Alliance Resources has - as my posts have shown - pretty ordinary operating metrics but exceptional financial metrics. Labor productivity is low and falling - profit is high and rising.
On an operating level this looks very like the (bankrupt) Patriot Coal. On a financial level it is world-beating.
Bluntly this is strange.
So far though I have shown only one explanation - and it only explains about 140 million pre-tax in cumulative profits. Alliance Resources seems to systematically under-reserve for (self-funded) workers compensation.
That is important - it invites a class action for instance - but the amounts of money are nowhere near sufficient to account for the differences in performance. There has got to be more to it.
One of the main differences between Alliance and its competitors is the price it receives for its coal. Alliance sells almost entirely high sulfur Illinois Basin coal. There is no price series for Illinois Basin coal in Bloomberg any more. When the series ended in 2007 high sulfur coal traded at a $5 per ton discount to mid-sulfur coal. If you look at Arch Coal's numbers their high sulfur coal trades at a $3.50 discount. The closing discount makes sense because more of the power stations have scrubbers.
Anyway here is the price series for Alliance Coal (by source) versus the mid-sulfur index.
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What you see is remarkable. There was a period where ARLP sold coal under contract at prices quite a bit lower than spot.
However the price they receive is now rising and well above spot.
In particular ARLP is now obtaining about $8 of premium per ton for their coal over Illinois Mid Sulfur coal. Whilst Bloomberg no longer have a price series for Illinois Basin high sulfur coal my contacts (and comparison with Arch Coal) say that ARLP coal instead of trading at an $8 premium it should trade at a $3.50 discount.
However the price they receive is now rising and well above spot.
In particular ARLP is now obtaining about $8 of premium per ton for their coal over Illinois Mid Sulfur coal. Whilst Bloomberg no longer have a price series for Illinois Basin high sulfur coal my contacts (and comparison with Arch Coal) say that ARLP coal instead of trading at an $8 premium it should trade at a $3.50 discount.
That $11.50 makes a huge difference. Alliance produces about 30 million tons of high sulfur coal - so the difference equates to $345 million in pre-tax earnings or EBITDA. Income from operations in 2012 were $334 million - so the higher prices accounts for all of it.
This price comparison has quite strong backing. Here is the price disclosure from the last Arch Coal annual:
This price comparison has quite strong backing. Here is the price disclosure from the last Arch Coal annual:
Arch sells Illinois Basin coal at $42.50 under contract. That is almost $14 below ARLPs latest blended received prices - however I think on a like-for-like basis [stripping out a some Appalachian coal] the difference is closer $11.
If prices were reset to market (that is $10-11.50 lower) then the ability of this MLP to make distributions goes away. Indeed it is hard to see how they pay their debts. Bankruptcy is the likely outcome. If the prices go towards the $42.33 that Arch Coal is contracted to (in 2014) for Illinois Basin coal then Alliance debt holders will wind up extremely short.
If prices were reset to market (that is $10-11.50 lower) then the ability of this MLP to make distributions goes away. Indeed it is hard to see how they pay their debts. Bankruptcy is the likely outcome. If the prices go towards the $42.33 that Arch Coal is contracted to (in 2014) for Illinois Basin coal then Alliance debt holders will wind up extremely short.
This is by far the main explanation I have found for the superlative financial performance of Alliance Resources. Alliance has just contracted at far higher coal prices than the opposition.
Without these high prices Alliance would look like another very stretched coal mine with mediocre operating performance - but with a lot of debt - and it will probably go bankrupt.
The stunning performance of Alliance is a little from under-reserving workers compensation but mainly because the management team have extracted contract prices massively better than the competition... this is a company where the successes have been by senior management and white collar employees (those who sell the coal) rather than the workers who mine it.
The chart itself suggests the explanation: the prices in the contract look like they are regularly escalating. They were way below market for a while and are now a fair bit above market. It looks like the company entered some escalating price contract when its bargaining power was very strong.
Without these high prices Alliance would look like another very stretched coal mine with mediocre operating performance - but with a lot of debt - and it will probably go bankrupt.
The stunning performance of Alliance is a little from under-reserving workers compensation but mainly because the management team have extracted contract prices massively better than the competition... this is a company where the successes have been by senior management and white collar employees (those who sell the coal) rather than the workers who mine it.
The chart itself suggests the explanation: the prices in the contract look like they are regularly escalating. They were way below market for a while and are now a fair bit above market. It looks like the company entered some escalating price contract when its bargaining power was very strong.
