I'm writing to you contrarian investors out there, those of you who are waiting patiently on the sidelines for an entry point into the torpedoed stock prices of a multitude of companies in the dirty business of mining coal. You can say what you want about the coal industry - only those who are exporting to China will survive, or everyone is doomed because of low natural gas prices, and these arguments are certainly valid, but that's "first-level thinking" as Howard Marks put it in his book, "The Most Important Thing". The level of thinking required in my analysis is "second-level thinking" and goes against the tide of investors who can't sell their shares of coal companies fast enough.
The first step I took in this process was to differentiate the good from the bad in terms of balance sheet strength and overall "quality" of the business and management. Nothing too difficult there.
Secondly, I took a strategic point of view in terms of the future outlook of the industry and wasn't particularly interested in pursuing those companies that are all competing in the same fashion - exporting coal to China and abroad. I know, it's a bit contrarian, but this is second level thinking at hand. This leads me to searching for a company that is well entrenched in the industry, with a moderately concentrated base of clients, and so won't likely be shutting down plants to build new ones for the sake of capturing currently low natural gas prices; is presently utilizing pollution control devices, so it won't come under severe disregard from the EPA; has strategically located mines to reduce shipping costs; and has strong bargaining power.
Case in point - Alliance Resource Partners, L.P. (ARLP). This company has actually been on my watchlist for over a year, but I never made the commitment to own the company, since it was rarely offered with enough of a margin of safety to my estimate of intrinsic value. I was especially strict in my required discount because I knew how much uncertainty existed in the outlook of the coal industry, the ongoing regulatory issues, and the price taking nature of what coal can be sold for.
I honestly have no idea why Mr. Market had a delayed reaction to the perceived value of ARLP, as many other coal related companies were suffering, but he certainly made up for it in an expedited manner. Considering within three months, investors were being greedy in the 80s, a little more eager to own, but slightly nervous as it dropped toward 70, extremely nervous and eager to capture whatever profits they'd made in the 60s, and then completely mindless and motivated by fear (or momentum investors going short) as it dropped into the 50s - this company and its stock price is like a mini case study on behavioral investing!
Now for the fundamental, absolute value, analysis. In my zero-growth normalized earnings power value estimate, I happened to calculate an estimated value of $57.25. Let's stop and think about this for a moment. What if, hypothetically speaking, this was actually true. Let's assume the following:
1) Future production of coal remains stagnant from 2012 through 2015. ARLP has fully secured sales of approximately 35.3mil. tons of coal for 2012. They've secured sales of 33.5mil. tons in 2013, 27.2mil. tons in 2014, and 19.8mil. tons in 2015, with prices locked in at $56.75. Let's assume they make up the differences, to equate to 35.3 each year, at a 25% reduction in the price of coal, to $42.56. Future revenue would approximately equate to (mil.) $2,003, $1,978, $1,888, and $1,783.
I'm going to give ARLP credit for its strong operational efficiency and effectiveness, and hold their net margin available for common equity to 16.44%. Holding # of outstanding shares constant, EPS becomes $8.90, $8.79, $8.39, $7.92. The current dividend payout is at an annual rate of $3.96, roughly 50% payout ratio, translating into a yield of over 7%, more recently.
Interestingly, ARLP has the capacity to increase this payout by 5% a year, and the payout ratio will still only hit roughly 60% in 2015. Should the company be willing to boost this by 10% a year, it's likely to hit roughly 73% payout. Point being, even under a zero-growth outlook, ARLP is essentially a high dividend growth vehicle efficiently priced in the market. Considering my options, this isn't unattractive at all.
2) As for my estimate of Franchise Value, maintaining the assumption that ARLP will continue to create profitable growth with an average ROIC of 25%, well in excess of its cost of capital (and that's using 12%-13% required return to equity as a component to WACC), even a long-term projection of growth in the 4%-6% range, which looks like a joke if you take a look at what it has been able to achieve in the not too distant past, those previous market prices in the 80s is absolutely accurate.
Considering I can buy ARLP today with a 7% dividend yield, which I have no doubt has the capacity and willingness by management to grow, with no expectation of resumed growth for ARLP, and/or the fact that the stock is presently on sale, with a margin of safety of over 30%, on the possibility that the company can continue to grow profitably, I like my chances either way.
Disclosure: I am long ARLP.