Buy the Amazing Coal MLP Story

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I've written a few times about the coal Master Limited Partnership Alliance Resource Partners(NASDAQ: ARLP). While coal fundamentals have gotten even worse, the outlook for Alliance remains bright because of prudent management decisions made before the coal market tanked. I had a long conversation with a senior executive at Alliance on October 2nd, and I continue to be impressed with the company's strategy and execution. I came away with a better understanding of how Alliance is thriving while peers suffer.  

Alliance is growing at a time when every other U.S. coal producer is cutting back. Some, like Alpha Natural Resources (NYSE: ANR) and Arch Coal (NYSE: ACI), are cutting back a lot. And, many believe another round of industry production cuts is coming. In thinking about Alliance once again I realize that in previous posts I reported that Alliance is growing, but I may not have explained HOW it is that Alliance can grow while others shrink. 

A Superior Operating Model?

Alliance chose an operating model many years ago and stuck with it. At times unit holders questioned the seemingly ultra-conservative style. For example, when coal prices were spiking in 2008, the company continued to sign long-term contracts while peers greedily held out for more. By early 2009, coal prices had collapsed and many were stuck with open positions they could not sell. In 2011, Arch, Alpha and Walter Energy (NYSE: WLT) made transformative (not in a good way!) acquisitions at the peak of the market.

Those unwise moves left them saddled with too much debt and burdensome interest expense. Over the past few years, peers rushed into the production of coking coal, a lot of it high cost and/or mediocre quality. Alliance stuck to its knitting: domestic thermal coal in its 2 favored regions of the country. Since last year, coking coal prices have fallen more than anyone thought possible. At the peak of the market last year, 1-yr forward earnings estimates were through the roof. Alliance's valuation looked rich and its margins meager by comparison.

From Worst To First

The phrase, "from worst to first" comes to mind in looking at the outlook for 2013. Alliance will almost certainly have the highest margins of the group. In good times a rising tide lifts all boats. In the heyday everyone was increasing production and coal prices were so strong that significant cost inflation wasn't a concern. Aggressive moves such as the stampede into coking coal and top-of-the market acquisitions appeared to be savy.

But, when the tide went out, only Alliance and Cloud Peak (NYSE: CLD) were found to be wearing bathing suits. Like Alliance, Cloud Peak did not dive into marginal coking coal assets or make a rash acquisition. Instead, Cloud doubled down on cost control measures and made their balance sheet bullet proof. Cloud is sitting pretty now with perhaps the strongest liquidity profile of them all.

The Avoidance of Mistakes Pays Huge Dividends

Alliance is thriving because it avoided the mistakes of peers. By actively contracting a high percentage of production years in advance, not only have they locked in growing volumes, but every single ton contracted in 2010-11 is at a price well above current prices. Therefore, while peers suffer earnings declines of 50% or more, Alliance (and Cloud) will have declines closer to 10%-20% this year. More important, Alliance locked in industry leading margins for 2013-14 because unit costs will remain low compared to peers who are forced to cut production.

Due to prudent contracting, Alliance was able to confidently fund a lot of growth projects in 2010-2012 that are coming to fruition in 2013-15. These growth projects are unlikely to be delayed or canceled because the increased tonnage is largely contracted. To be fair, by 2015 the percentage of coal priced and contracted falls off considerably. 

However, by 2015 there's a good chance that coal prices will be much stronger. Even if prices remain depressed, Alliance's 2 major growth projects in the Illinois Basin and Northern Appalachia are among the best in the country. Both will utilize very low cost long wall operations. Alliance contracts with large, regulated power companies that use the coal for base load electricity generation. Base load generation is the last to get cut back in a weak economy.  

Conclusion

By making and sticking with a few conservative operating decisions over many years and avoiding a few disastrous mistakes in recent years, Alliance has emerged head and shoulders above the rest. Despite market conditions, I believe that Alliance can maintain spectacular distribution growth because BOTH strong margins AND increased production are locked in for at least the next 2-3 years. If the coal market rebounds, then the company's history of MLP industry-leading distribution growth could continue even longer.

It's entirely possible that Alliance could average distribution growth of 8%-10% over the next 5 or 6 years. [This is entirely my view, not necessarily that of management]. As aggressive as that may sound, consider that growth has averaged about 15% over the past 9 years. Supporting this thesis is very low debt leverage and a meaningful cushion of distributable cash flow above cash distributions paid. Alliance offers a compelling risk-adjusted return opportunity suitable for a wide range of investors.  


MockingJay2011 owns shares of Alpha Natural Resources, Walter Industries, and Alliance Resource Partners, L.P. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Alliance Resource Partners, L.P.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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