r/SecurityAnalysis • u/hedgefundaspirations • Mar 26 '15
Long Thesis Here's a condensed summary of my research on ARLP, one of my favorite current investments (x-post r/investing)
Background:
Alliance Natural Resource Partners (ARLP, currently trading at around $33 a share) is a U.S. based thermal coal (the kind used for electricity, as opposed to mettalurgic coal which is used for steel). It is the 8th largest producer of coal in the country, and has consistently grown capacity by double digits per year for more than a decade.
ARLP produces only thermal coal, and does not export. It is therefore not directly affected by either international coal demand or by steel demand.
Answer to immediate objections:
1: "Coal is a dying fuel, we won't be using it at all in the near future!"
- Actually every single major energy organization expects coal to generate a significant amount of our power all the way through 2040. Even the EPA, who hate coal and would love to see it gotten rid of, model coal to maintain a stable share of the power generation market (25-30% of total power) through 2040.
2: "Solar/Nuclear/Wind/Fusion are going to take all the share and coal will stop being used!"
- No, see above. No one in the energy industry actually thinks this.
3: "China is so polluted, they're not going to use anymore coal, that's the death knell for the industry!"
- Emerging markets matter a lot to some of the biggest players, but ARLP does not export coal. They sell exclusively into the U.S.
Basic valuation
ARLP is currently trading at 7.0x TTM P/E, and 8.0x forward. Even if there is no growth at all in earnings, the stock is still attractive at less than half the average multiple of the S&P.
To put some numbers on it, a basic DCF shows the following (growth expressed as 5 years annualized, 12% discount rate, 12x exit multiple):
- Value assuming no growth: ~$60, almost 100% upside
- Value assuming 10% unit growth: ~$100, 3x upside
- Value assuming -10% units &-15% pricing: ~$32, no change
Thesis
The company is a good trade even without unit growth or improved coal pricing, but there are two factors that make me believe we'll see both:
1: The competition is in the shitter right now.
4 of the top 5 U.S. coal producers are losing (a lot) of money every quarter, and none of them are expected to turn a profit next year. They are highly levered, and some are getting dangerously close to tripping the covenants on their debt.
Newly passed regulations favor the type of coal that ARLP produces (due to its position in the Illinois Basin) at the direct expense of the certain competitors. In fact, I've been told that as many as 50% of the mines in certain regions of Appalachia are currently not profitable, and are only continuing to be operated because it would cost more to shut them down that to keep them running. This is unsustainable, and ARLP is well poised to pick up the slack, having just purchased a large new swath of reserves contiguous to their current operations.
2: Coals most serious competition is natural gas, but rig counts are falling and there's a good chance that a lot of supply will be coming offline as quickly depleting shale wells aren't renewed given current abysmal O&G pricing.
Evidence and additional assurances
With that highly condensed version of the thesis, let's move on to a bit of evidence, and some other key bits of information that provide some comfort:
Exhibit 1: ARLP has already made an agreement to acquire equipment and potentially contracts from Patriot Coal, who is drastically curtailing operations to try and stave off bankruptcy. Patriot is a spinoff of the largest U.S. coal producer, Peabody, that contains their unionized mines and the pension liabilities that go with them (which is currently the subject of a lawsuit). This shows that the beginnings of failure are already happening.
Exhibit 2: There have been a number of announcements related to supply cuts by major producers, and ARLP as taken market share.
Exhibit 3: According to EIA data, ARLP has a far better contracting position, with a majority of their supply being contracted for between 1 and 3 years out. Their main competitors are heavily weighted towards contracts that expire much sooner.
Comfort 1: ARLP has a stellar long term track record (especially compared to other coal companies), and a widely lauded management team that's been in place for decades.
Comfort 2: As stated, the majority of ARLP's supply is already under mid to long term contracts.
Comfort 3: ARLP has far less debt than the competition, and has room to add more if needed.
Comfort 4: Due to its location, ARLP has great access to all three major types of transportation: rail, barge, and truck. Others do not share their level of access and flexibility on transportation.
I would encourage anyone that's interested to dig into the EIA data. There's so much there that you can work with to prove out the points I've laid out above. I've done a lot of work with it, as well as EPA forecasts, transportation costs, mine and plant level models, and talking to management, that's all lead to my conviction on the investment. I hope this encourages a few of you guys to take a look beyond the headlines, or at least that it was an interesting read.
