One of the cheapest stocks in our all All Investable – Stock Screener is Alliance Resource Partners, L.P. (NASDAQ:ARLP).

ARLP is a diversified producer and marketer of coal to major United States utilities and industrial users. The company is the nation’s first publicly traded master limited partnership involved in the production and marketing of coal. It’s currently the second largest coal producer in the eastern United States with mining operations in the Illinois Basin and Appalachian coal producing regions. ARLP currently operates eight mining complexes in Illinois, Indiana, Kentucky, Maryland and West Virginia, and operates a coal loading terminal on the Ohio River at Mount Vernon, Indiana.

A quick look at the company’s share price history over the past twelve months shows the price has risen 76% from February 2016 to $23.65, 12% off its 52 week high of $26.65.


(Source, Google Finance)

ARLP recently announced its Q4 2016 and FY2016 results. While FY2016 total revenues were down 15% to $1.93 billion compared to $2.27 billion for the pcp, FY2016 net income rose 10.8% to $339.4 million compared to $306.2 million for the pcp. A quick look at the company’s quarterly income statements (below) for the trailing twelve months shows that while Q4 2016 revenue dropped slightly compared to the pcp, Q4 2016 net income increased nearly 5x to $119.6 million compared to $21.5 million for the pcp.

Fiscal Period (Amounts in millions) Dec16
Preliminary
Sep16 Jun16 Mar16 Dec15
Revenue 527 552 439 413 542
Gross Profit 226 195 187 153 202
Gross Margin % 42.79 35.35 42.62 37.05 37.22
Operating Income 124 96 90 55 6
Operating Margin % 23.57 17.47 20.58 13.29 1.15
Net Income 120 90 83 47 21
Net Margin % 22.68 16.26 18.83 11.46 3.96
EBITDA 209 178 170 136 120

(Source, Company reports)

Reasons for the improved profitability were a significant drop in operating expenses driven by a reduction in coal production volumes and a favorable production-cost mix due to ARLP’s initiatives to shift production to its lower-cost operations. The company also reduced its selling expenses, increased sales from its Hamilton mine, and reduced its coal inventory by 1.0 million tons.

The lower-cost production mix and higher productivity from the company’s Tunnel Ridge and Gibson South mines contributed to drive Segment Adjusted EBITDA Expense per ton down by 16.5% in Q4, to $27.72 per ton compared to $33.19 per ton for the pcp. All of this resulted in a 74.1% increase in Q4 EBITDA to $208.9 million compared to $120.0 million for the pcp.

This is good news for a company that continues to ‘buck the trend’ in an industry (coal) that is plagued by increased over-regulation and the move by some utilities away from coal to the cleaner alternative (natural gas) which is being greatly assisted by lower gas prices.

There’s a number of reasons why ARLP continues to have success in a industry that on the surface appears to have a dismal future. To better understand why ARLP remains successful it’s important to understand what makes this company different from a number of its coal producing competitors.

Firstly, without getting too technical, there are two broad types of coal produced, one is metallurgical coal, which is used in the production of steel, and the other is thermal coal, which is used to generate electricity. ARLP is in the business of thermal coal production. To do this, the company currently operates ten mining complexes in two operating regions: Illinois Basin and Appalachia.

(Source, Company reports)

The company’s mine locations are precisely the reason why ARLP has a strategic advantage over its competitors. The company has low cost mines due mainly to their concentration in the Illinois Basin which are located in close proximity to its customers. Its coal can be easily transported to its customers by rail, barge or truck. The availability and cost of transportation constitute important factors in the marketability of coal because customers typically pay the transportation costs from the mining complex to their destination.

Electricity Generation

Despite all of the talk regarding renewables and natural gas replacing coal in terms of electricity generation, the latest Annual Energy Outlook 2017 Report, released by the U.S. Energy Information Administration (EIA) below shows that coal will continue to outpace natural gas as a selected fuel through 2020 as natural gas prices rebound from their 20-year lows which occurred in 2016. While the role of coal may be diminishing in terms of electricity generation the report also shows that coal will still be a major source in 2040.

(Source, U.S. Energy Information Administration)

Furthermore, the same report also shows (below) that while coal production in general is set to drop in a number of regions, the one location set to rise is the Interior Region which includes ARLP’s sites in Illinois, Indiana, and Western Kentucky.

(Source, U.S. Energy Information Administration)

What often gets overlooked with regards to natural gas is the infrastructure necessary to transport this fuel. Natural gas requires large pipelines to deliver the gas from a gas well to a required location. Without that infrastructure the gas is required to be liquefied for transport which incurs additional costs. Coal on the other hand is easily transportable using any number of options including rail, barge, trucks etc.

