Description

Many of you are familiar with Alliance Resource Partners as a low-cost coal producer operating in Appalachia and the Illinois Basin, with a quality management team and one of the strongest balance sheets in the industry. Alliance is the proverbial cash cow, generating $330 million in distributable cash flow in 2019 and $416 million in 2018, and paying a recent distribution of $1.60 per share. In a move to bolster liquidity and protect their balance sheet during the shutdown that occurred at the height of the Covid-19 panic, the company slashed its distribution from $1.60 to zero, sending the stock to a low of $2.70.

Covid-19 was just the latest blow to the industry. Twelve years of falling natural gas prices and the burden of government regulations on power plants to reduce toxic emissions have had coal producers on the ropes. Many high-cost and middle-cost mines have been closed over the last eighteen months, with many more to follow, as the sector undergoes yet another round of financial and operational restructurings. Yet, for some in the coal mining sector, this is a period of opportunity. ARLP has the strongest balance sheet in its peer group as well as some of the lowest cost, highest thermal-content mines in operation. They also have a high-quality, conservative management team, whose 33% ownership in the company aligns their interests with those of unit holders. The company is positioned not only to survive the current downturn but to increase market share as other, higher-cost mines, and weaker competitors continue to be sidelined.

Currently trading at $3.40 per share, which is 70% lower than its price in January, Alliance is being valued at about one half the discounted present value that I calculate in the Valuation section at bottom using a fairly grim set of assumptions. This is a scenario in which natural gas prices remain perpetually below $2 per mcf, the economy remains in the doldrums for years into the future, coal-fired power plants are all retired within 20 years, and ARLP’s competitors, regardless of the quality of their assets or the weakness of their balance sheets, somehow manage to stay in business and retain market share during the downturn. The more likely outcome however is significantly less bearish. Some portion of the distribution will be resumed fairly quickly since ARLP remains substantially cash flow positive; the economy will eventually recover; consolidation and closure of mines in the industry will lead to market share gains for ARLP; coal-fired power plants will be around longer than predicted; and natural gas prices will stage some kind of recovery. As a result, distributable income could return to pre-Covid levels, which would imply a rebound in the stock price to multiples of where it is today. In the unlikely event that the worst-case scenario mentioned above is the one that actually prevails, the stock is still undervalued, trading at a 50% discount to its discounted present value under a near-worst-case set of assumptions.

Background

Thermal coal producers such as Alliance Resource Partners, which sell their coal to power generation companies for the production of electricity, have been battered by falling natural gas prices for most of the last decade. Prices for natural gas peaked at $12/mcf in 2008 and have been making new lows every few years, recently trading in the spot market at prices of $1.50/mcf, a 90% decline.  Since January, 2019, prices are down 50% to their lowest levels in 25 years.

Data Source: EIA

Power generation companies generally operate both coal-fired and natural gas-fired power plants. The decision to allocate a greater portion of their power generation to one fuel or the other on a given day is driven by the relative cost of each fuel as measured in BTUs, which is the amount of energy released during combustion. In simplistic terms, power companies will burn more coal when coal is cheaper per BTU and will burn more natural gas when gas is cheaper per BTU. As a result, the relationship between the price of natural gas and the fortunes of the coal industry are closely correlated, as can be seen in the below scatterplot, which graphs the price of natural gas vs. the percentage of total electrical power generated by coal-fired plants in the lower 48 states on a daily basis.

Given the close relationship shown above between natural gas prices and the demand for thermal coal to fuel electric power generation, it is not surprising that the ongoing bear market in natural gas has caused havoc in the coal mining industry, resulting in multiple mine closures and eleven bankruptcy filings among producers in just the last few years. Even more grave for coal producers than the simple substitution of natural gas for coal, which causes coal prices to fall in lockstep with falling natural gas prices, power companies have been actively shuttering older coal-fired plants, deeming them uneconomic in the face of persistently low gas prices and higher costs under government clean-air regulations. This has significantly reduced the demand for coal as a fuel source, putting further pressure on producers. According to the IEEFA, 15 power plants that utilize Illinois Basin coal, where many of ARLP’s mines are located, will be fully or partially retired in the next five years, and nearly all coal-fired power plants are scheduled to cease operations in the region served by the Illinois Basin coal producers within the next 20 years. Cheap natural gas has both destroyed the margins and reduced the tonnage sold by coal producers and is forcing yet another round of shakeouts in the industry. Many uneconomic mines are slated to be closed this year and further consolidation among industry participants is likely. Two good articles which provide a more in-depth overview of the current state of the coal industry appear below:

https://ieefa.org/wp-content/uploads/2019/03/Coal-Outlook-2019_March-2019.pdf

https://ieefa.org/wp-content/uploads/2019/12/Dim-Future-for-Illinois-Basin-Coal_December-2019.pdf

The latest setback for this beleaguered industry, occurring after the above articles were written, was the unforeseen collapse in coal demand due to manufacturing shut-downs and commercial business closures following Covid-19. While electricity demand dropped only about 5.2% nationwide, the bulk of that decline came from reductions in coal-fired generation with substantially less of the reduction coming from natural gas. The three graphs below illustrate this point. The first shows the drop in electric power demand that occurred nationwide as a result of Covid-19 which, even after adjusting for seasonal fluctuations, appears to have nearly recovered from its depressed levels. 

