The Richest Seam in Coal

Coal is a dirty fuel, and in recent years it’s become a dirty word for investors, as one producer after another has succumbed to falling prices and diminishing demand.

Cheap natural gas has made major inroads as the fuel of choice for US utilities, and while exports have recently increased they have not made up for the loss of domestic customers.

But one coal producer has not only weathered the collapse but used it to meaningfully increase its market share and distributions. Alliance Resource Partners LP (Nasdaq: ARLP) is only the sixth-largest US producer and last year it accounted for just 3.4 percent of the national output, roughly one-sixth the contribution by industry leader Peabody Energy (NYSE: BTU).

Alliance Resources operations map

Alliance’s mines in northern Appalachia and the Illinois Basin are the lowest cost producers in the Eastern US, well placed to capture market share from natural gas at gas prices even well below current levels. Under the leadership of Oklahoma billionaire Joseph Craft III, Alliance has made profitable investments that have grown its production and distributions to limited partners.

Output grew from less than 26 million tons in 2009 to an expected 39 million tons in 2013. ARLP’s distributions per share have also increased by roughly 50 percent in that time, and are expected to approach $4.50 per unit this year.

Alliance Resources fundamentals chart
Source: company presentation

Alliance has been growing its top and bottom lines even as US coal prices plumb multi-year lows. It operates 11 underground mines in Illinois, Indiana, Kentucky, Maryland and West Virginia, is building a 12th in southern Indiana and is an investor in another new mine in southern Illinois.

The vast bulk of the output is sold to utilities under long-term contracts with periodic price adjustment provisions. Louisville Gas & Electric and Tennessee Valley Authority accounted for 28.5 percent of Alliance’s revenue last year.

Alliance operates entirely with a non-unionized workforce and believes its workers’ productivity is a competitive advantage.

Alliance Resource Partners is managed by its general partner, Alliance Holdings GP LP (Nasdaq: AHGP), which holds a 2 percent general partner stake in ARLP, holds 42 percent of the ARLP common units and collects incentive distribution rights.

These rights entitle Alliance Holdings to 15 percent of quarterly ARLP distributions in excess of 27.5 cents per unit, 25 percent above 31.25 cents per unit and 50 percent above 37.5 cents per unit. Since ARLP paid a quarterly distribution of $1.13 in May, its general partner is well into the upper bound of the bonus scheme and entitled to half of any further growth in distributions.

Alliance Holdings’ incentive distribution rights receipts totaled $102 million last year, up from $83 million in 2011 and $67 million in 2010.

That growing income stream supports AHGP’s current 4.9 percent yield, and its 21-quarter streak of distribution increases. The most recent one in May represented a 3 percent hike from the prior quarter and a 14 percent rise year-over-year. IDRs should account for well over half of ARLP’s distributions to AHGP this year.

AHGP distributions chart

Source: company presentation

The underlying business is strong and improving. In its most recent quarter, ARLP reported a 15 percent output gain year-over-year, and a 23 percent revenue gain thanks to higher selling prices. Meanwhile, its mining costs per ton of coal declined, fueling a 32 percent jump in earnings before interest, taxes, depreciation and amortization (EBITDA). The partnership said it is likely to finish the year at the upper end of its prior guidance range for sales and profits.

On the April conference call, Craft said power generation “in the coal-consuming regions of our country” had risen 3.4 percent over 2012, thanks to a cold winter and improved industrial demand. Meanwhile, coal production was down 8.7 percent amid the price slump, even as higher natural gas prices encouraged some switching to coal.

“Even with a sluggish economy, we believe these favorable market fundamentals for domestic thermal coal will result in higher spot prices in the second half of the year, as utility stockpiles are drawn down toward historically normal levels. This should bode well for growth in revenue in 2014,” Craft said.

Even in the absence of higher prices, Alliance’s investments in new mines should boost affiliated production by up to 20 percent over the next two years.

More encouragingly still, this is not growth financed by spiraling debt. Alliance Resources boasts a debt-to-trailing-EBITDA ratio of 1.3, versus 2.7 for coal MLPs and 3.9 MLPs as a whole.

The combination of low leverage, solid yield, profitable growth and improving industry fundamentals marks Alliance as a winner, and Alliance Holdings is poised to benefit disproportionally thanks to its incentive distribution rights. We’re adding the partnership to our Aggressive Portfolio. Buy AHGP below $68.

In the LINE of fire

The Securities and Exchange Commission probe of Linn Energy’s (Nasdaq: LINE) accounting has scared some investors out of all upstream MLPs last week, resulting in lower prices and higher yields.

One unjustly tarnished victim was Aggressive Portfolio holding Vanguard Natural Resources (Nasdaq: VNR), which saw its unit price dive 9 percent over the last four trading sessions (though Friday), boosting the yield to 9.6 percent.

Yet Vanguard hasn’t been nearly as aggressive an acquirer as Linn, has not used put options to meaningfully boost distributable cash flow and in general has been a much more conservative spender. Its capital spending budget for the current year will consume just 18 percent of estimated EBITDA, versus 76 percent last year for Linn. This, along with the hedge accounting, has been one of the Linn vulnerabilities seized on by short sellers.

But Vanguard is very different on those counts, and as a result has not been heavily shorted. Its losses last week are likely the result of investors indiscriminately fleeing the space rather than anticipating a company-specific problem.

Yet, despite its financial prudence, Vanguard has delivered far and away the strongest distribution growth among upstream MLPs, delivering a cumulative 45 percent increase since its initial public offering in 2007. That record, the yield and the persistent strength in oil prices suggest that last week’s discount won’t last. Continue to buy Vanguard below $28.       








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