Assessing Survival Potential: Alliance Resource Partners

Summary

• Coal companies have been hit extremely hard by COVID-19 due to production suspensions and lower coal prices.
• A major coal producer, Alliance Resource Partners, has lost two-thirds of its value and trades at a TTM EV/EBITDA of only 2.5X.
• While 2020 will likely be a record poor year for the company, it has decent working capital and a surprisingly strong balance sheet to make it through difficult times.
• Even after a downgrade, the company's credit rating is only slightly below investment grade, so its bankruptcy risk is low.
• It has been the target of short-sellers. With production resuming, a short-squeeze is conceivable.
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With the market up 30% off of its March lows, many investors likely feel that there are few value opportunities left. That said, the market's rally has not been widespread, and large-cap technology companies have accounted for the bulk of the Nasdaq 100's and the S&P 500's strong performance. In fact, many smaller companies in hard industries remain at March 15th lows, one of which is the major U.S. coal producer, Alliance Resource Partners (NASDAQ:ARLP).

As you can see below, ARLP has drastically underperformed the coal ETF (KOL) and remains at a depressed price:

Data by YCharts

Without a doubt, the coal industry has been among the hardest hit by the efforts to fight the COVID-19 pandemic. The industry was already downtrodden after years of low coal prices due to a glut of fossil fuels, as well as depressed demand for steel (regarding metallurgical coal).

Alliance Resource Partners has shut down all of its coal production at its Illinois Basin Mines and has suspended its dividend distribution in order to maintain liquidity. It has also looked to cut capital spending and operational expenses, and anticipates that total sales will be 25% below its initial expectations. Other than that, the company has suspended all forward guidance.

On a TTM basis, the company has a dividend yield of 55% (though its dividend is currently suspended). It also trades at a third of its book value with an incredibly low TTM EV/EBITDA of 2.5X and a P/E of 1.15X. Obviously, ARLP is extremely cheap, and it appears investors are heavily discounting bankruptcy risk. However, if extreme equity dilution and/or bankruptcy can be avoided, the stock will likely see tremendous upside.

It is worth pointing out that the company also receives royalty revenues from oil and gas as well as transportation, yet those factors make up a very small portion of its total revenue.

Alliance Resources Needs Higher Coal Prices

Alliance Resource Partners is the second-largest coal producer in the eastern United States with seven underground mining complexes. These range across the Appalachian in many states with strict COVID-19 measures. Coal mining is generally considered a necessity, but that does not mean production will resume, as worker safety remains a concern for most producers. Additionally, with natural gas and crude oil at extreme lows, the demand for thermal coal is likely to remain low.

The onslaught in the energy market has resulted in considerable declines in the price of coal. Coal prices range depending on use and quality, but we will use the Central Appalachia price as our benchmark for ARLP. See how the price of ARLP and coal are associated below:

(Data Sources: Yahoo Finance (ARLP price), Quandl (coal price))

As you can see, ARLP generally declines if this price of coal is below the $60 level. Over the past few months, it has slipped below that level, and ARLP's price has collapsed by about 80% from last year's steady value.

It is difficult to say whether or not coal prices will rebound soon. With crude oil in a glut and storage at extremes, it is likely that crude will remain cheap for a long time, which will keep demand for coal low. The same is true to a lesser extent with natural gas. Uranium, however, has been on the rise.

The difficulty for ARLP is two-fold. One is that demand for coal is low, which leads to lower margins, which is a long-run issue for the company. More immediate is its production suspensions that are likely to result in abysmal sales until stay-at-home orders end.

The company had originally suspended Illinois production to April 15th, which was extended to April 26th. There is no news of continued suspensions, but it is likely that production remains at a "skeleton" level in order to lower the risk of going the way of meatpacking. Hopefully, more details will be provided in its earnings report later this week.

Can Alliance Resource LP Survive?

The fact is that ARLP's balance sheet is actually conservative. The company has made an effort to reduce its liabilities tremendously over the past decade and has managed to keep its financial debt-to-EBITDA and times interest earned at very safe levels. See below:

Data by YCharts

On top of strong financial management and consistently positive EBITDA (despite a poor environment), the company has strong working capital at $124 million. However, a large portion of its current assets is inventories and receivables, and not cash. Still, the company is trading at a significant discount to its book value. See below:

Data by YCharts

There seems to be a disconnect between the equity market and the debt market for the company. Looking only at its equity value, it seems that ARLP has an extremely high chance of bankruptcy. The company's decision to cut its dividend has likely stoked these fears.

That said, its balance sheet leverage is not too high, and the company's credit rating remains at "BBB-" to "BB+", which is just a notch below investment grade. ARLP will likely see poor/negative cash flow in Q2 with a slow recovery, but the company appears to have ample wherewithal to make it through a difficult period. Indeed, the past decade has been a difficult period for the coal industry, yet it has maintained positive free-cash-flow.

Bottom Line

Overall, I believe that ARLP is a solid deep-value turnaround opportunity. The coal industry is generally unloved by investors and the general public, and that is why it has perhaps the most discounted opportunities today. As long as there are requirements that pensions and others do not invest in coal companies, opportunities will remain for individual investors. The fact remains that a quarter of U.S. energy comes from coal, while only 1.8% comes from solar. Like it or hate it, without coal many of us would not be able to turn on our lights or charge electric vehicles.

Obviously, significant risks remain with coal prices low and production uncertain, but ARLP's extremely low valuation more than discounts for these risks.

The short borrowing rate for ARLP stands at 5.2%, and the company has been the target of short-selling over the past few months. See the buildup in short interest below:

Data by YCharts

With few shares left available to short, there is a decent chance of a short squeeze. The company is planning to announce earnings this Friday, and I do not expect a great report. That said, it seems the market expects an abysmal report, which means an earnings beat is possible.

I do not have a price target for ARLP, but I am long and expect at least 100% upside given the company makes it through this difficult period.

Analyst’s Disclosure: I am/we are long ARLP. 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.