In the past few months I've written 2 articles on Natural Resource Partners (NRP), an MLP that I continue to believe offers excellent risk/reward at today's unit price. Earlier this week I listened to a webcast presentation of Alliance Resource Partners, (ARLP) at the Raymond James coal conference. Unlike NRP, ARLP produces coal, 31 million tons in 2011 making it the 3rd largest producer east of the Mississippi. Like NRP, Alliance has a significant coal reserve base of about 900 million tons. And, like NRP, ARLP has large exposure to the low-cost Illinois basin. ARLP is one of the largest producers in the basin at about 25 million tons.
It's interesting how the tables have turned in the coal sector. Players like Arch Coal, (ACI), Alpha Natural Resources, (ANR) and Walter Energy, (WLT) pursued growth at any cost, vastly overpaying for large acquisitions in 2011. While Companies like Cloud Peak, (CLD) who did not make blockbuster acquisitions were thought to be missing the boat. Producers rushed to produce as much coking coal as they possibly could, without considering that coking coal prices could fall precipitously, that demand for lower quality coking coals could collapse or that costs might continue to rise despite lower coal prices.
Who would have thought a year ago that a boring thermal coal player with limited coking coal production and less than 5% of revenues from exports would not only easily survive this downturn but also be poised to thrive? By sticking to its knitting, keeping debt leverage low and maintaining steady long-term customer relationships, ARLP has avoided most of the turmoil in the industry and has reported 11 consecutive years of increased profits.
A year ago when coal prices were much higher and the long-term outlook appeared rosy, U.S. coal producers were earning strong cash flows. 2011-12 forecasted EBITDA margins were expected to be in the low-to-high 30%'s. Today, 2012-13 EBITDA margins are more likely to be wrapped around 20%. Yet through all of this volatility, ARLP delivered a 31.5% EBITDA margin last year and has guided to a 28.5% margin for 2012. The Company has risen from boring and overly conservative to prudent and sexy in just a year.
Sexy? Ok, I take that back, coal producers aren't sexy. But ARLP units are yielding ~7.5% and could comfortably achieve capital appreciation of 15%-25% for a total return of 22.5%-32.5% over the next 12 months. Given the risk profile of ARLP, I believe return potential in this zip code, with limited downside supported by a growing distribution, offers a compelling risk-adjusted opportunity.
Alliance has demonstrated strong and steady unit distribution growth over the last 6 years, from $1.92 per unit in 2006 to $3.63 per unit in 2011, a CAGR of 13.6%. In the first quarter of 2012, ARLP raised its annual distribution to $4.10 from $3.63, an increase of 12.9%. Management has been able to increase distributions because they prudently managed the balance sheet and acquired and developed low-cost assets in low-cost regions. Net debt divided by EBITDA is just 1.2x, compared to about 3.2x for coal MLPs overall and 4.7x for other energy related MLPs. [source: ARLP corporate slide deck, June 19th]
Even after years of spectacular distribution growth, ARLP still has a coverage ratio, (distributable cash flow divided by actual distributions) of 1.8x. Taken together, low use of debt, high production growth and high distribution growth, it's no wonder that ARLP steered clear of the mistakes made by others. ARLP has one of the best contracted positions in the industry with approximately 90% priced and sold for 2013. Peers have about 40%-70% of next year's thermal coal contracted.
Since 2010, ARLP units have yielded an average of ~5.5%. Today the yield is up to ~7.5% and the unit price is down ~35% from its 52-week high. This is not due to weaker financial health, ARLP is down in sympathy with the rest of the coal sector. Distribution growth could comfortably continue at 12% or more as the Company expects to increase production by up to 18 million tons (from 31 million in 2011) in the next 3 years. However, since cap-ex will be materially higher to bring that magnitude of incremental tonnage on-line, I assume the annual distribution will increase 8% going forward.
As coal market fundamentals stabilize, ARLP's yield should move towards its recent 5.5% average. A year from now units could be yielding 7.0% with an annual distribution of $4.43, (8% above today's $4.10) which would equate to a unit price of ~$63.4. That would be a gain of ~16% and a total return of ~23% for a relatively low risk security.