A few of Warren Buffett's (Trades, Portfolio) quotes before proceeding:
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
“I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.”
“Time is the friend of the wonderful company and the enemy of the mediocre.”
Three facts about Alliance Resource Partners L.P. (ARLP, Financial):
1. Founded in 1971.
2. Second-largest coal producer in the eastern U.S.
In its 2015 10-K, the company claimed that it had sold all (99.7%) of its 40 million tons of coal products to utility plants that has installed pollution control devices, or scrubbers, which eliminates sulfur dioxide in coal emissions.
The Environmental Protection Agency clearly does not favor the existence of the by-product sulfur dioxide (among other coal by-products) and wants it reduced.
3. Unique ownership structure
Alliance Holdings GP owns 31,088,338 common units of Alliance Resource Partners. That amount of shares would be 42% of Alliance Resource's outstanding units. Common units can be understood also as common shares outstanding.
Alliance Holdings GP is owned outright by Alliance Resource Holdings Inc. Alliance Holdings is also a publicly listed entity. Alliance Resource Holdings is owned outright by Joseph W. Craft III and Kathleen S. Craft.
Joseph W. Craft III, age 65, is the president and CEO of Alliance Resource Partners since 1999. He is also the director of Alliance Holdings.
Why I bought and averaged down in Alliance Resource Partners in the first place:
Two reasons: large insider ownership and interest and impressive historical financial numbers.
Alliance Resource Partners' price action
The S&P 500 has delivered 0.98% for the past year (March 26, 2015 to present), while Alliance Resource Partners declined 69%. The current dividend yield is as high as 23%.
One thing to take note prior to diving into Alliance Resource’s financial numbers is the ongoing coal price. Alliance Resource currently operates in 10 underground mining complexes in Illinois, Indiana, Kentucky, Maryland and West Virginia.
(Alliance Resource Partners, L.P., page 4 of 2015 annual report)
Coal prices
(Source: Quandl.com)
Therefore, the company is more or less affected in the coal prices set in the Northern and Central Appalachian and also the Illinois Basin.
These declining coal prices are brought by massive natural gas production and availability in recent years, improved use of renewable energy, as well as implementation of several environmental laws that treats coal as one of the causes of climate change.
(Regulations affecting the coal industry from OneEarth)
Further, I assume that higher coal price provides better earnings. Certainly, the ongoing collapse in the aforementioned districts of coal prices is not favorable for Alliance Resources and its peers.
A perfect example is Peabody Energy (BTU, Financial).
There is no moat being a large coal producer. This is best exemplified by Peabody Energy, the largest private-sector coal company in the world. Peabody had warned on March 16 that it may go bankrupt. As a result, its stock dropped by 45% that day. Nevertheless, Peabody had delivered a loss of 100% to its shareholders for the past five years.
Sad story, but I have some speculation that Alliance Resource can outlast the ongoing tragic events that are happening in the coal industry in recent years.
On the other hand, BP PLC (BP, Financial) (British Petroleum) could not have been more pessimistic with the direction of coal demand in the next few decades:
They were also pessimistic in terms of primary resources for power output (electricity generation):
The U.S. Energy Information Administration has the following forecast for primary energy use.
Natural gas price
Natural gas seems to be less of a pollutant than coal, and its low price definitely makes it a better and cleaner substitute to coal use. Unfortunately for the coal bulls out there, natural gas production has and still is expected to flood the market.
Alliance Resources was also candid about the declining use of coal in energy production. As stated in page 28 of its recent annual report:
“Changes in consumption patterns by utilities regarding the use of coal have affected our ability to sell the coal we produce. Since 2000, coal’s share of U.S. electricity production has fallen from 53% to 31%, while natural gas’ share has increased from 16% to 35%.”
Further, “Anticipated reduction of 25% of 2010’s total coal electric general capacity, at the end of 2015 15% of the planned 25% were retired and converted. This can be due to EPA (Environmental Protection Agency), lower natural gas price, and aging coal fleet.”
Alliance Resource Partners' financial numbers
Revenue and profits
Sales and profits have been steadily increasing until 2015. Reduction of growth in both sales and profits happened despite record number of coal sales (40.2 million tons).