My first take: the contracts will adjust
This is what the last 10-K said about contract resets:
Virtually all of our long-term contracts are subject to price adjustment provisions, which permit an increase or decrease periodically in the contract price to reflect changes in specified price indices or items such as taxes, royalties or actual production costs. These provisions, however, may not assure that the contract price will reflect every change in production or other costs. Failure of the parties to agree on a price pursuant to an adjustment or a reopener provision can, in some instances, lead to early termination of a contract. Some of the long-term contracts also permit the contract to be reopened for renegotiation of terms and conditions other than pricing terms, and where a mutually acceptable agreement on terms and conditions cannot be concluded, either party may have the option to terminate the contract.These are not reset to spot prices. These are reset in prices due to changes in operating costs and the like. Still resetting of the prices for this company to anything akin to market means likely bankruptcy - so the contract resetting terms are critical.
I figured that I have to look at more detail at the contract terms, price and volumes.
And what I found made left me with a few options - all ugly.
The mathematics of Alliance contract terms...
Unfortunately, you are going to have to bear with me through a little bit of arithmetic.
The 2009 form 10-K contains the following disclosure:
Coal Marketing and Sales
...[W]e have entered into long-term coal supply agreements with many of our customers. These arrangements are mutually beneficial to us and our customers in that they provide greater predictability of sales volumes and sales prices. In 2009, approximately 92.6% and 91.1% of our sales tonnage and total coal sales, respectively, were sold under long-term contracts (contracts having a term of one year or greater) with committed term expirations ranging from 2010 to 2016. Our total nominal commitment under significant long-term contracts for existing operations was approximately 138.7 million tons at December 31, 2009, and is expected to be delivered as follows: 29.2 million tons in 2010, 26.9 million tons in 2011, 20.4 million tons in 2012, and 62.2 million tons thereafter during the remaining terms of the relevant coal supply agreements. The total commitment of coal under contract is an approximate number because, in some instances, our contracts contain provisions that could cause the nominal total commitment to increase or decrease by as much as 20%. The contractual time commitments for customers to nominate future purchase volumes under these contracts are typically sufficient to allow us to balance our sales commitments with prospective production capacity. In addition, the nominal total commitment can otherwise change because of reopener provisions contained in certain of these long-term contracts.
The way to think about this: 25.0 million tons were sold in 2009 – 92.6 percent under long term contracts. That is 23.15 million tons were sold under contracts. The next years – as stated – are 29.2 million, 26.3 million and 20.4 million. After that we do not really know (we only know the totals) so I have assume 20 million tons per year – but marked this in the following table in yellow [to indicated that it is a guess].
We can complete the table for 2010. Here is the relevant disclosure:
In 2010, approximately 92.4% and 89.0% of our sales tonnage and total coal sales, respectively, were sold under long-term contracts (contracts having a term of one year or greater) with committed term expirations ranging from 2011 to 2016. As of January 28, 2011, our nominal commitment under long-term contracts was approximately 31.1 million tons in 2011, 27.3 million tons in 2012, 24.1 million tons in 2013 and 19.0 million tons in 2014.
Tons sold in 2010 were 30.3 million.
And the same for 2011 – here is the relevant disclosure
In 2011, approximately 92.2% and 90.5% of our sales tonnage and total coal sales, respectively, were sold under long-term contracts (contracts having a term of one year or greater) with committed term expirations ranging from 2012 to 2016. As of January 28, 2012, our nominal commitment under long-term contracts was approximately 33.8 million tons in 2012, 33.5 million tons in 2013, 27.2 million tons in 2014 and 19.8 million tons in 2015.
Tons sold in 2011 were 31.9 million.
And we for 2012:
In 2012, approximately 94.2% and 94.3% of our sales tonnage and total coal sales, respectively, were sold under long-term contracts (contracts having a term of one year or greater) with committed term expirations ranging from 2013 to 2020. As of January 28, 2013, our nominal commitment under long-term contracts was approximately 38.5 million tons in 2013, 30.7 million tons in 2014, 23.4 million tons in 2015 and 18.7 million tons in 2016.
Tons sold in 2012 were 35.2 million.
This gives us a more complete table thus:
Just can also work out the size of the incremental contracts sold in each year. This is in the following table.
