying us gorilla-sized yields.
Arch Coal Inc. (ACI) was founded in 1969 and is headquartered in St. Louis, Mo.
The company mines, processes and markets bituminous and sub-bituminous coal with low sulfur content in the United States. As of Dec. 31, 2006, it operated 21 active mines, and owned or controlled approximately 2.9 billion tons of proven and probable recoverable reserves. ACI's mines are located in West Virginia, Kentucky, Virginia, Wyoming, Colorado and Utah, and the company sells to electric power plants, steel producers and industrial facilities.
On Feb. 11, 2008, Arch reported its second-best year on record, posting fourth-quarter 2007 net income available to common shareholders of $81.3 million, or 56 cents per fully diluted share, and beating Wall Street consensus estimates of 47 cents by 9 cents, or 19% to the upside.
To quote CEO Steven Leer on the company's latest results, "Looking ahead, we are optimistic that domestic coal markets will continue to improve in 2008, driven by the strength of international coal markets. We also expect the company to deliver a record performance in 2008, with meaningful expansion in operating margins, earnings per share and EBITDA."
U.S. coal markets are dynamically responding to the scarcity of coal in the global landscape. With severe supply constraints in traditional coal export nations, including flooding in Australia, power outages in South Africa and coal shortages in China and India, Arch believes that U.S. coal increasingly will be valued for purposes of supply diversification.
Coal imports into the United States were essentially flat in 2007 as supply (primarily from South America) was diverted into higher-priced seaborne trade. Over the same timeframe, U.S. coal became the swing supply for the global market. In fact, Arch estimates that U.S. coal exports grew by close to 10 million tons in 2007 and conservatively expects another 20-million-ton increase in 2008.
The company also estimates that U.S. generators held a 51-day of supply in stockpiles at the end of 2007, compared with a 50-day supply at the end of 2006 -- leading it to believe that increased stockpiles stem, in part, from an effort by U.S. generators to increase inventories as a hedge against future supply disruptions.
Furthermore, Arch believes that 14 gigawatts of new coal-fueled capacity are now under construction in the United States, representing an additional 50 million tons of new annual coal demand as these plants are brought online in the next five years.
During the fourth quarter of 2007, Arch committed significant volumes of coal to international and domestic metallurgical markets for 2008 and 2009 delivery, at prices up to 70% above current domestic steam coal index prices in the region. Select 2008 business also has been placed in export steam markets at prices that meaningfully exceed comparable domestic prices -- and locking in huge forward profits. It's a beautiful thing!
The 12% Arch Coal SPARQS (AHB) due Sept. 20, 2008, are just the ticket to riding out the current market volatility. The United States is the king of global coal exports and pricing has never been better.
SPARQS (Stock Participation Accreting Redemption Quarterly-Pay Securities) are similar to STRIDES in that they are structured notes where a sophisticated option strategy where selling out-of-the-money puts and calls are applied to bring in the 12% income stream during the life of the investment.
All you really need to believe is whether the coal business is going to remain robust for the next six months -- the point at which these notes mature. At that time, if they aren't called away, you will be issued shares of Arch Coal (ACI) shares -- shares currently trading at $45 per share and in the midst of a multi-year technical breakout to the upside.
These SPARQS were issued at a price of $7.615 per share on Aug. 31, 2007, as a one-year note. The fact that we are mid-way through the month of March means there are only six months left before this note matures -- and that will provide us with a very predictable 12% yield on our money with an almost 100% chance of being called out of the notes before they mature on Sept. 20, 2008.
Why?
Because SPARQS are structured to either pay you back your principle, plus a premium and interest before they mature if the underlying stock is trading at a higher price than when the notes were issued, or they will pay you in shares of the underlying stock if, upon maturity, the share price is trading below the price of the notes when they were issued.
In the case of the 12% Arch Coal SPARQS, shares of ACI were trading at $30.46 when this note was issued back in late September 2007, and carry an exchange rate of 0.25 shares (one-fourth of a share).
Let's do the math to understand this conversion rate.
If you take $30.46 and multiply it by the stated conversion rate of .25 you get the SPARQS new issue price of $7.615 per note. Shares of ACI are now trading at $45. Multiply $45 by the conversion rate of 0.25 and you come up with a value of $11.25 per SPARQ note. Seeing as this is a whopping 33% premium over where the SPARQS currently trade and well above the stated redemption prices, I fully expect the issuer, Morgan Stanley (MS), to redeem this issue before it matures because of the appreciation in shares of ACI common stock. It's that easy.
The first call date is March 20, 2008 -- a week from now -- at a price of 7.8676 and then every month thereafter at incrementally higher prices. The next call date is April 30, 2008, at a price of $7.9196. The last call date is September 10, 2008, 10 days before the notes mature, at a price of $8.1153 per share.
Assuming Morgan Stanley doesn't call the issue until the final call date in September, we stand to collect two dividend payments equaling 6% and another 6.5% in capital appreciation for a total return of 12.5% over the next six months. Nice!
I can't think of a better way to manage through the extreme volatility of the markets, while bringing home an extreme short-term return on our capital.
Keep in mind, this current issue could be redeemed in a week (and you would, at least, breakeven), but Morgan Stanley will very likely issue another Arch Coal SPARQ soon thereafter. It's been the pattern for some time with these structured products that are working and being called away before they mature. Of course, I'll tell you what to do in that event.
The 12% Arch Coal SPARQS due Sept. 20, 2008, trade under the symbol AHB on the American Stock Exchange and are not hugely liquid, meaning they don't trade a ton of shares every day. That said, you must use limit orders to buy these shares so we don't drive the price up unnecessarily. Use some patience, as they aren't going to run away on you.
These shares just went ex-dividend on March 12, and dipped from $8 down to their current price of $7.62, which is just under the next call price. This is a good entry point and I recommend purchase up to $7.75 per share at this time.
There is little upside potential, but for many income investors, getting a 12% current return is just fine in a market that is dropping one shoe after another, day in and day out. It's just another way we can garner some Extreme Income without much guesswork involved. For many high-yield investors seeking stable returns, it's a great fit.
I'll see you later today with the Weekly Update.
Bryan Perry
Editor The 25% Cash Machine