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

But what about management’s claim to having the strongest balance sheet in the industry? In the most recent conference call, Joe Craft, CEO of ARLP once again made this point:

“We have always viewed ARLP’s strong balance sheet as a competitive advantage, and we have taken action to protect this advantage and enhance our liquidity”

Table 4 examines this claim by presenting the same publicly-traded peer group appearing in Tables 1-3 with a focus on their balance sheet and annualized EBITDA during Q1 2020. Using two measures of net debt, ARLP is considerably less leveraged than its peers.

Table 4

In terms of net debt to EBITDA, Alliance had a ratio of 1.7x whereas all but Contura Energy, a primarily metallurgical coal producer, has a ratio substantially higher. And in terms of total liabilities less current assets divided by EBITDA, which takes into account a variety of liabilities specific to coal mining companies, Alliance has a ratio of only 2.3x, seconded only by Hallador at 2.7x.

The strength of ARLP’s balance sheet and the quality of their coal assets puts them in a strong competitive position. Not only are they in a much better position to survive the downturn than their peers, they are in a position to capitalize on it by taking market share from higher-cost producers. If the downturn persists for an extended period of time, weaker operators - high cost operators - will be unable to survive. High profile bankruptcies such as Murray-Foresight and Peringa Resources have already occurred, but these are just the first of a long line of public and private companies whose balance sheets are not sufficient to survive the current downturn. And while bankruptcy helps from a corporate cash flow perspective, it doesn’t change the cost structure of the underlying mines. If the mines are not economically viable, as most are not in the current environment, a restructured company will still be losing money. The former creditors, who will soon be equity owners, and who have already seen a significant amount of value destroyed, will not be anxious to continue running an operation that loses cash on every ton of coal that’s produced. As management recently stated:

“If it stays locked-down like this….if this persists for an extended period of time, you will see, by necessity, meaningful levels of supply come out of the market. I’m not trying to suggest that this will open up a robust pricing environment because all the dynamics around natural gas competition will still exist. But to the extent that there remains coal demand in our markets of any kind we have an opportunity to capture a greater share of that as higher cost guys fall by the wayside”

It should be re-mentioned at this point that Q1 was only partially affected by Covid-19 and that the results for all these companies, including ARLP, will be substantially worse in Q2. In the Q1 conference call, which took place on May 8th, ARLP specifically stated that the volume of coal sold in Q2 would only be half of what it was in Q1. In the conference call, Joe Craft, ARLP’s CEO, elaborated on what to expect in Q2 based on what had already transpired in the month of April:

“the second quarter is going to be bad just because we had most of our mines down in the month of April. And once we get through that, I think the second half of the year, the cost should be probably slightly less than what we've seen in the first quarter for the Illinois Basin that we should be able to bring our mines back with a staffing level that is as efficient as possible”

“Our geology hasn't changed. And our people haven't changed. But, what we're dealing with, like everybody else in America, in most cases is a demand issue, and trying to tie our supply to that demand. Unfortunately, because the demand drop was so severe, it created inefficiencies. I think we've taken steps to eliminate those as much as possible. At the same time, we want to be ready if and when our customers may see a surge later on if natural gas prices rise, like some people are projecting”

Brian Cantrell, the company’s CFO, went on to say that:

"we've gone through multiple scenarios, trying to stress test our operations and our financial performance. Our key focus is on managing for cash...We feel very comfortable that we'll stay in compliance with our covenants and that we have likely the ability to not only sustain this liquidity we had at the end of the first quarter, but have an opportunity to see that liquidity expand throughout the year.”

Valuation

As mentioned previously, Alliance stock is now trading at a discount of roughly 50% to a theoretical DCF valuation using harsh assumptions about the future of the industry, the price of natural gas, and the competitive landscape. Here are the assumptions and the calculations:

Distributable cash flow in Q1 2020 was $46.6 million, the lowest in the company’s history, occurring during a quarter with record low natural gas prices on top of the disruption caused by Covid-19, which caused the company to operate at reduced levels for the last 6 weeks of the quarter. Distributable cash flow in Q4 2019 was the second lowest in the company’s history at $66.5 million, being negatively affected by both a collapse in thermal export prices as well as low natural gas prices. Since there is insufficient information to adjust the distributable cash flow of Q1 for the six-week period affected by Covid-19, I am averaging the distributable cash flow of Q1 2020 and Q4 2019 to arrive at a run-rate level of distributable cash flow that encompasses record low prices for both natural gas and thermal export coal. Let’s assume that natural gas prices and thermal export prices remain in the same depressed state for the remaining lifetime of the company, and that the company gains no market share from competitors during this period of record-low prices, even though they are one of the lowest-cost producers. In such a scenario, the company never again achieves any level of distributable cash flow higher than in this six-month period. Next, let’s assume that all coal-fired power plants are eliminated within 20 years and that the company’s distributable cash flow is reduced by an increasing amount, each year, such that distributable cash flow is zero after 20 years. Finally, for simplicity, let’s assume the company engages in no further investment in oil and gas mineral interests so that cash flow from royalties remains constant. Using these assumptions and a discount rate of 7.5%, the present value of the company’s future cash flows would be calculated as follows:

