Introduction and Disclaimer
This document contains an independent analysis of Alliance Resource Partners LP (NASDAQ: ARLP). Information on my investment philosophy can be found here.
Disclaimer: The author is currently long ARLP. All of the views expressed in this document are solely those of the author and do not reflect the view of any other person or company. I am not receiving compensation for it. I have no business relationship with the company whose stock is mentioned in this document. All investments involve the risk of permanent capital loss. I encourage everyone to do their own due diligence and to reach their own conclusions. Under no circumstances should this document be considered an offer to buy or sell any securities mentioned within. Custom charts within this document use data from www.eia.gov retrieved June 2016.
The narrative surrounding the coal industry goes something like this: thanks to the shale gas revolution and the renewed vigor for environmental regulations, coal is now dead as a fuel source. Everyone agrees that the trend in United States coal production will continue on its current downward path, and eventually, production will disappear completely. The bankruptcies of Peabody Energy, Arch Coal, Patriot Coal, Walter Energy, and Alpha Natural Resources all reinforce this narrative.
The percentage of total electricity generated by coal in the United States recently dipped below 30%. This is the lowest level since recording began.
Coal production in the United States has collapsed over the last ten years.
In situations of maximum pessimism, like I believe this one is, the correlation of everything indiscriminately goes to 1. Merely being associated with the coal industry is enough to have your future prospects significantly discounted.
But when everything is priced as if a whole industry is going to disappear, what happens if it doesn’t? More importantly, what happens to the companies, unfairly lumped together, that would have been fine even if it did disappear?
The truth of the matter is that things are never as dire as they seem. The EIA, using conservative metrics that include a strict clean power plan being implemented, estimates that coal will still represent 20% of U.S. energy generation in the year 2040.
The shale gas revolution, and the cheap gas that comes with it may only be temporary. The EIA projects the oversupply in natural gas to balance by 2019 and for prices to increase from there.
Assuming coal doesn’t disappear completely, someone is going to need to supply that future demand. Alliance Resource Partners is a low-cost producer of coal that has managed to remain profitable during this time of turmoil. This accomplishment was mainly due to their use of stable long-term contracts. The company currently has 75 tons of contracted orders between now and 2019. The company has maintained a conservative financial position and are strategically positioned to capitalize on any upside that might develop in the industry.
The management team owns approximately 42% of the company and has a proven track record of achieving disciplined growth. In response to the current market conditions, management has shifted production to its lowest cost mines, reduced capital expenditures, and lowered operating expenses in order to fortify its position for long-term success.
I believe that over the next three years, unprofitable coal supply will exit the market allowing for low-cost producers to flourish. Low natural gas prices will self-correct as the market naturally clears. Regulation will be implemented to curb coal use, but its impact will be manageable. This is contrary to the popular narrative, and if correct, Alliance Resource Partners may be worth more than its current market price reflects. People may come to realize that the coal market dying isn’t the same as the coal market being dead.
Alliance Resource Partners LP, referred to as ARLP going forward, is a diversified producer and marketer of coal to utilities and industrial users in the United States. They began mining operations in 1971, and have since grown to become the largest coal producer in the Illinois Basin and the second largest coal producer in the eastern United States. As of December 2015, they operated ten underground mining complexes with 1.8bn tons of coal reserves. Their economic livelihood is directly linked to coal consumption patterns of domestic electricity generating utilities. ARLP derives approximately 30% of their total revenues from two companies, Louisville Gas and Electric Company and Tennessee Valley Authority.
In November 2014, a subsidiary of ARLP began purchasing oil and gas mineral interests in various geographic locations within the continental United States. These are long-term investments with expected mid to high teen returns on capital and expected cash flow expansion starting next year.
ARLP is organized as a master limited partnership. The general partner is Alliance Holdings GP (AHGP). Aside from their GP and IDR interest in ARLP, AHGP also owns roughly 42% of the outstanding ARLP units. AHGP is managed and 68% owned by Joseph W Craft.
According to Forbes, Craft started his career as a lawyer and then joined diversified coal company MAPCO as an assistant general counsel in 1980. He later became president and was rewarded with a big stake for leading the firm’s LBO and conversion into a tax-efficient public master limited partnership in 1996. It was renamed Alliance Resource Partners three years later and Craft has served as chief executive ever since.
Companies in the coal industry compete on coal price, coal quality, transportation costs, and the reliability of supply. ARLP’s principal competitors include Alpha Natural Resources, Arch Coal, Consol Energy, Peabody Energy, Cloud Peak Energy, and Westmoreland Coal.
There has been a lot of pain in this industry over the last two years. Weak power demand, persistently low natural gas prices, ongoing regulatory pressures, and a oversupplied coal market, have all coalesced into a situation that has caused multiple bankruptcies.
ARLP’s relative outperformance during this time can be attributed to its conservative balance sheet and robust liquidity. ARLP has even managed to remain profitable during this period.
ARLP’s position of strength has allowed them to take advantage of several opportunities in the market, including the acquisition of coal supply agreements, coal reserves, mining equipment, and other assets that will help their position as a low-cost producer. In some cases, the other company’s losses have been ARLP’s gain. Joseph Craft, speaking on the Q1 2016 conference call, had this to say about the bankruptcies in the industry:
I think that from a competitive nature it’s strengthened our position, in the sense that from a customer perspective the credit quality of their suppliers is always an issue. So when they enter into a contract they want to know that the supplier has the financial ability to discharge that contract and also not have their contract be rejected. So from that standpoint it’s been a strength to us.
