December 31, 2009 - 4:52pm EST by
2009 2010
Price: 28.00 EPS NA NA
Shares Out. (in M): 37 P/E NA NA
Market Cap (in $M): 1,028 P/FCF 11x 10x
Net Debt (in $M): 353 EBIT 238 288
TEV ($): 2,900 TEV/EBIT 12x 10x

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Alliance Holdings G.P. is the General Partner of Alliance Resources L.P. Alliance produces coal in the Illinois Basin. It trades for 8.3x 2009 EBITDA, 11.6x 2009 unlevered fcf and 3.2x yearend estimated PPE. Using yearend 2011 PPE, it trades at 2.2x EV/PPE. The reasons to own Alliance are that it (a) occupies a lower point on the cost curve than other coal producers, (b) is available at a reasonable price relative to 2012 invested capital; and (c) it will continue to achieve ROICs of 30-50%, meaning that its current Enterprise Value of $2.9b is 4.4x-7.4x normalized maintenance free cash flow pro forma for capital expansion in 2010 and 2011. This will be a good value if there is no growth from that point forward and an outstanding value if it can invest incremental capital for returns at or near what it has historically achieved.

Let's take those points one at a time:

(a) Cost advantage: Alliance has achieved an average annual return on invested capital of 46% over the last decade. The lowest return year was 31% in 2001 and the highest return year was 64% in 2005. Most coal production companies are fortunate to deliver better than 10% returns on PPE. For example, Arch averaged 8% across a similar time period and calculating ROIC the same way (Numerator = EBITDA - Maintenance Capex (LP so no taxes); Denominator = PPE) and its experience is typical of the industry. No other publicly traded coal producer has achieved ROIC's remotely comparable to those at Alliance. The structural reason for Alliance's outperformance is that it has concentrated its efforts in the Illinois Basin, where coal can be mined more cheaply than the other major producing areas (Central Appalachian and Northern Appalachian). Also, it has very low levels of unionization amongst its work force. The operational reason for Alliance's cost advantage is that it is oriented toward fulfilling long-term contracts with utilities. As a result, it manages both operating and capital spending more efficiently than peers with less focus on long-term contracts. For example, it does not commit growth capital to expand production unless it receives multi-year price and volume commitments from power producers that guarantee it an acceptable rate of return on capital. Also for example, it does not chase demand spikes, and its miners do not work weekends, which can be used for maintenance. This ends up being cheaper than working the mines 24/7.

Perhaps the most important explanations of the company's high returns is the CEO, Joe Craft. He is a superb capital allocator. In addition to his record, other confirming data points on Joe are: (a) checks with industry contacts, who respect Joe in a way that is unusual in our experience; (b) his large personal stake in AHGP stock; and (c) careful attention to what he says on calls or at conferences; he doesn't say much but what's there indicates he thinks about his business like an investor, not a volume-producer.

(b) I Calculated Enterprise Value for a GP as follows: 60mm shares in AHGP x $27.50 stock price + $353mm net debt + the value of shares in the LP that the GP does not own (in this case 21.1mm shares x $43 stock price). Total Enterprise Value comes to $2.9b. 2009 EBITDA will be approximately $350mm. Maintenance capex is about 3.75/ton or roughly $100mm. They should end the year with PPE of roughly $880mm. During 2010 and 2011, they company will add 10-11mm tons of production capacity (to an existing base of 26mm this year). They will spend about incremental $400-500mm of growth capital to do this (maintenance capex will be additional to this), taking their yearend 2011 PPE to $1.3 - $1.4B. If they can achieve 30-50% ROIC, then 2012 unlevered fcf range will be $400mm to $700mm.

(c) Continued ROICs of 30-50%. Despite the tremendous decline in demand for coal this year (about 13-14%), nothing has altered the basic force that produced AHGP's superior ROIC - its low-cost mines in the Illinois Basin, reinforced by good execution and Joe Craft allocating capital. Having said that, here are the things to worry about: (i) coal is an alternative to natural gas; the cost of finding and developing natural gas may have declined with the surge of shale drilling, lowering returns for coal and non-shale gas producers; (ii) the coal industry is currently over-supplied relative to demand and may stay that way for an extended period of time; (iii) legislation relating to CO2 could increase the cost of coal versus less-CO2 intensive gas, lowering returns for all coal producers.

As to (i), shale F&D costs may or may not be significantly cheaper than the cost of developing conventional gas over the last decade. But so far there is not much evidence yet in the F&D costs of major gas producers to suggest that the capital cost of producing gas across the entire domestic gas industry has actually fallen. Very few of even the best companies we study have been able to push F&D costs per proven developed mcf much below $3 (excluding any asset value for proven undeveloped). And I would say $4-5 remains more characteristic of the industry, which does not represent a reduction in cost versus the time period in which Alliance compiled its track record.

As to (ii), the point of buying a low-cost producer of a commodity is that it relieves you of the need to determine where you are in the cycle. A long-term owner of Alliance doesn't need to know when the cycle will turn. He just needs to know that Alliance will preserve the cost advantage it has demonstrated historically. 

As to (iii), it is hard to size this risk, since the legislation is not yet clear. So far, anti-coal regulatory action has constrained coal supply (via permitting constraints, ever-harder safety regulations, etc) much more than coal demand, producing upward pressure on returns for Alliance, not downward pressure. We have no particular insight into the probability of worst-case legislative outcomes emerging. I will hazard the guess that legislation meaningfully increasing the relative cost of coal will be deeply objectionable not only to the industry's sizable Congressional representation, but to utility-bill paying Americans generally.


Company delivers on the scenario outlined above.

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