The table has one startling implication: the company has never quite delivered the contractual amounts under contract. For example in 2009 they had contracted for 29.2 million tons to be delivered in 2010 under contract and they only delivered 28.0 million tons under contract. Incremental contracted volumes are negative in every year - though contracted volumes are positive in the out-years.
Prices in each year:
We also have the price received for each year. This is disclosed in the relevant 10-Ks.
From 2009 form 10-K
We reported Net Income of ARLP of $192.2 million, an increase of 43.2% in 2009 compared to Net Income of ARLP of $134.2 million in 2008. The increase of $58.0 million was principally due to improved contract pricing resulting in an average coal sales price of $46.60 per ton sold, compared to $40.23 per ton sold in 2008, partially offset by lower sales volumes and higher operating expense per ton sold in 2009.
From the 2010 form 10-K
We reported record Net Income of ARLP of $321.0 million in 2010 compared to $192.2 million in 2009. This increase of $128.8 million was principally due to increased tons sold and improved contract pricing resulting in an average coal sales price of $51.21 per ton sold, as compared to $46.60 per ton sold in 2009.
From the 2011 form 10-K
We reported record Net Income of ARLP of $389.4 million in 2011 compared to $321.0 million in 2010. This increase of $68.4 million was principally due to increased tons sold and improved contract pricing resulting in an average coal sales price of $55.95 per ton sold, as compared to $51.21 per ton sold in 2010.
From the 2012 form 10-K
A higher average coal sales price in 2012, which increased to $56.28 per ton sold as compared to $55.95 per ton sold in 2011, resulted from improved contract pricing for Illinois Basin coal sales offset partially by lower coal volumes sold by our Mettiki mine into the metallurgical export markets.
Prices per year were thus $46.60, $51.21, $55.95 and $56.28.
These higher prices were achieved in an era of falling prices and when older and presumably higher priced contracts were not entirely delivered.
The bull case for ARLP (and for many other MLPs) is that the revenue is ensured by longer-term contracts. But these longer term contracts appear to be priced further and further out of the money - and incremental prices achieved appear to be way-out-of-the money.
Explanations
At this point I expected to be reverting to my (late) high school linear algebra but it does not work [this can only be solved if the prices per incremental ton contracted are implausibly high].
The company did not even deliver its contract and yet realized price per ton kept rising despite spot prices falling.
There are only three alternatives I can see:
(a). The contracts have very large escalation clauses – clauses that are by and large not disclosed
(b). The contracts are fixed price – and as market went down the utilities paid big termination fees (which are entered as part of realized price) and after which the company entered new contracts at lower prices. However the termination fees ensured the realized price went up each year. Explanation (b) would also explain why contracted volumes are consistently not delivered or
(c). The accounting disclosures are simply fiction.
I have been around US capital markets long enough to know that you can never quite dismiss the third explanation (that the accounting disclosures are just fiction). But that is still a big step.
Explanation (a) large escalation clauses - is consistent with the price chart above. Alliance sold at prices well below market in 2008 and sells well above market now. However (a) has a very big problem. This is that none of the 10-Ks tell us about a coal price escalation clause. And the management team are promotional and would normally tell us.
Explanation (b) thus looks more plausible... The prices received are an artifact of cancelling old contracts set at higher prices. That would also explain why the company has failed to deliver its contracted tonnage in every year studied. In that case the new tons must be at much lower prices.
We get some guidance in this matter from the accounts of the two largest customers - the Tennessee Valley Authority and LG&E (the large German owned utility). Both these companies suggest that they have derivative liabilities on coal contracts - that is they are contracted to buy coal at above market prices. However in both cases the derivative liabilities are falling fast (consistent with explanation b above).
The disclosure from the TVA is most germane:
At September 2012 The Tennessee Valley Authority had 46 million tons contracted and they were $267 million underwater on those tons. In other words their coal was $5.80 per ton overpriced.
By December they had 48 million tons contracted but were only $224 million underwater - or $4.67 a ton underwater.
At this rate by early 2014 The TVA will have rid itself of all out-of-the-money contracts. They may be doing it this fast by paying their way out. Whatever happens Alliance Resources (whose biggest customer is The TVA) will be receiving closer to market prices.
Future outcomes
Explanation (a) large escalation clauses - is consistent with the price chart above. Alliance sold at prices well below market in 2008 and sells well above market now. However (a) has a very big problem. This is that none of the 10-Ks tell us about a coal price escalation clause. And the management team are promotional and would normally tell us.