Similar findings can be observed in Alliance Resource’s margin numbers. A drop in operating and profit margin suggested that the company experienced increased cost with its operations.
My 10-K digging revealed that the company had taken several asset impairment charges totaling $100 million on a couple of mines and several undeveloped coal reserves and related property (page 91 of 2015 Alliance Resource annual report).
This $100 million Alliance Resource asset impairment charge in contrast to Peabody Energy’s $1.6 billion (p. 44 Peabody Energy’s 2014 annual report).
Dividend growth
One can observe visually that dividend growth has always been consistent throughout the past decade; only recently (2013 to present) that the company had maintained 10% growth rate.
Free cash flow growth
Despite these challenging times, free cash flow has been on a steady growth. Nevertheless, it is important to remember that Alliance Resources had a $100 million asset impairment charge, which is taken as positive cash flow in the financial statement resulting into 700 million cash flow; without this asset impairment charge, Alliance Resources may have $100 million less in free cash flow or $600 million -- still higher than the five-year average of $300 million.
Net shareholder returns as percentage of profits and free cash flow
Interestingly, 2015 was the first year since the Great Recession when Alliance Resources provided more than its profits to its shareholders.
Debt to equity
Debt to equity has been more than 0.5 all this time.
Alarmingly, debt has been climbing up for the past five years, while cash has steadily declined. In contrast, free cash flow appears to be steadily increasing.
DuPont analysis
Alliance Resources may also have failed this metric.
Despite its high return on equity of 16% in 2015, historical data shows that the company is experiencing difficulties with its business operations.
Reasons to be an optimist
Insider buys
John Neafsey, who is the independent chairman of the board of Alliance Holdings General Partner has been buying actively last month.
Commitment of customers
According to Alliance Resource’s 10-K, it stated the following percentage of sales are already committed under long-term (lasting a year or more) contracts.
Keeping in mind that the company had sold 40.2 million tons of coal in 2015, 34.3 million tons booked for 2016 represents, assumingly, that roughly 85% of coal sales is secured.
There are two things to consider in terms of long-term contracts. First, the value 85% may be inaccurate, since coal tonnage sales have been climbing at an average of 5% in the past three years. Second, the nominal commitment can otherwise change because of reopener provisions contained in certain of these long-term contracts.
Valuation
Traditional P/E and P/B revealed that Alliance Resource currently has a wide discount compared to the S&P 500.
Intrinsic value calculations
S&P 500 multiple application
I use the S&P 500’s P/E and P/B values and multiplied it with today’s Alliance Resource earnings per share and book value per share.
Industry average multiple application
I use the industry’s P/E and P/B values and multiplied it with today’s Alliance Resource earnings per share and book value per share.
Simple multiple
Capital asset pricing model (CAPM)
Finding the appropriate growth rate is tricky. I would rather assume a negative growth rate for its cash flow despite that the company showed improved free cash flow in recent years.
Yahoo Finance produced a more pessimistic forecasting approach in Alliance Resource’s growth rate numbers:
Using a 10-year decline rate of 3% and a terminal decline rate of 2%, I arrived at the following intrinsic value calculation:
Other data used and not shown in the graph are as follows: 10-year Treasury rate of 1.88%, beta average of 0.80, equity risk premium of 6%, weighted average debt interest of 3.33%, corporate tax rate of 1% and recent quarterly data of total shareholder equity, free cash flow and total debt.
Applying all the calculated intrinsic value in a table and figuring the percentage upside/downside revealed the following:
Alliance Resource Partners LP is definitely undervalued right now. Whether a prospective investor should buy its shares now is a question they must ask themselves. Interestingly, a dividend investor would like to be cautious and expect a possible dividend cut if ongoing operations continue with its trend. Other questions to ask yourself before buying Alliance Resources is if you would be willing to risk your investment money in case Alliance Resource Partners goes belly-up. Or better yet, would one be able to sleep at night despite the ongoing natural gas flooding?
I guess for an Alliance Resources bull like me, one must figure out if he has the intellectual and emotional capacity to stick to his conviction that Alliance Resources would outlast this crisis in the coal industry. This stock is not for the weak stomach.
Disclosure: I am long Alliance Resources Partners LP. My current portfolio weighting in the stock is 3.5%.
Happy investing!