Distributable CF Q1 2020…………..$46.6 million

Distributable CF Q4 2019…………..$66.5 million

Run-rate distributable CF…………..(46.6 + 66.5)/2 x 4 = $226.2 million

Minerals contribution Q1 2020……..$11.4 million

Minerals contribution Q4 2019……..$12.6 million

Run-rate minerals contribution……..(11.4 + 12.6)/2 x 4 = $48.0 million

Run-rate dist CF coal segment……..$226.2 - $48.0 = $178.2 million

The total of ALL liabilities on the company’s balance sheet at the end of Q1 2020 less ONLY its current assets is $1,021,425. This assumes that the value of all the company’s long term assets goes to zero over 20 years, although in reality there would probably be some residual value to certain of the properties.

Current Assets (Q1 2020)…………….......$307,392

Total Liabilities (Q1 2020).......................$1,328,917

Total Liabilities - Current Assets………..$1,021,425

Subtracting the above number from the discounted value of future cash flows in the chart above leaves us with the discounted present value (DPV) of the equity:

DPV of future cash flows……………......$1,859 million

Total Liabilities - Current Assets………..$1,021 million

DPV of enterprise…………………………..$838 million

Shares outstanding…………………...……..127 million

Implied DPV per share (bear case)………$838 million / 127 million = $6.60/ share 

This number, which assumes no recovery in gas prices ever, no increase in market share, the elimination of coal power plants in 20 years, and an economy that never fully recovers from Covid-19, is still 2x the current market price.

The Natural Gas Wildcard

In closing, I would like to make a quick case for an increase in the price of natural gas, which has been the primary source of the coal industry’s woes and which would change ARLP’s fortunes dramatically if it reverses. Stocks of natural gas producers rose significantly after Covid-19 on hopes that the rapid shut-in of oil wells combined with a steep decline in new oil drilling over the coming year would cause a protracted drop in associated natural gas and liquids, thereby reducing the most significant overhang on natural gas prices in the US.

Below are two charts that emphasize the point. Chart 1 shows the total volume of associated gas that is produced in various regions of the US stacked on top of the total volume of natural gas produced from gas formations in those same regions. A dotted white line separates the two.

                                                             Chart 1

From this chart we see that, by the end of 2019, associated gas was approaching 20% of total gas production in the United States. This production comes from wells that were primarily drilled to produce oil but for which the associated gas, as a by-product, is acquired for little incremental cost and dumped onto the market at whatever price the producer can attain at the time. Since there is little incremental cost of production, there is almost no lower bound to natural gas prices that would compel producers to curtail this production. Any reductions in associated gas production must therefore come from the shut-in of oil wells, or a halt in the drilling of new oil wells, that produce associated gas.

The second chart shows the number of oil and gas rigs in operation each week from 1987 to the present.

      Chart 2

Data Source: Baker-Houghes

From this chart we see the rapid collapse in oil drilling rigs in North America that occurred at the onset of Covid 19 (blue line). Since the decline rate of production from shale oil wells is roughly 20 to 30% in the first few years of production, the absence of new oil drilling should lead to a substantial reduction in associated gas supply over the next 6 to 18 months. This is partially offset by the fact that older wells gradually produce a greater amount of natural gas than oil, but a decrease in natural gas production overall will still occur.

In addition to a reduction in associated gas due to the shut-in of existing oil wells and a decline in new oil drilling, producers have been curtailing investment in new gas-only wells since the natural gas bear market began in 2008. Natural gas drilling rigs have fallen from a peak of 1600 in 2008 to only 78 rigs in operation today. This can be seen from the orange line in Chart 2 above, which shows the number of gas rigs in operation from 1987 to present.

My earlier valuation calculations have all assumed natural gas prices remain below $2 for the foreseeable future. Should natural gas instead rally to $4, or even $6, prices for coal could increase dramatically and the volume of coal consumed by electric utilities would increase as well. A doubling of the price of natural gas, for example, would lead to a corresponding doubling in the price per ton of coal and more than a doubling of distributable income. In such a scenario, whether temporary or not, the market price of ARLP’s units could trade back to the pre-Covid levels of $10, or even $20 per share.

Catalyst

Distributions are resumed

Future increases in distributions

Future gains in market share

Recovery of the economy in the southeast

Higher natural gas prices