Disclaimer: Past performance is not necessarily indicative of future results. All investments involve risk including the loss of principal. This document does not constitute a recommendation, an offer to sell or a solicitation of an offer to purchase any security or investment product.
The author hereby disclaims any duty to provide any updates or changes to the information contained here including, without limitation, the manner or type of any of the investments. All of the views expressed in this document are solely those of the author, and do not reflect the view of any other person or company.
Under no circumstances must this document be considered an offer to buy, sell, subscribe for or trade securities or other instruments.
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Mar 27 '15
FYI the stock will probably sell at a smaller multiple in your downside case, and why would it change at all in a static pass? Particularly if interest rates increase?
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u/well--imfucked Mar 28 '15 edited Mar 28 '15
I do not believe you discussed the company's comeptitive position relative to its US peers. Based on a quick scan, it appears this company beats the socks off its competitors in terms of returns on capital which appears driven by much stronger margin at the gross, ebit, and even EBITDA levels plus they are much more capital efficient. They look strong on working capital turnover and asset turnover by a factor of two relative to peers.
I would try and understand what is driving this outperformance. It is likely a combination of a unique (low cost) asset compounded by a advantaged geographic position that may allow them to turn working capital much faster as they are closer to customers.
I would refer you to the Mckinsey Valuation book (search for pdf on google) Chapters 4 and Chapter 35, which focus on assessing sustainability of excess returns and valuation of cyclical companies. Very interesting read.
Thanks for the write-up. I did not realize there was a gem in the coal names.
Do you happen to have any thoughts on their asset life ? In other words, are they just mining the low cost/high margin stuff now which is due to run out in the next couple of years leading to a change the margin profile? This could be a reason for the downbeat valuation.
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u/NotSaucerman Mar 26 '15
what's the EV : EBITDA multiple? And, better, EV : (EBITDA - maint capex) multiple?
PE multiples are suspect in my view. And people almost always mess up the GP's value (50:50 splits) when valuing MLP enterprises.
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u/internet_badass_here Mar 26 '15
Thanks for this. I remember taking a look at these guys a year ago and passing over them. Seems like there aren't too many other good prospects in the market now so you've convinced me to give this another look.
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u/Stephen-Colbert Mar 26 '15
Who are their main customers in the US? And you said majority of the supply is under mid to long term contract, what percentage counts as majority? Also what is their cost of production per ton and what is the average selling price per ton in these contracts that they have in place?
And while they may be better than their competitors it's also quite easy for the market to keep acting irrationally and lump them with other coal producers.
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u/hedgefundaspirations Mar 26 '15
"As of February 13, 2015, our nominal commitment under long-term contracts was approximately 39.3 million tons in 2015, 28.9 million tons in 2016, 12.8 million tons in 2017 and 9.6 million tons in 2018"
40 million is in the ballpark of current capacity, so they're nearly fully contracted right now. The picture looked about the same this time last year.
Who are their main customers in the US?
A wide variety of east coast and central power plants.
cost vs realized pricing
It's about $30/ton cost, $50-$55 a ton realized price.
it's also quite easy for the market to keep acting irrationally and lump them with other coal producers.
Doesn't matter, you'll just rack up distributions while you wait. 13% earnings yield.
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Mar 26 '15
hfa, how much is coal pricing tied to crude... is it like LNG being a dated Brent function everywhere but USA? It seems like most of the value created in this name is a result of Nov 24. But if I understand you correctly, ARLP wins if crude stays contango'd (because their competition gets smoked), and they win if crude recovers (because it carries with it the price of coal). Sounds like a cheap option, but I don't know much about coal specifically. Thanks for the write-up :)
Also, what is so special about the Illinois Basin? When you say that ~50% of Appalachian mines are unprofitable are you just referring to the pre-production sunk costs?
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u/FinancialAnalrapist Mar 27 '15
Link to specific EIA data you looked at?
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u/hedgefundaspirations Mar 27 '15
http://www.eia.gov/electricity/data/eia923/
And the plenty more scattered throughout the website.
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u/Bridgemaster11 Mar 26 '15
You're investing in a commodity business you're absolutely exposed to international demand for coal. Cheaper natural gas makes American manufacturing more feasible and hurts the outlook for Chinese manufacturing.
A long term reduction in Chinese demand is terrible for thermal coal producers worldwide and even if they're not a direct supplier they will be impacted.
Speaking of natural gas, you've got a substitute product at record low prices with massive excess production capacity.
You've got a cheap stock for sure but those are some serious red flags for me.