Alliance Resource Partners Is a Profitable Coal Company That Yields 12%

Alliance Resource Partners L.P. (ARLP, Financial) is the first coal company I’ve studied. The company interested me because it has fallen from a 52-week high of $50 per unit to its current closing price of $24.11 per unit.

It has a TTM PE Ratio of 6 and a TTM Price to FCF ratio of 4. Per GuruFocus, the PE Ratio in the last 15 years has ranged from 9 to 18 and the Price to FCF ratio has ranged from 7 to 20. Alliance Resource is a master limited partnership (MLP) that began mining coal in 1971 and is the third-largest coal producer in the eastern U.S. It has 10 underground mines located in Illinois, Indiana, Kentucky, Maryland and West Virginia. The company had revenues of $2.3 billion last year, net income of $497 million and a market capitalization of $1.79 billion and pays distributions yielding close to 12%.

The unit price has been beaten up because coal prices have fallen this year.

Taking a closer look

To begin, Alliance Resource is an MLP, which means that investors aren’t shareholders but instead are unitholders. There are positive and negative implications. From the diagram below, you can see the partnership structure is extremely convoluted. Management’s interest may not be squarely aligned with unitholders. It has ownership interest in a number of the entities involved, and there are related party transactions.

Since Alliance Resource is an MLP, it does not pay taxes like a corporation but passes the taxes to partners. Note that many people will pay less than the corporate tax rate. You can find more information on MLP tax implications here.

The good news about Alliance Resource is that the company has not lost money since at least 2000. I don’t have data prior to that. You can see the company’s steady revenue trajectory since 2000 with a CAGR of 9.34% over the last five years.

Net income growth has steadily grown as well with a CAGR of 9.26% over the last five years.

Net income margin percent has stayed above 10% over the last 10 years. It noticeably outperformed the coal industry and peaked in 2014 at 21.61%.

Another positive is that for 2015, 96% of Alliance Resource's production is contracted at favorable coal prices, and 75% is already contracted for 2016. The question then is, “What will happen to coal prices after 2016?” Coal price is dependent on the cost of production, transportation costs and physical characteristics like BTU (British Thermal Unit) and sulphuric content. There are different types of coal such as Powder Basin coal, Appalachian coal and Illinois Basin coal. You can see from the table below that Alliance Resource's coal produced for 2014 was approximately 75% Illinois Basin coal and 25% Appalachian coal.

From www.quandl.com/collections/markets/coal

The chart above shows how coal prices have fallen dramatically since 2013. The orange line represents Central Appalachian coal. It has fallen from approximately $65 per short ton to approximately $48 per short ton. The green line represents Northern Appalachian coal. It has fallen from approximately $65 per short ton to approximately $47 per short ton over the last three years. The purple line represents Illinois Basin coal, Alliance Resource's primary revenue driver. It has fallen from approximately $65 per short ton to approximately $33 per short ton over the last three years.

What’s even more concerning is that Alliance Resource generates over 97% of its revenues from utility plants and had two large customers for 2014 that accounted for 25.1% of their revenues. Each customer – Louisville Gas and Electric Company (LG&E) and the Tennessee Valley Authority (TVA) – accounted for more than 10% of sales each. We can see which power plants in the U.S. are being converted from coal to natural gas here. Below is a table of coal units and the scheduled retirement dates for LG&E and TVA.

The total gigawatts (GW) retired from these two companies will eventually be approximately 8 GW. As a frame of reference, total U.S. coal plant capacity in 2011 was 318 GW. From what I can tell, LG&E will be retiring a small percentage of its coal plants. In contrast, the TVA has 10 coal facilities and will be retiring units at seven facilities for a combined 5.4 GW of capacity from 2015 onwards. Their remaining coal facilities at Cumberland, Gallatin and Bull Run will have 4.57 GW of capacity. Does this mean that Alliance Resources will eventually lose over 50% of the revenue from TVA? That’s definitely a possibility, but my guess is that it depends on the utilization rates of each power plant which will be influenced by the price of coal and natural gas. In any case, the trend of power plants converting from coal to natural gas is being spurred by environmental regulations and will hurt ARLP’s bottomline.

Conclusion

Alliance Resources is an example of a company where backward-looking metrics look good, but past performance does not reflect the current situation. Earnings for 2015 and 2016 should be positive as production has already been sold on long-term contracts with favorable pricing. In the long term, the company’s prospects are much more uncertain. Note that the revenue for Alliance Resources is very straight forward to model. It's (number of coal short tons produced) multiplied by (average price realized per short ton).

The trick is knowing where Illinois Basin coal prices will bottom. Falling coal prices also imply that asset impairment charges may appear in the coming quarters. Given that I'm new to the industry, I don't have good working knowledge of how flexible the company's cost structure is. I welcome comments from readers who are more knowledgeable about the industry. What I do know is that Alliance Resource's addressable market is shrinking unless somehow it becomes profitable to export coal internationally. A contrarian view is if weaker coal players fold and Alliance Resources grows market share, then the company may make a good long-term investment.

I’ll check in on this company quarter by quarter to better understand the business and industry. I will be especially interested in how Alliance Resource's fiscal 2017 results materialize.