Description

There are two prior reports on ARLP (2015 and 2017) and several others on coal players (ARCH, HCC, FELP, NRP) during the past year which provide a good overview of the coal industry, its fundamental drivers, and the positioning of various players.  I think now is an especially opportune time to invest in ARLP, in particular given a combination of valuation and near/medium-term catalysts.

ARLP is a producer mostly in the Illinois Basin, where it gets premium pricing for its high-heat-content coal, with a smaller percentage of its production coming out of its mines in the Northern Appalaichin Basin. It is one of only a handful of MLPs in the space, along with FELP and SXCP (not exactly comparable, but closer than other MLPs).  ARLP no longer has any IDRs.  I am excluidng NRP from the comparable set since it is a royalty stream/non-producer and also has soda ash and aggregates businesses.

ARLP is compelling on a valuation basis relative to its two comparables.  I expect the valuation gap to close as we move through the next three quarters or so.

Valuation:

ARLP is trading at 4.3x ebitda and at an 11.4% (growing) distribution yield; and a 17.3% FCF yield

FELP is trading at 7.8x ebitda and at a 6.2% (stable/somewhat recently reduced) yield; 9.7% FCF yield

SXCP is trading at 6.0x ebitda and a 10.2% (recently cut) yield; and a 15.3% FCF yield

Here's why the valuation gap should close:

1) ARLP is down about 10% YTD most likely because of some congestion in the river transportation system which caused some tonnage to slip from 1Q to 2Q/3Q.  But that is correcting now.

2) A recent litigation settlement of $80M (about $0.60/sahare) net of expenses improves an already strong balance sheet and gives ARLP increased financial flexibility to move forward with a meaningful capital allocation program. 

3) For the capital allocation plan, I am estimating that the company would be comfortable leveraging up to 1.25x-1.5x debt/ebitda from the current approx. very low level of 0.70x.  (For the right strategic fit, ARLP might be willing to go to 2.0x).  But even leveraging up to just 1.25x over the next 18 months would be a big positive, provided there is a meaningful buyback component and/or investment returns in excess of the returns on the buyback.

On the 1Q conferenec call, ARLP said:

"that decision [on how to allocate excess capital above the distribution] is in front of us and we will be making that before the end of the second quarter. So we will have more color and exactly what we are going to do on our next call if not sooner"

4) they will have a PR out in the next couple of weeks announcing the finalization of the simplifiaction of their corporate structure, where there will be no more GP (current ticker: AHGP) which should make ARLP more attractive and improve liquidity.

5) the distribution is currently growing 1% per quarter.  I am expecting that this could grow to 1.5%-2.0% per quarter as we enter 2019, as long as there are no major shifts in the market.

Other/Misc.:

• ARLP has invested some of its growth capital in oil and gas assets which are currently generating about $30m/year in ebitda.  The goals is to double that to $60M over 3-5 years.  But, it is a small contributor, at less than 5% of ebitda.  ARLP is not planning a major re-allocation of capital into oil and gas, but this could provide a bit of a cushion through the cycle.

• Coal production guidance for 2018 was increased coming out of 1Q and they will see another natural small bump in production next year due to an expansion at their Gibson North property that is only contributinig for part of the year in 2018.  There is potential for a bigger bump, depnding on how growth capex is deployed versus buyback, etc.  I am using 40.5m tons this year and 41.25m tons as a base case next year.

• Inventories at utilities are down to around 120m tons, the lowest in about 4 years.  This should be supportive of flat/firming pricing.

Summary:

With these catalysts above (along with some others mentioned below), free cash accruing, production growth, flat/firming pricing, and the prospect of an acceleration in distribution growth in 2019, I expect ARLP to trade to at least $25 by the end of the year (approx 6x trailing ebitda and approx 8.5% distribution yield on 4Q run-rate).  If you add in the balance of the distributions one will receive for the next three quarters, that's a total return of roughly 45%.

Risks:

natural gas price decline

unusually warm winter weather

mine collapse/fire/etc.

further transport issues, esp. in the winter.

acceleration of decommissioning of coal-fired plants

weakening of international markets

interest rate spike

Catalyst

Near-term:

• Investor conference presentation 5/23.
• corporate structure simplification finalized and announced next two weeks.
• increased liquidity due to simplification
• announcement of capital allocation plan, inlcuding esp. stock buy-back "by second quarter confeerence call, if not sooner" (i.e., approx within next two months).
• De-bottlenecking of the river transportation system which caused some tons to be stockpiled in 1Q.  The congestion has started to ease at the end of April and the extra tons will ship over the next two quarters, leading to a bump in sales growth.

Medium-term:

• modest production growth
• continued distribution growth
• possible acceleration in distribution growth beginning early 2019 back to historical range of 1.5%-2.0% per quarter.
• Potential hybrid c-corp/MLP structure (alluded to on 1Q conf call)
• rotation back into MLP space as more MLPs eliminate IDRs/simplify their corp structures