As you think about how it affects the financing market, lenders are spending a lot of time trying to protect the loans that they made to bankrupt companies. It just takes more time to try to go through the dialogues so that they remember they are talking to us and not some other competitors who are in bankruptcy.
As far as tons that will be on the market, I think there is still a lot of capital available to those companies within bankruptcy. And so they could come out and reorganize, get new financing, and keep the production levels just rolling. I think that creditors are going to force these debtors to go ahead and rationalize their production, their costs are above their contract positions and it is not sustainable.
The Bear Case
Bear case #1 – Coal is dead
The argument: Coal is dirty, and it will be replaced by cleaner burning fuels in the coming years. This isn’t just a wish but a necessity. If coal burning isn’t done away with soon, catastrophic damage will be done to the environment. For this reason, any reserves of coal are essentially worth zero.
Why it is wrong: It ignores the difficulty of replacing 30% of a country’s energy generation. Every major energy organization projects coal remaining a significant source of our country’s power generation through 2040.
Bear case #2 – Natural gas is eating coal’s lunch
The argument: Not only is natural gas cleaner than coal, but it is now also cheaper. The country is awash in shale gas. The environmental imperative is no longer relevant, power plants will shift away from coal simply because it is the economically rational thing to do. Coal is no longer economically viable.
Why it is wrong: It ignores the second order effects of low natural gas prices. Low prices directly impact the economics of drilling, which reduces supply. At the same time, low prices increase the demand for natural gas. Production for a shale gas well is heavily front loaded and drastically drops off after a mere 3 to 5 years. What is plentiful today may be scarce tomorrow.
Bear case #3 – Hostile political environment
The argument: Any investment in coal will be subject to the whims of the government. One day you will wake up and coal will be either banned or taxed into oblivion.
Why it is wrong: The projections in this document have taken into account the effects of the clean power plan, which is currently being held up in supreme court hearings. The projections show that ARLP will still be in a stable position. There is a lot of political difficulty in outlawing a business that employees as many people as the coal industry does. A better way would be to nationalize the coal industry by paying the market price for its assets. After which, they could retrain and relocate employees, while simultaneously shuttering plants. Destroying an industry, without some consideration for its stakeholders, doesn’t seem politically likely.
Bear case #4 – China is collapsing
The argument: China is the largest consumer of coal, and they are currently in a debt bubble that is larger than the one that blew up our markets in 2008. Not to mention, they a huge pollution problem that coal only makes worse.
Why it is wrong: I’m not sure that it is wrong. If I could predict a market crash in China I wouldn’t need to be analyzing coal companies. But if China does blow up, what effect will it have on ARLP? Not much. ARLP does not export coal and the cost of transporting coal makes it prohibitively difficult for foreign suppliers of China to flood our markets. ARLP will still suffer from second order effects, as the world economy slows, but it shouldn’t threaten the viability of the business.
Bear case #5 – An MLP? Really?
The argument: Why invest in a structure where the GP essentially has all the voting rights and an incrementally larger share of the distributions as the company grows. Not only that, but the GP’s incentives are skewed. They only hold a 2% interest in the company, but they have a 50% interest in future growth. Their downside is capped but their upside is unlimited. The GP may be inclined to make risky decisions that are not in the LP’s best long-term interests. If that wasn’t bad enough, as the GP’s share of distributions increases, the hurdle rate for future growth becomes insurmountable.
Why it is wrong: This is mainly true, but that doesn’t mean it applies to ARLP’s situation. The GP actually holds a 40% interest in the LP, not 2%. History also shows that management hasn’t levered up the balance sheet in the search of growth. Even when the price of coal was soaring, management kept a disciplined approach to acquisitions. Recently management even went so far as to reduce the quarterly distributions despite them being well covered. Management had this to say:
Even though the distributive cash flow for 2016 is expected to come in as
previously guided. This decision was made to ensure that Alliance maintains the access to a reasonable level of capital necessary to prudently manage its business for the future.
As many of you know my family and our management team and I own a very significant portion of AHGP so we are very well aware of the impact of reducing distributions to our unit holders. I am confident however that this was the right decision for us to make.
The base case scenario assumes prices continue to drop over the next 4 years. After which, prices and production will begin to increase moderately. Expenses are in line with company estimates. I give this scenario a 50% likelihood.
The best case scenario assumes prices rebound faster over the next 4 years. After which, prices increase at a level in line with EIA estimates and production starts to grow at historic rates. Economies of scale reduce estimated expenses going forward. I give this scenario a 30% likelihood.
The worst case scenario assumes everything goes wrong. Prices fall at an increased rate over the next 4 years and stay there. After which production drops steadily for 10 years. Expenses come in higher than estimated. I give this scenario a 20% likelihood.
The expected return, given what I think are conservative assumptions, is 60%.
Note: All three scenarios place zero value on the future of ARLP’s oil and natural gas assets. ARLP has capitalized on the turmoil in those industries by acquiring mineral rights at fire sale prices. Those assets provide ARLP with a reasonably priced call option on a future turnaround in those industries.
In my opinion, ARLP is a buy with a price target of 24.02 and a time horizon of 3 years. This would represent a 17% annualized rate of return from the current market price.
(Update 8/12/2016: I cut this position in half today. Though there’s still plenty of room to the upside, the risk-reward at $19.95 is far less attractive than it was at $15.00. I feel the capital is better used in a situation that is more insulated from a general market sell off. The selling price of $19.95, combined with the distribution of $0.43, brings the total pre-tax return to 35.9% over the two month holding period.)