(Published Jan. 10 by Bob Ciura)
One of the industries most eager to bid farewell to 2016 was coal. Demand for coal fell off a cliff, from a variety of sources including intensifying regulation as well as a broader shift away from coal toward natural gas.
Even well-run, highly profitable coal companies like Alliance Resource Partners (ARLP, Financial) suffered.
Despite a unique competitive advantage and a long track record of success, Alliance Resource slashed its distribution by 35% last year.
Prior to the distribution cut, Alliance Resource had an enviable dividend track record. Coming into 2016, the company had raised its distribution for 29 consecutive quarters. At the time, it was a Dividend Achiever.
(Note: The stock is still technically on the Dividend Achievers List but will soon be removed.)
You can see the entire list of all 272 Dividend Achievers here.
Now that Alliance Resource has reset its distribution at a lower but more sustainable rate, the question is whether investors should give coal another chance.
Business overview
Alliance Resource isn’t your average MLP. It is a coal-mining company and was the first coal MLP.
The company operates nine mining complexes in Illinois, Indiana, Kentucky, Maryland and West Virginia. Its production facilities are located in two coal-producing regions, Appalachia and the Illinois Basin.
It also operates a coal loading terminal and has one mine development project under way.
Source: Annual Report, page 9
The company’s premiere assets led to steady growth for many years. From 2011 to 2015, Alliance Resource enjoyed rising production and sales volumes.
Source: Annual Report, page 11
This led to significant growth in revenue and EBITDA in that same five-year period.
Source: Annual Report, page 11
In turn, Alliance Resource consistently raised its distribution.
Source: Annual Report, page 11
But all this came crashing down, starting in 2015. Revenue fell just 1.2% for the year, which was a mild decline. Alliance Resource realized record production. This kept revenue intact.
But the company’s efforts to produce more only masked the deteriorating underlying economics of the coal industry.
Alliance Resource’s average realized price fell 3.5% in 2015. In addition, higher costs related to its expanded production and attempts to retain market share caused net income to decline 38% for the year.
Conditions have not improved much over the course of 2016. Revenue and net income declined 19% and 9.1% through the first nine months of the year. Alliance Resource again kept growing production, but weak pricing and soft demand more than outweighed the benefits of rising output.
Growth prospects
Judging by Alliance Resource’s past performance, the stock looks like a great bargain. But future returns are based on what happens moving forward. From this perspective, the company’s outlook is cloudy.
The reason is because the growth prospects of the U.S. coal industry are quite bleak. Domestic coal production has steadily declined over the past decade from nearly 1.2 billion tons in 2006 to less than 800 million tons in 2016.
And the forces causing coal’s demise do not seem to be easing any time soon.
In particular, the boom in domestic natural gas production caused the price of gas to fall sharply. This incentivized industrial firms such as electrical utilities to switch from coal to natural gas.
For example, according to the Energy Information Administration (EIA), the average daily natural gas spot price fell from $2.63 per million British thermal units (MMBtu) in 2015 to $2.40 per MMBtu in 2016.
This resulted in rapid adoption of natural gas versus coal. In 2016, natural gas represented 34% of electricity generation in the U.S. By contrast, coal accounted for 30% – thus marking the first time ever that natural gas surpassed coal.
Making matters worse for the U.S. coal industry is that exports are not a viable option for growth. The EIA states that U.S. coal exports declined 23% in 2016.
Alliance Resource is a well-run company with a strong asset base. But prevailing economic conditions can trump even a great company like Alliance Resource.
Competitive advantages and recession performance
Alliance Resource enjoys two specific competitive advantages, which at least helped the company stay afloat while so many other coal miners went bankrupt.
First, Alliance Resource’s coal mines are situated close to its industrial customers. This helps keep distribution and transportation costs low.
Second, Alliance Resource primarily produces thermal coal, which is used to generate electricity. The economics of thermal coal have remained intact relative to metallurgical coal, which is used to produce iron and steel.
These competitive advantages led to Alliance Resource’s strong growth over the past several years. In addition, they helped the company remain profitable during the Great Recession.
Alliance Resource’s performance during the Great Recession is as follows:
- 2007 earnings per share of $1.42.
- 2008 earnings per share of $1.21.
- 2009 earnings per share of $1.78.
- 2010 earnings per share of $3.34.
Earnings per share fell 15% in 2008 during the heart of the recession. But because of the company’s competitive advantages and strong business model, profits quickly recovered by 2009 and beyond.
Distribution analysis
If the distribution is secure, and there is no guarantee of that, Alliance Resource could generate strong returns moving forward.
That’s because, in addition to its 7.8% yield, the stock is cheap as well. Alliance Resource currently trades for a price-earnings (P/E) ratio of 11.
If the stock were to experience expansion of the P/E multiple in addition to a 7.8% distribution, investors could easily earn double-digit returns on an annualized basis.
However, one can hardly argue with the current valuation multiple. Coal is under fire – and not in a good way.
If demand for coal continues to drop, the price of coal will follow. And if that happens, it is likely the company’s earnings will decline. This typically results in valuation compression as well.
While the economics of the coal industry seem to have firmed, investors cannot rule out continued erosion if conditions worsen moving forward.
Conceivably, Alliance Resource could generate 10% annual returns or greater, largely because of its high distribution. But the worst-case scenario would be for earnings to continue declining, which would jeopardize the distribution.
Even at its reduced rate, Alliance Resource’s annualized distribution makes up 92% of its trailing 12-month earnings per share.
Final thoughts
Alliance Resource Partners’ distribution cut last year was painful but necessary. The good news is that Alliance Resource Partners seems to have right-sized its distribution, based on the realities of the coal industry.
Still, investors have to be willing to take the risk that coal could continue to fade in relevance.
As a result, investors should view Alliance Resource as a high-yield MLP that carries a high level of risk. There are better high-yield MLP choices elsewhere.
Disclosure: I am not long any of the stocks mentioned in this article.
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