Alliance Resource Partners Kills It!
On July 27th, Alliance Resource Partners, (NASDAQ:ARLP) reported an outstanding quarter with record sales and EBITDA. To be clear, this was not just a great result relative to coal producing peers. Management continues to deliver robust production and unit distribution growth. And, not just robust distribution growth compared to MLP peers, but tremendous and consistent absolute growth. For the 17th consecutive quarter, ARLP increased its distribution, this time to $1.0625, for an annualized $4.25 per unit. That's up an incredible 15.2% from the year ago period.
Is the Company's Growth Sustainable?
How on earth is Alliance doing so well while peers are truly struggling? Management has positioned the company in the 2 strongest coal basins of the Illinois Basin, "ILB" and Northern Appalachia, "NAPP." Solid long-standing customer relationships has enabled the company to be 90%+ contracted in 2013 and 70%-75% contracted for 2014. These priced and contracted tons offer significant downside protection.
The chart below shows the simple math of how ARLP units can be valued. As of Friday's close the unit price was $58.9 and the yield 7.2%. If the distribution rate were to increase by 12% over the next 12 months and the yield moved to 7.0%, the unit price would be $68.0, generating a total return of 22.6%.
How aggressive an assumption is 12% distribution growth? The following chart shows the progression of the distribution over the past 10 years. The average annual increase has been 15.5% and the latest announced quarterly distribution is up 15.2% from the year ago period. Given this tremendous growth in one of the worst coal market environments imaginable, I believe that 12% growth over the next 2-3 years is reasonable.
In addition to 12% distribution growth, the yield could easily fall to 6.5% from 7.2%. How aggressive a yield assumption is that? For much of March, 2011 Alliance units were trading in the low $80's and yielding as low as 4.2%. At a 6.5% unit yield and 12% distribution growth, the unit price would rise to $73.2 for a total return of 31.5%. Unit yields have ranged from about 4.2% to 7.5% with a mid-point of 5.85%. A reasonable upside case would be a unit price of $79.3 derived from a yield of 6.0% and the same 12% distribution growth, which would equate to a return of 41.8%.
Intuitively, expecting a unit price rebound to prior highs may seem irrational. Investors might wonder, will Alpha Natural Resources, (ANR) Peabody Energy (BTU) and Walter Energy, (NYSE:WLT) also return to last year's highs? No, not necessarily. Because there's a HUGE difference between ARLP and U.S. coal producing peers. Today's annualized distribution of $4.25 per unit is 23.5% above last March's annualized distribution of $3.44. Therefore, a full rebound in the unit price could be achieved by the yield moving only half way back to 4.2%
A Cash Flow Cushion to Support Distribution Growth
A very important metric for any MLP is a ratio of its distributable cash flow compared to the actual distributions paid. A ratio of 1.0x or greater is desirable. Alliance had a ratio of 2.5x in 2010 and 1.9x in 2011. In 2nd quarter of 2012 the ratio was 1.9x. This substantial cash flow cushion is a major selling point for the units.
Over the next few years I believe the ratio can remain at 1.5x or higher even with distribution growth of 10%-15%. For Alliance to be able to maintain such a favorable ratio in times like these is indicative of the company's operational excellence. To justify the current unit price and yield, investors appear to believe that distribution growth will fall below 10%, an assumption that's overly conservative given the dynamics of Alliance's business.
Historical Distribution Growth Does Not Ensure Future Growth
To be clear, extrapolating historical distribution trends forward is not meaningful without also discussing the underlying fundamentals of the business. In the first 2 quarters of 2012, 83% of tons sold were in the ILB, 11% in NAPP and 6% from Central Appalachia, "CAPP." Clearly, ARLP has been an ILB play. Going forward, ALL growth is coming from the ILB and NAPP.
The 2 key growth vehicles are Tunnel Ridge in NAPP and White Oak in the ILB. Both are low-cost, efficient, long wall operations ramping up over the next 2-4 years. Tunnel Ridge is now in production and expected to reach 6.5-6.8 million tons by 2014. White Oak represents a new model for Alliance. The company is acquiring 200 million tons of reserves and leasing them to an entity that they will own 20%-40% of. For White Oak, the company is adopting the well-tested royalty collection strategy like that of National Resource Partners, (NYSE:NRP).
Low Risk, Low Cost, Efficient Organic Growth in Place
Combined, Tunnel Ridge and White Oak will increase attributable production by 10-11 million by 2015-16 from 30 million tons in 2011. Importantly, about 60% of the total cap-ex required to reach a run-rate of 40-41 million tons has already been deployed. Cap-ex in 2013-15 should be down an average of 33% per year from that of 2010-12. And, all of this cap-ex from 2010-2015 will be done with debt leverage of just 1.0x-1.5x.
In summary, with ARLP one is getting strong absolute and relative growth in production, sales, cash flow and distributions without the use of high debt leverage. Robust organic growth is low-risk because the tonnage is coming from low-cost long wall operations in NAPP and the ILB. This growth is defensible in a tough environment with a cash flow cushion and will be strong in a more normal coal market.