Explanation (b) thus looks more plausible... The prices received are an artifact of cancelling old contracts set at higher prices. That would also explain why the company has failed to deliver its contracted tonnage in every year studied. In that case the new tons must be at much lower prices.
We get some guidance in this matter from the accounts of the two largest customers - the Tennessee Valley Authority and LG&E (the large German owned utility). Both these companies suggest that they have derivative liabilities on coal contracts - that is they are contracted to buy coal at above market prices. However in both cases the derivative liabilities are falling fast (consistent with explanation b above).
The disclosure from the TVA is most germane:
At September 2012 The Tennessee Valley Authority had 46 million tons contracted and they were $267 million underwater on those tons. In other words their coal was $5.80 per ton overpriced.
By December they had 48 million tons contracted but were only $224 million underwater - or $4.67 a ton underwater.
At this rate by early 2014 The TVA will have rid itself of all out-of-the-money contracts. They may be doing it this fast by paying their way out. Whatever happens Alliance Resources (whose biggest customer is The TVA) will be receiving closer to market prices.
Future outcomes
If (a) is true then the contracts will wind up being reset. There is a huge contract that was there in 2009 (and still accounts for the bulk of contracted value). That contract does roll over fairly sharply now. When it rolls off prices will be much lower.
If (b) is true then the profitability of this company is going to crash because the forward contract prices are massively lower than realized historic prices. This decline will happen fairly fast in this case.
Under both scenarios (a) and (b) it is difficult to see how this partnership services its large debt. Any price close to what Arch Capital receives for its coal will result in fairly rapid bankruptcy. Debt-holders beware!
The third possibility (c) is probably the best one for shareholders. The third possibility is that this is a massive fraud. In that case it can keep going as long as the management keep lying. In the fraud possibility the stock might take a while to crash (as lies can be very long-lasting) - especially if they can - Ponzi like - continue to raise capital. They will keep paying dividends as long as lenders in particular are dopey enough to continue to lend to them.
This is one of those rare cases where I am a short seller and I am hoping the company is not a massive fraud. If its not a massive fraud I am going to get paid fairly quickly.
If it is a massive fraud I might be waiting some time. As a short seller I hope it is not a fraud - then I get a quick fairly guaranteed collapse.
John
John,
ReplyDeleteFor what it's worth, I fairly recently met with an Illinois Basin competitor of Alliance. The topic of Alliance's pricing came up, and this management team expressed a sense of bewildered appreciation for the pricing power of ARLP. They said they didn't understand at all how Alliance accomplishes their pricing.
john,
ReplyDeletefor a large part of the last several years there was an oversupply of coal in especially the Eastern U.S
In some cases, the utilities didn't have physical space to store the coal they had contracted for.
I know in many cases the utility paid the coal miner to NOT deliver the coal -- either through straight up termination payments, or more likely, thru higher prices for coal in subsequent years. Or perhaps, for extension of their existing contracts.
The company would never break this out of course, but it could account for some of the pricing dynamics you have noted.
Congratulations, John. You have the catalyst.
ReplyDeleteRegarding the possibilities you list at the end of the post, there is also d) that they have booked payments termination payments as sales so far and when that song ends -- perhaps this year -- they will lie.
I owned this stock many years ago (2008ish). At the time they had a large bolus of mines coming down the pike. As a MLP they try to lock in cash flows, and luckily I believe they entered into some pretty attractive LT contracts as these mines came on thru 2009 and maybe 2010.
ReplyDeleteKeep in mind that in 2008 the environment was very different than today. Central Appalachian coal peaked at $150 per ton -- triple the prior year.
Thus, a very long term ILB contract at say $50 - $60 was actually below market and quite attractive!
ARLP was not the only coal company to sign these contracts. Check out JRCC's year by year pricing. Of course, in JRCC's case, it's probably going bankrupt after the favorable contracts expired.
The Market for whatever reason is pretty lazy in figuring this out. The JRCC problem was very visible (after all, all the contract terms were disclosed), but the stock took its sweet time to realize what was going on.
In ARLP's case, I wonder if you will have to wait until 2015-2016 to see the fruits of a short... esp given that the shareholder base is mostly retail customers looking for yield.
I have gone to the CME for prices for Appalachian coal futures and I see that the coal future price a few years out is twenty per cent higher than spot prices so Alliance may be able to renew or extend its long term prices at much higher prices than the spot market.
