Value Investors Club / ALLIANCE RESOURCE PTNRS -LP (ARLP)

Description

Summary

I am probably slightly mad for writing up a coal company, particularly amidst a worldwide glut of cheap,

clean(er) energy. Not to mention the current administration’s efforts to “kill the coal industry”. But

Alliance Resource Partners’ stock has dropped over 30% in the past 3 months. At 36 and change, ARLP

trades at a 14% FCF yield, a 7.1% dividend yield, 4x EBITDA, and boasts very smart management in the

form of Joe Craft (whom I consider the Rich Kinder of the coal industry). Interestingly, IL Basin coal

prices are only down 3-4% since the peak last summer (Uh, oil is down 50%+ people).

What separates ARLP from the rest of the coal universe is that they produce thermal coal from the

Illinois Basin, a low cost region, and also coal with high heat content that utilities prefer. While overall

coal demand will continue to decline over the next decade, IL Basin coal demand is expected to grow at

a 3.9% CAGR between now and 2025. The losers are the coal companies in the high cost Central and

Northern Appalachian regions, where demand is expected to decline by 12%/year. There have been a

couple good write ups on the GP, Alliance Holdings (AHGP), by Thistle933 that can provide some decent

background here.

Since 2005 ARLP generally has traded between a 4% and a 7% distribution yield. Today’s 7.1% is the

highest since 2009. At a 5.5% yield on 2015 estimated distributions, ARLP could easily trade to $50 in

the next year, or to $55 by 2016, upside of 40-60% including dividends.

Background

Alliance Resources annually produces roughly 40mm tons of thermal coal today and owns rights to a

total of 1.6BB tons of coal reserves. 90% of these reserves are in the Illinois Basin, and almost all of

ARLP’s coal is sold to utilities under long term contracts, with 93% of 2015 production already sold out.

Pricing fears are overblown too, as management has indicated that overall pricing in 2015 will only be

about 2-3% lower than 2015.

Given that coal is used to provide baseload power, its demand is much more consistent than demand for

natural gas, which is more expensive on an energy equivalent basis, and often used in “peakers” to fuel

gas-fired power plants in particularly hot or cold weather.

There are 3 primary coal producing regions in the US: Powder River Basin (PRB) in Wyoming, Appalachia

(CAPP) along the East Coast, and the IL Basin (ILB). Appalachian coal has been produced for decades,

and is depleted to the point where costs/ton are in the $50-60 range. With Big Sandy coal prices at $53,

only the lowest cost producers can continue to profitably produce coal there.

The PRB is mostly cheap to mine surface variety coal, but transportation costs and low heat content

(8400 BTU vs 12,000 BTU in other regions), make it far less attractive than Eastern coal.

The chart above illustrates that IL Coal is highest in sulfur content, but has high heat content which

utilities prefer.

The regulatory history of coal and its future appear difficult in the aggregate. In 1990, the EPA passed

the Clean Air Act, which limited sulfur content in coal-fired power production, and demand for ILB coal

dropped dramatically. At the time, aggregate ILB coal production was 141mm tons, and fell to 88mm by

the year 2000.

Instead of buying sulfur credits, utilities eventually choose a different route in order to continue to burn

high sulfur content ILB coal. The development of scrubber technology became widespread around the

turn of the century, and given that 1) utilities could add the cost of scrubbers to its rate base (effectively

charge customers more to offset the cost of them), and 2) scrubbed sulfur could then be sold as a by-

product, ultimately made high sulfur/high heat rate coal the most desirable in the market.

Today roughly 60% of US coal plants have installed scrubbers, and needless to say, it’s the scrubber-less

older plants that are being phased out of the US power industry.

This chart above shows an estimate of demand for ILB coal heading toward 151mm tons by 2016 from

143mm this year. Below is an illustration of ILB production and its recent increases. Management

forecasts that ILB coal demand will range between 140-145mm tons this year, about flat with 2014. This

is actually quite remarkable in light of the fact that 1) a warmer winter this year is dampening demand

for coal, 2) rail constraints have made it difficult to get coal delivered, and 3) gas prices are now sub $3.

