Keeping with the theme of using quantitative spread ratios to find good hedged trade setups (which might be a good technique to use in the upcoming cash prize contest), this time I’m looking at a Master Limited Partnership (MLP) stock that pays a nice dividend in addition to offering good capital appreciation upside.

Alliance Resource is an Appalachian coal miner that I first looked at about six months ago (see the ARLP Stock Report), and the stock made a nice move from the low/mid-$30s up to $45 before coming back down. The MLP units (MLPs are an ownership structure that gives tax-preferred treatment to dividends - ARLP currently yields 6.65%) that trade under the ticker ARLP are sitting back where they were in March even though Central Appalachian Coal Futures have increased considerably during that time. This is important for the company because about 85% of production is sold under pre-determined contracts that are only renegotiated once every several years, so as Alliance renews its contracts it will benefit from the higher coal futures prices. Of particular note is the long-dated contracts for 2009 and beyond, which were just above $48 in March and now trade from $52 to $55, as these should give Alliance greater pricing power and profits on its future production.

In addition to ARLP, which are units of the Limited Partnership interest in the company, interest in the General Partnership units is sold under the ticker AHGP. Both offer ways to own a piece of the company, and each has its own particular nuances. How do the shares relate to each other in trading?
[You may need to scroll down to see the chart]

The shares have traded in a reasonably close manner, although ARLP has consistently been getting cheaper relative to AHGP as indicated by the long downtrend the pair has been in since Thanksgiving 2006 (red line). The 1.40 ratio of ARLP/AHGP had been acting as some form of support (yellow), but the ratio broke and retreated to a low of 1.23 before rebounding to the current 1.404, just above that support/resistance line as a minor uptrend has become apparent (green). Taking the consensus analyst targets for both ARLP and AHGP yields a ratio of 1.515, and on this hedged trade I would look to take profits between there and 1.550, or just below the 1.575 average ratio the shares have traded at historically.

While this is just a short-term trade setup, I also think you’d do yourself a favor in exploring ARLP or AHGP as a long-term investment; I don’t see coal’s role as an energy source diminishing anytime soon, and Alliance is well-positioned for future growth even beyond its current 17% operating margins (among the best in the industry), as free cash flow should improve as the company’s capital investment expenditures decrease and a return on investment is realized from that. And of course, the 6.6% yield offered by ARLP would be a boost to the average yield of many portfolios, and AHGP is no dividend lightweight either - notably, both dividends come as part of payout ratios less than 70%, so this isn’t some temporary bait-and-switch or reckless dividend policy either. Alliance Resource is an interesting company that currently offers something for both the short-term trader and the long-term, dividend-oriented investor, and I’ll be tracking it closely on both counts in the coming weeks.
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See Cullen’s Stock Report on ARLP.