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We upgrade our recommendation to Neutral from Underperform on Missouri-based Arch Coal Inc. (ACI - Analyst Report). The company reported mixed financial results in the second quarter of 2012.

We believe the company’s coal prospects look encouraging in the forthcoming quarters with a gradual increase in demand for coal from the Asian, European and Middle Eastern markets. In addition, train traffic increasing out of Powder River Basin (“PRB”) and projected start-up of long-wall operations in the Leer mine would contribute substantially to the company’s top-line.

We believe Arch Coal’s strategy to shift its resources to core operations will reduce its capital spending on low return units. This will enable the company to divert the proceeds towards development of lucrative projects as well as for modernization initiatives. 

Also on a positive note, Arch Coal’s comparative advantage in mining costs over countries like Australia, Indonesia, Canada and Russia is expected to boost the company’s revenue and will aid in weathering the current downturn and strengthening its position in the market.

However, these growth opportunities could be tempered by softened global and U.S. demand for steel from coal companies which will influence Arch Coal’s financials in the following quarters. In addition, increasing substitution of coal with natural gas could drive down coal prices and impact the company’s margins. This will be compounded by increases in coal stockpiles which will adversely affect the company’s production and hence its profitability

In 2012, the company expects to sell 135.5–141.5 million tons of coal, which includes 128–134 million tons of thermal coal and 7.5 million tons of metallurgical coal. The company’s capital expenditure in 2012 will likely be in the range of $410–$430 million.

The Zacks Consensus Estimates for the third quarter and full year 2012 are currently pegged at losses of 14 cents and 42 cents, respectively. Arch Coal’s closest peer is Virginia-based Alpha Natural Resources, Inc. (ANR - Snapshot Report).

The company presently holds a Zacks #3 Rank, which translates into a short-term Hold rating. Arch Coal engages in the production and sale of steam and metallurgical coal from surface and underground mines located in the United States. With market capitalization of $1.45 billion, the company at the moment has 7,400 full time employees.

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