ReplyDeletehttp://www.cmegroup.com/trading/energy/coal/central-appalachian-coal.html
Thank you for all the research you publish. Much appreciated.
John,
ReplyDeleteI knew the company had locked in their coal production at higher prices, but I didn’t realize how much of an impact it will have on their bottom line if they took a $10/ton haircut on their pricing. They’ll go from being massively profitable to breakeven/slight cash bleed.
Alliance definitely has a high cost capital structure that many retail investors are failing to realize including myself until your article sparked me to check out the numbers myself. Thank you for saving me potential future capital loss! You definitely can’t allow the market to do your Due Diligence for you.
Hey John - in ARLPs most recent 10K, which you sampled in this post, contract term expirations go from 2016 to 2020, implying they've signed more LT contracts (albeit, price unknown). Aren't blended prices likely to slowly converge to something close to spot, rather than an earnings cliff, as you allude to?
ReplyDeleteMany resources companies have a portfolio of long term contracts struck at prices above current spot, that roll off and are re-priced over time. So what? The precise escalators and terms of these are commercially sensitive and not going to be disclosed by a company.
ReplyDeleteI'm not sure how you can go from that to suggesting the whole thing is a masssive fraud, that's a fairly giant leap of paranoia.
I see zero evidence of fraud here. Also, I see zero evidence of a looming earnings collapse at the company. The business has a portfolio of contracts that will roll off over time. The spot commodity price may fall, or it may increase. I am not a commodity price speculator. If the price does continue to decrease, the company will have lower revenues. You could say the same for every resource company. Inquiry should be focused on the company's ability to meet that potential challenge with cost reductions. In my experience falling commodity prices are generally followed by falling mining and other costs. Forecasting imminent bankruptcy is ridiculously premature.
However the biggest issue I have is that the author points to the fact that contracted volumes have consistently been undelivered as some startling insight that must have significance.
Contracted volumes are in practice almost never delivered, for a combination of reasons including lost production time due to weather, force majeure events, processing failures, grade variances, variances in coal quality, rail delays, to name a few.
This is a fact that anyone with any investing experience or industry experience in mining would know. It has none of the implications that the author is suggesting.
On the contrary, if the company had precisely delivered its contractual volumes year-in, year-out, that would be highly unusual and grounds for further investigation. Such a result would require a level of supply chain and production management efficiency never achieved in the history of mining and resource logistics.
I think the author needs to do some minimum level of industry research before actually committing funds for investment. His certainty about the outcome of this trade ("I get a quick fairly guaranteed collapse") supported by such a basic, incorrect supposition is scary.
If you're short shares the dividend will really sting. I don't agree with your premise that this is a fraud, but even if it were there are plenty of fraudsters out there that pay little to no dividend. I think you've hooked into a monster that will never make it up and over your gunnels and may just pull you down into the sea.
ReplyDeleteThank you for a well articulated thesis. If I had to summarize the thesis in one sentence - ARLP has a high cost structure and inflating prices so px's will come down that will cut profitability to close to 0, and the co will cut the dvd, and the stock will collapse. I dont mean to downplay the work that you have done but just trying to simplify (I especially liked the TVA insights). So where can this be wrong?! I think that ARLP will try to grow to make up for the shrinking profitability... based on current run rate and projects probably growing production by ~10% per year in 2013-15. If that's the case, and they manage to bring px/ton down by $1 by pushing away the problem, then EPS avail to limited partners will be ~$6 in both 2014 and 2015. So, you need to believe that the px/ton will come down by more than $1 per year. Given the $8-12 gap to ACI, HNRG it's plausible that px/ton comes down more than $1 but curious to get your thoughts? Thank you.
ReplyDeleteHi John,
ReplyDeleteAny continuing thoughts on ARLP? AFter speaking to many people in the industry, the fact that their realized prices are above spot is not strange at all. They have higher btu than the spot with lower chlorine content, which deserves a premium. Add in the transportation factors as people seem to generally like doing business with them. Different thesis would have been low NG prices.
Thoughts with hindsight?
Thanks for the blog!
Hi John, Im really curious if you held your short for all this time? it would of cost a bunch of dividend payments but ARLP has finally tanked hard! I went long at 18 and wish I would waited! todays price 13. ARLP has lost 50% in a month unfortunately for me.
ReplyDeleteyes i did remain short and added on the way down. What possessed you to buy at 18? I think you would be right to take the loss.
ReplyDelete