From the April 2008 issue of Research Magazine • Subscribe!

Well Positioned

Strong domestic and international usage in 2008 should benefit the coal sector, analysts say.

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David M. Khani, CFAFriedman, Billings & Ramseydkhani@fbr.com

Outlook: Though utility inventory is still high, we expect that inventory could fall to around 100 million tons by the end of 2008, given growing exports (about 70 million tons), flat-to-down imports, Central Appalachian Coal (CAPP) production declines (about 20 million tons), and demand increase from new power plants (about 1,200 million watts/megawatts due in 2008). The negatives could be a slowing economy and more coal-on-gas competition.

We are hearing that CAPP contract prices are rising again, with domestic delivery heading into the high $50s and export tons into the low $60s. Furthermore, Northern Appalachian Coal (NAPP) discussions are now starting in the high $60s/low $70s. Utilities at present feel very confident about their Powder River Basin exposure, usually a signal that it will move within the next six months.

Foreign exchange is only a partial driver. The main driver remains China and India's coal-fired power-generation growth.

Why Natural Resources Partners (NRP)? NRP has solid exposure to the rising Northern and Central Appalachian (NAPP and CAPP) coal markets (13 million tons and 30 million tons respectively) and the metallurgic coal market (15 million tons). Additionally, the company's model is based on revenues and actually benefits from cost inflation (drives future price increases). Moreover, due to the recent drop in the 10-year Treasury yield, we are raising our 12-month price target to $41 from $39, reflecting a 6.85 percent discount rate on our 2008 and 2009 average distributable cash flow of $193 million.

The combination of 6 percent yield of 2008 forecasted distributions of $2.11/unit and capital appreciation of 24 percent creates a 30 percent total return for shareholders.

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Michael BlumYves Siegel, CFAWachovia Capital Markets, LLCMichael.Blum@wachovia.comYves.Siegel@wachovia.com

Outlook: Coal market fundamentals have strengthened considerably over the past few months. Demand for coal in the international market has increased due to a decrease in exports from China, Australia and South Africa. The decrease in exports is both weather- and infrastructure-constraint related. In addition, domestic utilities are increasing their installation of scrubbers, which is driving incremental demand for high sulfur coal.

Finally, U.S. demand for coal continues to increase. Through the first three quarters of 2007, year/year demand for coal increased by 15.4 million tons or 1.8 percent, according to the Energy Information Administration. Accordingly, Penn Railcar and Big Sandy Barge coal prices were up 28.2 percent and 30.6 percent respectively in 2007, while Illinois Basin coal prices remained relatively flat throughout 2007.

Why Alliance Resource Partners (ARLP)? Adjusted earnings per unit of $0.89 vs. $1.03 a year ago was ahead of our estimate of $0.85 and consensus of $0.79.

There's no change to our 2008 EPU estimate. We're introducing 2009 EPU and DCF/unit estimates of $3.06 and $3.77 respectively. We forecast 2009 distribution growth of 17.0 percent with a 1.3 times coverage ratio.

ARLP is well positioned to increase distributions at a five-year CAGR of approximately 12 percent supported by a strong overall coal market, four mine development projects totaling over $600 million, and a favorable long-term outlook for Illinois basin coal fundamentals, in our view.

Why Penn Virginia Resource Partners L.P. (PVR)? Excluding an unrealized loss on derivatives of approximately $17 million, Q4'07 adjusted earnings per unit was $0.43, as compared to our estimate of $0.40, consensus of $0.45, and $0.40 a year ago.

Quarterly results were driven by a robust commodity price environment. Fourth-quarter fractionation spreads drove strong gross midstream processing margins ($1.81 per million cubic feet versus our estimate of $1.20), which more than offset lower than forecast midstream volumes (185 million cubic feet per day versus our estimate of 200) and coal segment performance. We continue to forecast a five-year distribution CAGR of 6.8 percent.

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