Mining For Returns

I decided to add a high dividend yielding stock to my portfolio. The stock I found and am sharing with you today is Alliance Resources Partners (ARLP) which I own from around $19. It pays an annual dividend of $2.14 (Q1 annualized) or 11%. So what’s the catch? Poor growth? Poor margins? Actually, no! The firm has had 4 consecutive quarters of double digit revenue growth, while margins have improved in the last 3. Over the last 4 years, FCF has been in range of $400-600m with dividends currently only costing ~$280m. Not only does it have a great dividend but is trading at ~12% FCF/EV yield, an EV/EBITDA of 4.5x and a P/E of 7x.

So… is it the industry? Bingo! The firm is active in the much hated coal industry. So it’s both hated and a commodity producer. To make things even more complicated it’s an MLP (Master Limited Partnership) which completed a “simplification” process in 2018. This process occurred in 2 stages. In the first stage in 2017 the current sole general partner that manages the MLP gave ARLP all its IDRs (incentive distribution rights) and it’s 0.99% managing general partner interest in ARLP in exchange for ARLP common units and a non-economic general partner interest. SGP also gave ARLP it’s 0.01% general partner interest in ARLP (and the intermediate partnership) in exchange for ARLP common units. In second stage in 2018, AHGP (Alliance Holdings General Partner – a separate listed stock) became a subsidiary of ARLP, and all AHGP units were cancelled. AHGP unitholders received ARLP units. For more details, see the 10-K. I see this all as a net positive as conflicts of interest are reduced. Theoretically, IDRs were supposed to be an incentive for management to drive performance and thus increase distributions. But there are cases where MLPs increased distributions while neglecting the operating companies themselves. Joseph Craft is the CEO and essentially converted his IDRs to MLP units. It’s worth noting that his salary in 2017 and 2018 was $1 with total compensation at $377k and $468k respectively. He is the lowest paid executive at the firm. The CFO, COO, General Council, and Marketing head make in excess of $1m each.

The significant change in the units outstanding affects the historical earnings per unit ((EPU)) and thus this company may not screen well. The 10-K provides pro forma EPU which is shown below.

(Source: ARLP 10-K)

From an annual perspective, the company results over the last few years look flat to down despite the recent good performance. Note that my numbers for sales and COGS look different from numbers you may see on financial sites because I excluded transportation costs. These costs are included in both revenue and COGS as they passed on to the clients so I’ve excluded them for analysis purposes. Analysts expect the growth to continue in 2019. Analysts estimates include transportation costs (FYI, these were$112m in 2018).

(Source: Author, 10-K, Bloomberg)

Surely doesn’t look very exciting but as Buffett has said “Good investing is boring”. If someone showed you these margins and FCF, coal probably wouldn’t be the first industry to come to mind.

The ups and downs of the top line are purely the result of the nature of the industry. It’s due to quantity of coal sold and price achieved which is pretty much set by the market. The company does have contacts and sells the majority of its production in advance but based on what I’ve read in the filings, these aren’t necessarily set in stone (see: “Coal Marketing and Sales” of the 10-K). As shown in the table below, the average price achieved over the last 5 years has declined by -4% annually. This decline has been offset partially by an increase in shipments (+1%) and a decline is average cost (-4%). One of the reason 2016 production was lower was due to idling the Gibson North mine. At the time, the CEO said "an oversupplied market, combined with weak pricing, forced us to take these actions and shift production to our lower-cost mines". And as you see the average cost did drop by around $4. Note the ARLP has focused on the Illinois Basin where coal is cheaper to mine. Management have done a decent job as we see that despite a ~$10 decline in sales price, the net margin only declined by ~$5. Over the last few years volume has increase and in 2018 it was at a 6 year high.

(Source: Author, company filings)

As investors we are at mercy here to the fluctuating coal price, and I really have no special insight to give regarding what the future coal prices will be. But the reality is that fossil fuels will be around for a lot longer than the mainstream media would have you believe. Back in January I saw an interesting presentation by value investor Robert Leitz. I was surprised to see that fossil fuels account for around 85% of the global energy mix and that this mix hasn’t changed since the seventies! It all boils down to the need for electricity. As the world population continues to increase and the share of the middle class increases as people move out of poverty, the demand for electricity will continue to increase. The only true environment solution available today is a move to nuclear which is also not too popular. Renewables like solar and wind may not be as reliable, and scalable as people believe. And there remains the issue of storage. I recommend you check out this TEDx talk on YouTube about “Why renewables can’t save the planet”.

Regarding ARLP’s income stream, two more important points to mention are exports and revenues from royalties. First, exports have increased considerably over the last few years. For 2016, 2017 and 2018, they represent 5%, 17% and 28% respectively of tons sold. The CEO has stated numerous times that the demand is there and that he believes that they can maintain market share. Pricing though in 2019 has been weak with the CEO stating the following in 1Q19:

"Internationally, transportation congestion, falling natural gas prices in Europe, and aggressive discounting by foreign producers have created pressure in the seaborne thermal coal markets, driving all international thermal indexes significantly lower. Although we continue to view long term fundamentals for international coal favorably and expect current market conditions to improve, the timing of this improvement over the balance of 2019 is unclear. In response, we are lowering our 2019 target for export coal sales to approximately 11.0 million tons and delaying our planned growth ramp for Illinois Basin coal volumes by approximately 1.0 million tons this year. ARLP now anticipates full year 2019 results near the lower end of guidance ranges for total coal sales and production tons, revenues, net income and EBITDA. Combining our coal outlook with increased contributions from ARLP’s oil & gas royalty platform, ARLP plans to deliver solid year-over-year growth in 2019 and generate healthy distributable cash flow supporting our continuing goal of increasing quarterly unitholder distributions while maintaining a comfortable coverage ratio."

The low end of company guidance for 2019 was 43.5m tons (2018: 40.4), and consolidated EBITDA of $720 (2018: $647 – company methodology). The significant increase in tons sold will help cushion price falls. Note that 8mt of the total 11mt has already been priced.

Secondly, the company made passive investments in oil & gas minerals and it has become significant enough for it to break it out in its filings. In Q1 there were $10.7m of royalty revenues of which $9.1m ended up as EBITDA (before eliminations). The company has guided for $37-47m in EBITDA for 2019 (5-6% of total). Some investors may not like this move, but from my readings it is my understanding that the CEO looks at this through the lens of an investor and a good allocation of capital. Joe Craft went on to mention in the Q1 conference call the valuation of a recent mineral IPO (Brigham Minerals). This IPO was valued at 15.7x EV/EBITDA (last quarter annualized). He went on to state that “[He is] excited about the many opportunities to grow this part of our business in the future”. So I’m speculating that Craft’s plan may involve a future spinoff or sale at multiples significantly higher than the current 4.5x EV/EBITDA. So there is an option here.

For sure this company is not without risk (commodity with substitutes) but that appears fully priced in with investors getting paid handsomely to wait (11% dividend yield). If you valued this company as a zero growth perpetuity (implying real negative growth which is in-line with the -2.7% 5-year historical) then the equity is worth around $32 (assuming a 9% cost of capital). To get $32, I used a forward FCF of $425 (using maintenance CAPEX) compared to 5-year historical average FCF of $480. For a firm with a 5-year average return on capital of 22%, the price is attractive.

Originally published on

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. I have no business relationship with any company whose stock is mentioned in this article.

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