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Why High-Yield Investors Shouldn't Keep Overlooking This Commodity Stock

By Reuben Gregg Brewer - Oct 21, 2017 at 9:13AM

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No one wants to get stuck in a yield trap, but if you like fat yields, you should consider Alliance Resource Partners L.P. -- even though it's a coal specialist.

Alliance Resource Partners L.P. (ARLP 2.74%) has a distribution yield of 9.7%. That number should grab your attention because it's huge. Alliance, however, is a coal miner, which will probably make you assume it's a yield trap. But don't make the mistake of dismissing it before doing some more homework; you could be overlooking a great opportunity in this specialized miner.

The lone survivor

The U.S. coal sector was a tough place to operate for a few years. The risks were highlighted by the high-profile bankruptcies of giant coal miners like Peabody Energy (BTU) and Arch Coal. Others such as Cloud Peak Energy (CLD) saw their bottom lines fall deep into the red. So it's reasonable to be concerned about Alliance.  

A man standing at the mouth of a mine with the sun behind him

Image source: Getty Images

However, Alliance was -- and still is -- different. It wasn't forced into bankruptcy and never saw its earnings fall into negative territory. In fact, it has a strong balance sheet even after suffering through the coal industry's darkest days. For example, at the midpoint of 2017, long-term debt made up a modest 25% of the capital structure and Alliance had a solid current ratio of 1.1. There's really little risk of it finding itself in the type of financial trouble that pushed so many of its peers to the brink, and beyond.  

But coal is dead

You might also be tempted to overlook this high-yield opportunity because coal appears to be on its way out as a fuel source. That's actually a legitimate concern, but coal's death has been greatly exaggerated. It still supplies around a third of the power in the United States, and the U.S. Energy Information Administration expects that percentage to hold relatively stable through 2025. The fundamental issue is that you can't just pull that much power-generating capacity off the grid rapidly.  

Two pie charts showing that coal's use for power generation is expected to remain roughly stable over the next few years

Coal is expected to remain an important contributor to the power grid for a long time. Image source: Alliance Resource Partners, L.P.

But it's important to understand the real problem the coal industry was facing. It wasn't renewable power, it was economics. Low natural gas prices led utilities to shift away from coal. That transition was material since it involved building gas-fired power plants. Coal won't get the market share it's lost back. However, most of the oldest, dirtiest, and least-efficient coal plants have been retired at this point. With the low-hanging fruit largely gone, further declines in U.S. coal demand are likely to be less severe.

Alliance, however, is particularly well positioned even in a more competitive environment because it operates almost exclusively in the Illinois Basin. While demand has fallen for the coal produced in other regions, demand for Illinois Basin coal has actually been holding up because of its low cost relative to the power it provides. And the future looks equally bright.  

A line chart showing Alliance's mines toward the low end of the coal cost curve

Alliance's coal mines are toward the low end of the coal cost curve. Image source: Alliance Resource Partners, L.P.

Between 2016 and 2025, Alliance expects demand for Illinois Basin coal to increase by 30% -- in the worst case scenario. It could increase by as much as 50% if environmental regulations that favor cleaner fuel options are rolled back. This, however, is just one of the puzzle pieces. A key reason Illinois Basin coal is so desirable is because it's relatively cheap compared to other coal options and, more important, natural gas. Moreover, Alliance owns some of the least-expensive coal mines in the industry when you look at coal costs compared to the power provided by the fuel.    

Giving back to unitholders

If you step back just a little, you can see that Alliance is really a different type of coal miner and a solid high-yield opportunity. But there's a little bit more to keep in mind here. Alliance increased its distribution by 14% in the second quarter, following through on an earlier comment that the partnership's outlook was improving.    

To sum up, Alliance has held up better than its peers, has a solid financial foundation, is well positioned in the industry it serves, and it is returning value to unitholders via distribution hikes. Now that the worst of the coal downturn appears to be over, you would be well served to take some time to do a deep dive here.

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Stocks Mentioned

Alliance Resource Partners, L.P. Stock Quote
Alliance Resource Partners, L.P.
$18.73 (2.74%) $0.50
Peabody Energy Corporation Stock Quote
Peabody Energy Corporation
Cloud Peak Energy Inc. Stock Quote
Cloud Peak Energy Inc.

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