While I certainly did not get in at the bottom, the position I recently started in Alliance Holdings (NASDAQ:AHGP) is quickly bearing some sizeable capital gains since starting a position in early June ( see prior research on Seeking Alpha here, currently behind PRO paywall). The green days have just kept rolling in recently, and market sentiment was further bolstered by Q2 2016 results released on June 26 th that were well ahead of expectations. I think it is worth highlighting what Alliance Resources (NASDAQ:ARLP) (the source of the holding company's income) did so well in Q2 2016, and how that ties back in to the original thesis surrounding both companies. Further, after a quick run, it is worth pondering a bit to think about if there is still room for capital gains appreciation after the sizeable move, or if I should go ahead and take the 560% annualized gain I'm sitting on with this name.
Q2 2016 At Alliance Resources
Alliance Resource Partners' GAAP earnings of $0.82/share beat expectations by $0.27/share, which is by all accounts a massive thrashing of bottom line expectations. While the revenue being down 28% y/y may give some investors cause for concern, it really isn't that troubling once you take the current market pressures into account. Atlantic coal producers have cut production by over 25% on the whole for 2016 due to pressures from weak power demand coming out of the winter and persistently low natural gas prices, so Alliance Resources finally shifting away from years of production growth, instead adopting a more disciplined mining strategy, is not surprising. Given the movement in natural gas recently, comps should be more favorable as lap these weak top line numbers in 2017. Still, 2016 looks favorable, and management has now raised revenue guidance to $1.82-$1.91B, with my previously high top line estimate of $1.9B now within the company's own guidance range. Just as a refresher, here are my estimates from that prior article:
Focusing on the top line does miss the real story here in my opinion, which is management's continued strength in keeping this small coal producer profitable in one of the most challenging coal environments in years. Margins are the real story here given that revenues were in-line with expectations, so Wall Street analysts once again underestimated the company's ability to drive down costs.
One of the key points of why I took a position in this company was its low-cost operations and its light leverage profile, both of which are not trademarks of the under pressure coal. Just because the company already has industry-leading efficiency doesn't mean management can't squeeze more out of the operation. Part of my original thesis was the likelihood of further cost reductions, a sizeable portion of which were driven by the idling of the Onton and Gibson North mines back at the end of 2015, along with shifts to longwall mining where possible and the usual generic efficiency initiatives in SG&A. Costs per ton are now at all-time lows for the company.
Management believes these low costs are sustainable throughout 2016 and 2017 (given current estimates on coal demand), and may even improve with sustainable results out of the Hamilton mine, which could likely be one of the company's lowest cost coal sources (which is now being ramped up to full production).
Getting more granular from a numbers perspective, EBITDA expense per ton in the Illinois Basin fell 12.9% y/y. In the Appalachia Basin, costs fell 15.9% y/y. Even sequentially, cost drops were in the high single digits. Coupled with the fact that blended realized pricing was down just 2% y/y, and you've set yourself up for major earnings accretion.
Net income guidance for 2016 is now up to $270-310M, in-line with my original $285M estimate. On the cash flow front, Alliance Resource Partners generated $212M in operating cash flow through the first six months of 2016, well in excess of capital expenditures ($48.6M) and distributions ($141.8M).
The investment case here revolves around the distribution yield and what constitutes a fair level of risk. After the recent run (up towards my price target), the yield is now 9% on Alliance Resources after the cut (8.3% at Alliance Holdings), in-line with historical averages. At this point, I believe this marks a fair value point when it comes to risk versus reward. For there to be further appreciation, the market has to begin contemplating whether or not there will be distribution increases in the future for the company. The likelihood of a major increase (or any increase at all) so quickly after a cut is likely small, especially given some constrained demand. The story here has now become more about when (and what price) the company's excess production capacity can come back online. In my opinion, that won't be until the back half of 2017/2018.
If you got in when I did (or earlier) great. You likely have sizeable gains and may have picked up a couple dividends along the way. In my opinion, there isn't wrong with protecting those gains at this point. I've currently sold half my position, reducing my exposure here to some degree. This plays into a broader market strategy that is seeing me raise cash as the S&P 500 tries to hold above what had been a hard resistance level at 210-212 for several years.
Alliance Resources remains best of breed when it comes to the sector, but it has had a heck of a rally off the lows. Expect a little more caution from the market on all coal names, especially heading into what almost assuredly be a highly contentious election season when it comes to coal. It is still a strong hold and a high quality name in the market, but do keep the big picture in mind.
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Disclosure: I am/we are long AHGP.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.