While weather can have a big influence on demand, generally I view it as noise if one can look out

beyond a couple of quarters. Last winter’s cold temperatures surprised a few utilities who were caught

a little short coal stocks. As of Nov 2014, power sector coal stocks are 18% below the 5 year average at 133mm tons.

Sometimes extremely low natural gas prices induce coal to gas switching; generally 1 ton of coal

produces the same amount of power as 25mcf of gas. So, at $3 gas, that is the equivalent of $75/ton

coal. ARLP by the way sold coal at an average price of $56 in the third quarter 2014. The negative of

course is that coal produces 2000 lb of CO2 per ton, while gas produces 1100 CO2.

Recently the EPA has proposed cutting emissions by 30% by 2030, compared to 2005 levels. These rules,

if passed, will take years to implement at best. It is clearly a risk however, that higher carbon emitting

coal power plants will continue to close. While there are some technologies being developed to

sequester carbon (from burning coal), it’s too early to really gauge how these will play out.

Logistically speaking, ILB coal is the cheapest to deliver compared to PRB or CAPP coal. There are

numerous rivers and train capacity from IL to the Northeast or power demand regions in the South.

ARLP ships just under half its coal tons via rail, 40% by barge, and the rest trucked. Recent results have

been slightly impacted by difficulty in finding rail capacity, but with the lessening of oil demand, slowing

(and likely eventually declining) oil production should free up transit capacity. Management believes by

mid 2015, and certainly by year end, delivery congestion will ease as rail companies also add capacity.

It is worth noting that these rail delivery bottlenecks have been the primary culprit in coal inventory

depletion since 2012, and once alleviated, could provide significant demand for coal in late 2015 and

through 2016.Coal generation from power plants is actually up 1% year to date through November.

Long Term View

It’s hard to paint a terribly bullish long term case for coal, but we don’t see coal plants entirely being

phased out either. Since the last peak in 2006, overall electricity demand has grown by around 0.1% per

year, and coal based power production fallen by 3.1%/year. ILB coal pricing on the other hand, has grown by 5%/

year, as its market share has continued to grow. 2015 will see 7 GWs of coal plant capacity, and 2016

will see 16 GWs of capacity taken off the grid. But scrubbed capacity will again, continue to expand

through 2016 before it levels out.

Over the next 10 years, the IEA forecasts 13% of US coal plant capacity will disappear. While long term

forecasts will certainly be wrong, directionally it appears that ILB coal will continue to replace App coal,

and in by 2024, could be producing between 175-200mm+ tons per year, meaningfully higher than

today.

Even going out to 2035, the IEA forecasts that coal will represent 34% of US power generation

(compared to 39% last year).

Cash Flow

For 2015, I took the company’s guidance at face value, which in the past has proven to be a conservative

measure. For 2014 for example, management guided to $720mm of EBITDA in January, and ended up

doing over 800mm. The company is actually producing 4mm tons this year less than capacity, due to rail

issues and lower demand due to a warmer winter. The newly constructed Gibson South mine will

produce 3mm tons in 2015, up from 800k tons this year. Ultimate capacity at Gibson is 5mm tons. I

have entirely ignored their investment in White Oak, which is a mine leased to another operator,

whereby ARLP receives royalty payments, production fees and preferred distributions from their equity

investment. It’s a JV, structured as an equity investment on the balance sheet, and hence will only show

up as “other income” below the EBITDA line. However, ARLP has invested almost $400mm in White

Oak, and production just began in October 2014. White Oak will produce up to 6mm tons per year once

fully ramped. That could add $50-70mm of EBITDA in the next couple of years.

