Alliance Resource: Strong Mid-Cap Income Holding In Core Industry

| About: Alliance Resource (ARLP)

Like Warren Buffett, many of us prefer companies we can readily understand. One such company is Alliance Resource Partners, LP (NASDAQ:ARLP), a mid-cap coal company which mines coal in the Eastern U.S. and sells it to electric utilities. It's the 4th largest coal producer in the East. At its recent price of $73.20 per unit, the NASDAQ-listed company paid a 5.2% distribution. According to Value Line Investment Survey [12/9/2011], ARLP is expected to pay a $3.96 cash distribution per unit in 2012 which would be a 5.4% annual rate.

ARLP was recently [October 2011] "ranked by S&P in the top 1% of 7,500 public companies, having delivered a 27.2% compounded annual total return to unitholders over the last 10 years" [ARLP, Wells Fargo MLP conference, Dec 2011]. This exceptional performance resulted from market recognition of truly outstanding results. Since 2006 coal production has grown at a 6.3% compounded annual rate while revenues - reflecting strong pricing - grew 14.7%, and EBITDA rose at a 17.7% rate which drove an annual distribution rate of increase of 13.6%.

Approximately 45% of electricity generation in the U.S. in 2010 was from 600 coal-fired generating stations, and despite the EPA's anti-carbon stance, the Department of Energy projects coal will produce 43% of electricity in 2030 with total consumption in excess of 950 million tons vs. 929 million in 2010. Therefore the market for ARLP's coal is expected to remain strong for many years to come as 92% of its coal production is sold to utilities, with the balance to industrial users. To clean coal residue, electric utilities use highly sophisticated "scrubbers" to remove carbon and sulpfur dioxides from coal burning - scrubber capacity has increased by 300% since 2005 and is expected to rise an additional 28% by 2019. This pollution control equipment can cost up to 20% of the total cost of the generating plant.

Though headquarterd in Tulsa, ARLP's production is focused in three regions with 9 underground mines and 3 more in development: the Illinois Basin, centered around the Evansville IN area where IL, IN and KY meet; Central Appalachia along the KY/WV border, and the Northern Appalachia region where WV and PA meet. Although Central Appalachia underground production has been dropping steadily for many years, ARLP has been building up overall coal reserves in the Illinois and Northern Appalachia regions with new mines and acquisitions. Currently the company owns about 697 million tons of coal equal to 24 years at 2010 production rates. The coal industry is well-developed and very competitive. ARLP competes with Alpha Natural Resources (ANR), Arch Coal (ACI), CONSOL Energy (NYSE:CNX), James River (JRCC), Massey (NYSE:MEE) and others. Four major customers accounted for 41.8% of sales. ARLP sells most of its coal pursuant to long term contracts of 1-5 years.

ARLP is conservatively financed, and highly profitable. Debt and equity are approximately equal, and leverage is low at just 1.2x EBITDA compared to an average of 2.4x for coal MLPs and 4.3x for the popular pipeline MLPs. Cash distributions are only about 1/2 of available cash. ARLP has a 23% operating margin, and produces a 31.5% return on total capital [VLIS, 12/9/2011].

Cash Flow from Operations - always a key consideration - shows that ARLP produces sufficient cash from ongoing operations to pay for necessary capital expenditures, and still nicely cover cash distributions to unitholders. In 2010 the company produced $520.6 million of cash and had to spend $289.9 million for cap ex, leaving $230.7 million for distributions. With 37.0 million units and a 2010 distribution of $3.21 per unit, ARLP distributed $118.8 million in cash. This is helped, of course, by the MLP structure such that ARLP did not have to first pay corporate taxes before paying distributions. On September 30 ARLP had $307 million of cash on hand.

The one aspect of ARLP which investors sometimes find troubling is the complexity of the management and ownership structure. Page 2 of AHGP's SEC annual report [Form 10-K] shows a detailed diagram of the complex management structure. In the case of ARLP, its general partner is Alliance Holdings GP, LP (NASDAQ:AHGP), of which Joseph Craft is the CEO. The GP - by calculations from data filed with the SEC - owns 43.3% of ARLPO's units, and Mr. Craft owns or controls 79.4% of those units.

Over the past 5 years ARLP's cash distributions to unitholders have increased at a CAGR [Compounded Annually Growth Rate] of 13.8% - a very good record - but research shows that during the same period the General Partner's distributions grew at 27.0%! This is concerning, but reflects the fact that once ARLP's distributions exceeded $0.275 per quarter [AHGP, 2010 SEC 10-K, p. 20], AHGP received up to 48% of the distributable cash. However, AHGP is now at the maximum and my research indicates that from now on cash distributions to both ARLP and AHGP will rise at the same rate, a fair outcome.

Cash distributions will typically not be taxable to the unitholder until the unitholder's capital account becomes negative. Normally the unitholder's initial tax basis will be the price paid for the units. For example, if a unit was bought for $73.20, and distributions were at the expected 2011 rate of $3.63, the distribution will reduce the basis such that after one year the basis would become $69.57, and so on. The distributions would not be taxable until the basis was eventually reduced to below $0.00. However, the unitholder is also allocated his or her share of taxable income which will be different. In short, units can enjoy tax advantages but an investor should rely on his or her CPA for specific tax advace.

In summary, while unlikely to match the "Top 1%" total return figures of recent years, ARLP is a conservatively financed, very profitable coal mining MLP which should produce continuing increases in its cash distributions in coming years, with the potential for the units to rise from the current $73 level to $107 or more within several years. While each investor should do his or her own homework, ARLP is highly recommended for a strong mid-cap income holding in a core industry.

Disclosure: I am long ARLP.

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