ARLP remains in a great position to maximize its ongoing coal production activity driven by its strategic locations which are close to its customers. What’s also apparent is that the management of ARLP have done an excellent job of keeping the company in this strong position while a number of its competitors have failed.

Outstanding Management

ARLP has a strong balance sheet and recently completed an amendment and extension of its revolving credit facility which provides for approximately $480 million of senior secured financing maturing in May 2019.

Despite challenging debt markets facing the coal industry, the company was able to obtain this financing at a modest increase in pricing across the leverage grid with borrowings under the revolving credit bearing interest at an attractive rate of LIBOR plus 235 basis points, at ARLP’s current leverage of less than one times.

As part of ARLP’s debt reduction efforts, the company significantly reduced its borrowings under its revolving credit and paid down its existing term loan to a remaining balance of $50 million, which will be paid in full at the expiration of its primary term in May of 2017. With the completion of this amended credit facility and its strong balance sheet ARLP maintains excellent liquidity and financial stability.

The company also took the difficult step of adjusting its distributions; not due to its performance, its outlook or its balance sheet, but to preserve liquidity that will help ARLP maintain access to the debt capital markets, during what has been a dismal period in the general coal production industry.

Loads of Free Cash Flow

ARLP has illustrated that it’s a very durable business with prudent management when it comes to capital allocation. The company has a tremendous ability to generate loads of free cash. It’s this ability to generate free cash that also sets ARLP apart from its competitors.

A quick look at the company’s quarterly cash flow statements below for the trailing twelve shows ARLP generated $704 million (ttm) in operating cash flow. At the same time, due to good management the company had just $92 million (ttm) in capex, which equates to $612 million (ttm) in free cash flow. If we subtract the $248 million (ttm) paid out in cash dividends for FY2016 that still leaves $364 million in free cash flow. And, with a current market cap of $1.759 Billion that means ARLP has a FCF/Price yield of 20% (ttm) after dividends.

Fiscal Period (amounts in millions) Dec16
Preliminary
Sep16 Jun16 Mar16
Cash Flow from Operations 209 282 132 81
Purchase Of Property, Plant, Equipment -21 -22 -17 -32
Cash Flow for Dividends -53 -53 -53 -89
Free Cash Flow 188 261 115 49

(Source, Company reports)

Valuation

A quick look at the company’s balance sheet ending December 2016 shows that the company had total debt plus minority interests of $668 million and cash and cash equivalents of $40 million. If we subtract the $40 million in cash and cash equivalents from (total debt plus minority interests) that equates to $628 million. If we add that $628 million to the company’s current market cap of $1.759 Billion that means ARLP has an Enterprise Value (EV) of $2.387 Billion.

Fiscal Period (amounts in millions) Dec16
Preliminary
Cash, Cash Equivalents, Marketable Securities 40
Current Portion of Long-Term Debt 177
Long-Term Debt & Capital Lease Obligation 485
Minority Interest 6

(Source, Company reports)

We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–if you were to purchase the entire company. EV is calculated as:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents.

With an Enterprise Value (EV) of $2.387 Billion and Operating Earnings* of $366 million (ttm), that means ARLP is currently trading on an Acquirer’s Multiple of 6.52 or, 6.52 times Operating Earnings*.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

With a FCF/Price Yield of 20% (ttm) and an Acquirer’s Multiple of 6.52, or 6.52 times Operating Earnings*, that places ARLP squarely in undervalued territory.

Summary

Due to lower gas prices and ongoing emission control legislation, 2016 wasn’t a great year for coal producing companies. However, despite all of the talk about renewables and natural gas replacing coal in terms of electricity generation, the latest Annual Energy Outlook 2017 Report, released by the U.S. Energy Information Administration (EIA) shows that coal will continue to outpace natural gas as a selected fuel through 2020 as natural gas prices rebound from their 20-year lows which occurred in 2016. The same report also shows that while coal production in general is set to drop in a number of regions, the one location set to rise is the Interior Region which includes ARLP’s sites in Illinois, Indiana, and Western Kentucky.

ARLP is a terrific company that has excelled thanks to the strategic location of its mine sites being in close proximity to its customers and the fact that it produces thermal coal. The company is extremely well run with a strong balance sheet and the ability to generate loads of free cash flow. Ongoing improvements in operating efficiency mean ARLP has continued to improve both its operating and bottom line margins while remaining prudent with regards to its capital allocation.

In terms of its valuation, ARLP generated $364 million in free cash flow after dividends for the full year 2016 and remains squarely in undervalued territory with a FCF/Price Yield of 20% (ttm), a P/E of 6.98, and an Acquirer’s Multiple of 6.52, or 6.52 times operating earnings. The company also provides a nice shareholder yield of 14% (ttm) thanks to its outstanding track record of providing shareholders with dividends.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.