ARLP owns 3 non-IL Basin mines, the most recently completed being the Tunnel Ridge mine. Costs / ton

started in the mid 60s, but last quarter fell to $39/ton, primarily as its located directly on a river and can

load coal directly onto a barge (the cheapest form of transit). In any case, ILB coal generates 95% of the

company’s EBITDA, and its CAPP mines 5%.

Pricewise, coal prices are not affected by global oil prices. Cool summer weather and rail congestion

have been the primary culprits in recent coal price weakness. But compared to oil, coal prices are only

down 10% from their spring peaks. ILB index prices are around $45 today from $47-48 in the summer.

Given that ARLP sells almost entirely to utilities, they have sold forward already 93% of 2015 production,

and 65% of 2016 production.

Comps

There is only one decent comp for ARLP, which is Foresight Energy (FELP). Names like Peabody (BTU)

and Consol Energy (CNX) produce different varieties of coal (met coal for example) in different regions,

with far different economics. Foresight just went public in June at $20, but at 3.0x leverage, with much

of its production sold to the export market (which is much lumpier than selling to US utilities), it’s not a

terribly attractive investment comparatively speaking. FELP is entirely an ILB producer, and does have

some of the lowest cost production ($20/ton, but ARLP is somewhat skewed by its CAPP production and

its costs run mid 30/ton).

In any case, FELP trades at 5.6x 2015 EBITDA, vs 6.1x at ARLP fully loaded with IDRs. Peabody (BTU)

trades at over 9.0x 2015 EBITDA for the record.

Management Team and IDRs

Joe Craft, CEO since 1999, is a very smart, careful manager who only makes 700k in salary per year, but

owns 39% of the GP (publicly traded stock AHGP), and hence 16% of ARLP indirectly (around $500mm).

Other managers (excluding Craft) own 33% of the GP, and 14% of the ARLP indirectly. The GP holdco

owns no assets other than shares in ARLP, and the General Partnership shares which receive incentive

distributions from ARLP. Overall, the GP takes 50% of distributions over 38c/quarter, but I view the

heavy cross holdings as aligning management very closely with the LPs.

It’s interesting to note that despite the company’s growth, the share count has remained unchanged

since 2003. Growth capital has been spent either buying single mines, or building new mines on existing

leased mineral rights. Growth spending probably slows over the next 2 years, as investments in Gibson

and White Oak are almost done, but that should improve FCF. Given the high levels of FCF, several

investors have questioned the company’s conservative payout ratio, which I peg at almost 2x. The

response is typical conservative management philosophy – there are lots of coal risks, we will continue

to grow the distribution carefully. Guidance is almost always beaten.

Conclusion

Lots of coal risk, but lots to like too. Particularly in terms of management and the level of FCF generated

here. The downside case I estimate to be $30 on the stock, assuming coal prices down 5-10%, perhaps

due to a combination of a cool summer and warm winter weather, depressing demand. Against an

estimated $2.75 in distributions in 2015, would imply downside of 12% in ARLP.

The flipside is that improved rail capacity in the second half of 2015 and continued production growth

yields a stock that trades to a more normalized level (10-12x FCF), or $50-55 pre dividends in the next

12-18 months.

It worth noting that this is a stock characterized by massive trading swings, with ARLP dropping from $41

to $26 amidst the warm winter of 2011/2012, then last fall to from $50 to $39, before rebounding back

to almost $50 in November. Just since January 1st, ARLP is down 14%; each pullback has proved to be a

solid entry point.

Risks

power demand, coal to gas switching, mine production issues, gas/oil/coal prices, coal plant closures, weather

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Continued production growth at ARLP, cheap valuation, gas prices recovering as rig counts fall, weather

show sort by

			2015	2016
Price:	36.44	EPS	4.05	4.21
Shares Out. (in M):	74	P/E	9.0	8.6
Market Cap (in $M):	2,697	P/FCF	7	6.6
Net Debt (in $M):	628	EBIT	515	545
TEV (in $M):	3,325	TEV/EBIT	6.5	6.0