The Best Coal Company for Your Portfolio

Ryan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The United States holds the largest coal reserves in the world. Generating electricity using coal, while environmentally destructive, is economically more viable than most other methods of power production. The electricity that coal makes possible is incredibly important for America. Given that over 90% of the coal our country consumes comes from domestic sources, investors ought to give some consideration to buying an American coal company. 

Stock performance
Peabody Energy (NYSE: BTU) is the largest American coal producer. In second place is Arch Coal (NYSE: ACI). But, there's a smaller coal company that might perform better than both of them. 

Alliance Resource Partners (NASDAQ: ARLP) is that company. The following chart shows that Alliance Resource Partners has, in the recent past, performed much better than Arch Coal or Peabody Energy. There are good reasons to believe that this trend will continue in the foreseeable future.

ARLP data by YCharts

So, what exactly makes Alliance Resource a better business than the top two players in the industry?

Margins
When it comes to operating efficiency, Alliance Resource Partners is clearly the best of the three companies. 

ARLP Profit Margin TTM data by YCharts

That chart shows net profit margins for all three companies. Despite spot prices of coal not being particularly high, Alliance maintains respectable margins through its portfolio of long-term sales contracts. While the net profit margin is one of the multiple margins for investors to check, if you look at the others (gross, EBITDA etc.), you'll find Alliance Resource Partners almost always outperforms its peers.

Although it isn't a margin, return on equity (ROE) is an excellent metric to compare how competent management teams are. Arch Coal and Peabody Energy have ROE figures of 0.11 and 13.17, respectively. Alliance Resource Partners' 5-year average ROE of 27.16 is much better than the top two coal companies. 

Shareholder returns
One of Alliance Resource Partner's most enticing features is its hefty yield. The company's status as a limited partnership means that the majority of its earnings are distributed to unit-holders in the form of a distribution.

ARLP Dividend data by YCharts

Granted, Arch Coal and Peabody Energy are not limited partnerships. Still, dividend growth at those companies has been either minuscule (in the case of Peabody) or non-existent (in the case of Arch Coal).

On the other hand, distributions from Alliance Resource Partners have been growing at a rapid rate. The company paid its first dividend in 1999. Since then, the company has paid a distribution in every single quarter. Alliance Resource Partners has never lowered its distribution either. Payouts have been raised for 21 straight quarters.

Alliance has a 66% payout ratio and a yield of 6.1%. Arch Coal shares yield 2.7% but don't have a payout ratio because the company is in the red. Peabody's yield is 1.9% and there's no payout ratio for the same reason as Arch Coal.

Alliance Resource Partners has posted record profits in each of the past four years. The company's operating efficiency, as shown by its superior margins, and long-term sales commitments should ensure generous distributions for years to come. 

Negative developments
The quarterly results most recently released by Arch Coal were not encouraging. Operating revenue dropped 21% year-over-year. A weaker market for metallurgical coal led to the company lowering its 2013 forecast for shipments of coking coal. The company notes the market for thermal coal is improving. But at the same time, Arch Coal has been focusing more on the weaker metallurgical coal market. In June, the company sold its thermal coal mines in Utah for $435 million.

Peabody released second-quarter results that included a 13% drop in revenue and a 55.9% drop in net income. The company predicted its per-ton revenue would decline 5%-10% this year, in the midst of what the company describes as a tepid pricing environment.

That's a problem that does not have as serious of an effect on Alliance Resource Partners. A large portion of Alliance's sales occur through long-term sales contracts. These contracts are typically with the company's core customers, large utilities primarily in the southern United States. Alliance states the prices agreed upon under these contracts are comparable to current realizations. Such contracts ensure that the company will sell more of coal in 2013 than 2012, regardless of whether any new sales agreements are reached.

Final thoughts
In 2012, Peabody Energy sold 248.5 million tons of coal and Arch Coal sold 140.8 million tons. Both of those companies posted net losses. In contrast, Alliance Resource Partners generated $671.1 million in net income from just 35.2 million tons of coal sales.

Both Arch Coal and Peabody Energy trade at discounts to tangible book, which Alliance Resource Partners does not. However, that does not make them better investments. Alliance Resource Partners is a high quality company trading for a fair price. Buying those almost always works out better than buying a mediocre company at a cheap price. 

Compared with Arch Coal and Peabody Energy, Alliance Resource Partners has superior returns on equity and margins. It's a company that beats estimates practically every quarter. It is is constantly breaking its own records for production and sales, and contractual agreements ensure that the money will keep rolling in. Meanwhile, the two biggest domestic coal producers are having a tough time making a profit.  

If you are going to invest in an American coal company, my advice is this: Buying Arch Coal or Peabody Energy is a mistake, especially when Alliance Resource Partners is a better option.

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Ryan Palmer owns shares of Alliance Resource Partners, L.P.. The Motley Fool recommends 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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