Data Source: EIA

The second and third show the drop in coal generation in two of ARLP’s hardest-hit markets, the Tennessee region and Southeast region, where nearly all coal generation was suspended for several weeks in April and May. Here we can see that while coal generation is now substantially off the lows, it is still somewhat lower than the levels of 2019. This corroborates first-hand accounts from people in industry who say that coal demand in the Tennessee and Southeast parts of the country are still below normal due to the slow recovery of manufacturing in the region.

Data Source: EIA

An important side note is that the data used to create the above graphs can be downloaded from the website of the Energy Information Agency (EIA). Coal generation data both regionally and nationwide as well as electricity demand is updated both daily and hourly. If you want to know exactly how the recovery in coal generation is progressing, or even the state of the economy in various regions of the country, you can log onto the website and download this data in real time. Below is a link to the appropriate page. Click on “download data” and then on “Balancing Authority/Regional Files”.

https://www.eia.gov/beta/electricity/gridmonitor/dashboard/electric_overview/US48/US48

Given the depressed state of the coal industry in general, its unpopularity with the public, the continuing slump in power demand in parts of the south and southeast due to Covid-19, a seemingly endless decline in natural gas prices, and general agreement that coal-fired power plants are almost all expected to close at some point in the not-too-distant future, why would anyone want to invest in this sector?  In the case of ARLP, the discounted cash flow from its remaining years of productive coal mining, even if natural gas prices remain stubbornly below $2 and all coal-fired power plants close their doors within 20 years, less the sum of all its liabilities, and giving credit only to current assets, is currently twice its market capitalization, meaning that investors should expect a reasonable rate of return even if the most bearish scenario comes to pass (see Valuation at bottom).

Why Alliance Will Survive the Downturn Whereas Others Will Not

ARLP’s primary strengths are its balance sheet, the quality of its assets, and the conservative manner in which it manages its business. In response to the shutdown of the economy in March through May of this year and the resulting drop in demand for electric power, particularly coal-generated power, the company immediately suspended its distribution for two quarters, halted production at its higher-cost Illinois Basin mines, and announced a number of initiatives designed to optimize cash flow and preserve liquidity: 

http://www.arlp.com/file/Index?KeyFile=403440030

http://www.arlp.com/file/Index?KeyFile=403922116

On top of these liquidity measures, Alliance had fortunately both extended and increased their credit facility in late 2019 giving them an additional margin of safety. During opening remarks on the company’s Q1 conference call, Joe Craft, ARLP’s CEO, commented that: 

“During the 2019 [4th] quarter, ARLP successfully completed an amendment and a four-year extension of its revolving credit facility. The new facility provides for increased capacity of $537.75 million through May of next year, at which time, it steps down to $459.5 million, and in addition, gives us the flexibility to separately finance ARLP's mineral interests in the future. We ended the 2020 quarter with liquidity or $258.4 million and remained comfortably in compliance with our debt covenants, including total debt of approximately 1.6 times trailing 12 months EBITDA.”

Management of ARLP has made numerous statements in the past that they consider their balance sheet to be a competitive advantage and that their existing mines are some of the lowest-cost, highest thermal-content mining operations in the industry. Just a few weeks ago, Brian Cantrell, CFO of ARLP, commented that:

“We do have very long-lived, very low-cost assets that will compete very effectively even in a significantly reduced demand environment for an extended period of time.”

It is comforting to hear statements from management that they have confidence in their assets and the solidity of their balance sheet, but these statements can also be verified independently by looking at the financial statements and comparing them to those of ARLP’s competitors.

Below are three tables which compare all the publicly-traded coal companies that primarily produce thermal coal or which break out thermal coal as a segment in their financial statements sufficiently to make comparisons. 

From Table 1 we see that ARLP consistently had among the highest gross margins during fiscal years 2017-2019, with gross margin being defined as price per ton sold divided by cash operating expenses per ton sold. Even more interesting, there is a sharp division in gross margins between the top third of producers and the bottom third, which illustrates the vulnerability to low coal prices, and low natural gas prices, of the bottom third. A similar result can be seen when examining total margin per ton in Table 2, defined as gross margin per ton less maintenance capex requirements per ton. ARLP consistently had among the highest total margins per ton in the years 2017-2019 among publicly-traded peers, and a sharp contrast exists between the top third and bottom third of producers, revealing the poor quality of the assets held by the bottom third.

Tables 1 and 2

These findings become even more pronounced if we examine the results during Q1 2020, a quarter that was partially affected by Covid-19. In Table 3 we see that the same four producers with the lowest gross margins and lowest total margins are also the ones who ran a substantial negative cash flow in Q1 2020. Meanwhile, ARLP showed the highest FCF of any of its publicly-traded peers. So it would appear, based on publicly-available evidence, that ARLP’s claim to having some of the lowest cost mines in the industry has merit.

Table 3