By Reuben Gregg Brewer
April 6, 2018 - Over the past year the stocks of Peabody Energy (NYSE:BTU) and Arch Coal are up 17% and 25%, respectively. Alliance Resource Partners, L.P.'s (NASDAQ:ARLP) units are down over 20%. However, Alliance could still be the best coal miner for investors, particularly if you are looking for income. Here's why you shouldn't get too wrapped up in the big gains from Peabody and Arch, and give lagging Alliance a second look.
The Force of Steel
One of the big differences between Alliance, Peabody, and Arch is that Alliance's coal production is mostly thermal. The coal it mines largely goes to domestic utility customers that use it to produce electricity. Peabody and Arch both have notable metallurgical coal businesses. Met coal, which is a higher grade coal, is used to make steel.
Met coal generally costs more than thermal coal, providing met coal miners with larger profit margins. However, thermal coal has historically been a highly stable, if lower-margin business. In fact, the U.S. Energy Information Administration (EIA) is projecting coal demand to be roughly stable through 2050 at this point (note that the EIA has been revising these estimates lower in recent years), providing a solid backdrop for Alliance's business. This is an important distinction right now. The huge advances at Peabody and Arch were driven by a run-up in demand for met coal in the back half of 2017.
To give you an idea of just how big of a run-up, Peabody's Australian met coal operation contributed around $70 million to adjusted EBITDA in the second quarter of 2017, but nearly $200 million in the fourth quarter. A roughly doubling of demand was the big driver. The contribution from the rest of Peabody's coal businesses, which consisted largely of U.S. and Australian thermal coal, were basically flat over the same span. In essence, met coal was the big performance driver -- and the one that led investors to push the shares higher.
This chart show the EBITDA contribution of Peabody's different coal businesses, which highlights the volatility of its Australian met coal business which went from negative EBITDA to positive and outperforming all of its other businesses in a six quarter span.
Image courtesy of Peabody Energy
Without a material presence in the steelmaking coal market, Alliance got left behind. That's understandable, but there's a downside to met coal. It can be a volatile business driven by supply and demand out of the cyclical steel industry. In fact, a steep decline in the price of steelmaking coal was a key factor in the bankruptcies of both Peabody and Arch, which had taken on material levels of debt to buy their way into met coal not too long ago. To give you an idea of how volatile met coal can get, the adjusted EBITDA contribution from Peabody's met coal operation was negative in the third quarter of 2016. Alliance, meanwhile, has long focused on maintaining a conservative, low debt balance sheet, and operates mainly in the relative stability of thermal coal markets.
Slow and Steady
To be fair, 2017 was not the best year for Alliance. Although coal sales volumes were up roughly 3% year over year, the expiration of long-term contracts inked in better times led to weaker pricing. In the end, revenues were lower by about 7%. And despite successful efforts to reduce costs, net income fell by around 10.5%. Couple that with an increase in the number of units outstanding, the result of Alliance buying the incentive distribution rights from its general partner, and net income per unit fell 17%.
That last statement, though, is really important. Yes, 2017 was a tough year, but the impact on the partnership's bottom line was made worse by the increase in the unit count. However, this is a part of Alliance transforming itself into a simpler business, which is set to continue as it recently announced plans to buy, or "internalize," in industry lingo, its general partner. That will require more units to be issued and will probably make 2018 look like another difficult year no matter what happens in the coal markets it serves. But the key is to remember that Alliance is positioning itself to be a simpler business while at the same time reducing its cost of capital. Although still just a small part of the business, Alliance has been using the relative stability of the thermal coal business to branch out into the midstream energy space.
ARLP Chart by YCharts
There's one more thing to look at: the distribution. Despite the relatively weak performance in 2017, Alliance increased its distribution in the third and fourth quarters last year. It recently announced another increase for the first quarter of 2018. The partnership expects to increase the distribution by roughly 4% in 2018, as it simplifies its structure and continues to expand its presence outside of the U.S. thermal coal market, including investments in the oil and gas industry and selling U.S. coal into foreign markets. These are small businesses, but they are increasingly helping to diversify the company's revenue sources.
All in all, Alliance's financial results appear to be hiding the fact that it is getting stronger, not weaker. It's probably best to view 2017 and 2018 as transitional years. The distribution trend, though, is suggesting that management thinks things look OK.
Exciting or Boring
While Alliance is adjusting its business, investors can collect an 11% yield backed by a growing distribution. (Neither Arch nor Peabody pays a material dividend.) The big stock gains at Arch and Peabody, meanwhile, could prove short-lived if demand for met coal slumps, or if met coal prices weaken materially. All that would take would be a downturn in the cyclical steel industry.
Alliance's thermal coal business, on the other hand, is unlikely to see a material shock because of the nature of power generation. In fact, Alliance already has commitments for 85% of its projected 2018 production. In the end, income investors shouldn't shy away from Alliance just because the market is down on the units, there are still good reasons to like the outlook and the stability offered by this boring and high-yielding thermal coal miner. Particularly when you consider the impact that the volatile met coal market can have on investor sentiment at Arch and Peabody.
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