Alliance Resource Partners: Circle Of Competence In Action
Summary The concept of a circle of competence is probably more important to avoiding risk than anything else, but it is not discussed enough in context. Coal is obviously hated right now. I can’t think of anything more universally hated. That can mean opportunity. And Alliance’s track record is incredible. Just looking at the financials, you would never guess that this is a commodity company. But I don’t understand the legal/regulatory environment and the price of coal in the Illinois Basin has declined to a point that implies breakeven EBITDA for ARLP. Circle of competence is probably the most important concept in investing for avoiding catastrophic risks. Most people can understand some businesses, but everyone has many businesses they do not understand well enough to touch at any price. Understanding can be changed. You can learn, but that should be done before making investment decisions regarding the businesses you don’t understand. Circle of competence gets a lot of attention among value investors, but still not as much as it deserves, and where it is discussed, it is usually abstract because no one wants to discuss specific things they don’t understand. It’s tough on the ego. That’s exactly what I’m going to try to do here. Coal I don’t understand coal. Alliance Resource Partners LP (NASDAQ: ARLP ) came up on my list of low EV/EBIT stocks. To this point, I’ve been dismissing MLPs entirely, but I decided to give this one a chance. This is important because I’ve never invested in an MLP before, so there’s already a layer of non-understanding here. The MLP issue is not the crux of it. It looks like MLPs are publicly traded limited partnership interests. Only companies in certain industries like commodities can structure as MLPs. They aren’t taxed at the corporate level, and distributions (not “dividends”) are return of capital – they lower your cost basis but are not taxed immediately in most cases. When you sell, your capital gain (hopefully you have a positive total return) is taxed at your ordinary income rate, not at capital gains rate. You should always own MLPs in taxable accounts because they are actually taxed preferentially there compared to in a tax-exempt account like an IRA. Great, so maybe I could own an MLP. But coal is another story. Coal must be one of the most, if not the most, hated industry out there right now. The industry ETF (NYSEARCA: KOL ) is down almost 50% over the last 12 months: (click to enlarge) Environmentalists hate it because it produces more CO2/energy produced than other energy sources. Coal produces 2000 lb of CO2 per ton, while gas (natural gas is its closest competitor) produces 1100 CO2. The government hates it because environmentalists hate it and environmentalists are voters. There are also reasonable negative externalities but I’m trying to be pragmatic. Investors hate it because the stocks have been killed to the point where it’s tough to be an institutional investor and hold anything related to it. Utilities hate it because its controversy is causing them to spend billions converting electric power plants to gas-powered and other energy sources. Kids hate it because it’s what they unwrap on Christmas instead of the things they actually wanted or could do anything with. I may or may not be able to keep going, but you get the point. My insight was that there might be a market prejudice in all this hate and maybe there is opportunity in the pessimism on coal. Alliance in particular looked interesting. Despite being a cyclical, commodity business, the financials look really interesting. Operating income has been positive every year over the last 10 years, and substantially so with OM% never getting below 13%. FCF conversion from EBIT has been about .6x, unheard of in my experience for a commodity business. Book value per share has compounded from 1.68 to 14.16. Revenue has grown every single year. The share count has not been diluted at all… Just unusually fantastic long-term numbers. (click to enlarge) And the stock price has done well long-term: (click to enlarge) There’s a really informative post from Value Investors Club that perfectly laid out the bull case on the stock. It’s quite compelling. The company has been led by Joe Craft since the mid ’90s and he’s been with the company since he left college around 1980. He owns a substantial interest in both the GP and ARLP and is thus properly incentivized. He only takes a salary of $700k/yr. Apparently, ARLP is a low cost producer generating some 95% of its coal in the low-cost Illinois Basin. I don’t know much about commodities, but I know being the low-cost provider is everything in terms of competitive dynamics. ARLP stock now trade at an EV/FY15 est. distributable cash flow of like 4.3x. And a third of that EV is debt. In other words, they could hypothetically pay a ~33% distribution. This all sounds great, except that there are many things I just don’t understand about coal. One is regulation. According to John Huber , there is regulation in the works that could force utilities to move away from coal: Adding to the cyclical woes are the regulatory hurdles that the industry currently faces, and will likely continue to face going forward. The US Supreme Court remanded the EPA s Mercury and Air Toxic Standards on June 29th , which would have cost power plants upwards of $10 billion annually. This was perceived as a victory for the coal industry, but many power plants have already been converting from thermal coal to natural gas in anticipation of regulatory requirements. Who knows what lower courts will decide regarding mercury emissions, but once a plant switches to gas, it’s not going back to coal regardless of price. Then there is the unrelenting decline in coal prices. In the Illinois Basin in particular, coal prices have declined to a point that implies breakeven EBITDA for Alliance: (click to enlarge) Source: Quandl / US Energy Information Administration . I don’t know how their margins will hold up given that. The current 20% operating margin seems unusually high for a commodity company. Maybe ARLP will even lose money this time around. I just can’t get comfortable with this. I’m using too many “maybes.” Even if ARLP is attractive now on an expected value basis, without a great deal of knowledge, there’s no way for me to say with any degree of certainty in the face of declining coal prices that my downside is limited. And that’s a requirement for my portfolio. I may do further work here, but for now coal and ARLP are getting put in the “don’t understand/too hard” pile. Hopefully this not only provides some information about coal and ARLP, but serves as an example of the circle of competence concept in action.