A Lump of Coal

By David Dittman • August 24, 2012

What to Buy: Natural Resource Partners LP (NYSE: NRP)

Why Now: Natural Resource Partners LP (NYSE: NRP) is a master limited partnership (MLP) headquartered in Houston, Texas, with its main base of operations in Huntington, West Virginia. The MLP owns and manages mineral reserve properties, primarily focused on coal, aggregate and oil and gas reserves in the US.

Natural Resource Partners doesn’t actively mine any of its reserves. It leases its properties to various operators in exchange for royalty payments. Production from mines it owns accounts for about 25 percent of all the metallurgical coal produced in the US on an annual basis. And about 5 percent of all US coal (metallurgical and thermal) is produced from its properties.

The unit price has basically been cut in half since it hit a closing high of USD41.20 on Jun. 30, 2008. It actually closed as low as USD12.97 on Nov. 20, 2008, as the Great Financial Crisis took hold and shook the global economy to its foundations. From there it rallied to as high as USD37.48 on Mar. 16, 2011, but has sold off hard again on renewed fears about global growth and substitution of natural gas for coal in US electricity generation.

It closed at USD21.25 on Thursday, Aug. 23, having bounced from a 12-month low of USD18.83 on Aug. 3. The MLP is down 25.9 percent from its 2012 high of USD28.67, established Jan. 6, and now yields 10.4 percent. The MLP has never cut its distribution since it first paid one in February 2003. Buy under USD22.

The Story

The US Court of Appeals for the District of Columbia recently struck down Obama administration Environmental Protection Agency rules on cross-state air pollution. This decision reinstates Bush administration rules allowing considerably more time for reducing emissions of sulfur dioxide and nitrogen oxide gases that cause acid rain.

The decision is a major victory for electric utilities that have historically been heavily reliant on coal, particularly American Electric Power Company Inc (NYSE: AEP), Southern Company (NYSE: SO) and Edison International’s (NYSE: EIX) nearly bankrupt Mission Energy unit. The added time and flexibility for compliance potentially means billions of dollars in savings.
Coal’s court victory is unlikely to affect the long-term shift to natural gas by electricity producers. Gas will generate 23 percent more electricity in the US this year, while coal’s share will fall by 12 percent. But the court decision is still great news for Natural Resource Partners and is likely to add to its recent bounce.

Gas is cheaper than coal in the aftermath of the US shale revolution. But coal is still the dominant fuel when it comes to US power generation. It remains abundant and cheap. Americans still use about 20 pounds of coal every day in the form of electricity, and producing electricity from coal costs about half that of using other fuels.

The kingdom is certainly under assault. But according to the Energy Information Administration (EIA) coal will be the major source of electricity generation in the US until 2035. Even under worst-case assumptions it will account for 36 percent of the US electricity generation from 2010 to 2035, a higher share than any other fuel used to generate power.

Electricity generation, however, is just one use of coal in the US. Coal is used to make chemicals, cement, paper, ceramics and metal products. And due to its heat-producing feature, metallurgical/coking coal is a key ingredient in the production of steel. Nearly 70 percent of global steel production depends on coal and NRG’s lands are a major producer.

Roger: I have to admit I was a bit surprised by the District of Columbia Appeals Court decision on cross-state border air pollution, though I guess I shouldn’t have been. Coal is such a political football in the US. But it does make me a lot more interested in coal stocks.

I don’t think this is going to make that much difference regarding US power companies’ decision to close old coal plants. That’s just simple economics. Natural gas is too cheap. But I also have to agree with you that this is more evidence that coal will maintain a significant presence in the US and the global economies.

David: That’s what I’m saying.

Roger: And that the decline in coal prices over the past year-plus is a short-term phenomenon that will reverse.

David: Exactly.

Roger: OK, I’m with you, and I like Natural Resource Partners LP (NYSE: NRP), too, a member of the MLP Profits How They Rate coverage universe, particularly in the aftermath of the federal court rollback of those new EPA rules. In fact, this looks like our next 10 percent plus yielder.

But first we have to talk about a couple Open Positions, beginning with Otelco Inc (NYSE: OTT).

David: It appears they’ve now suspended interest payments on the bond portion of their hybrid security, which includes debt and equity components.

Roger: This is true, so it’s time to vacate that position.

The suspension, which follows the elimination of the dividend on the equity portion of the security, accompanied the announcement of second-quarter results that deteriorated sharply from the first quarter. They can still suspend payments for one more quarter without officially defaulting on the bond. But the fallout from the loss of the Time Warner Cable Inc (NYSE: TWC) contract is yet to come.

And this is just one more example of management springing a decision on investors. I admit we should have been out of this one when it went back up over USD7, the par value of the bond portion of the income deposit security. The accounting is opaque as ever. Let’s get rid of it.

David: Understood. So sell Otelco.

Roger: I would like to hear your thoughts on a more recent selection, and this one is positive: CSR Ltd (ASX: CSR, OTC: CSRLF), as of this hour, is up about 20 percent in price-only terms since we hunted it down in the July issue. Not bad for a month’s work.

David: The stock actually hit a post-recommendation closing high on Aug. 16 at USD1.56 per share. That’s about 29 percent. Wish we’d issued a “book your gain” alert on Aug. 15 in the US so Big Yield Hunters could’ve realized it on the Australian Securities Exchange (ASX) the following morning.

There’s nothing new fundamentally, maybe just a broader sentiment shift toward riskier picks and those that were perceived to be oversold on “the fear.” The price of aluminum, the decline of which explains the stock’s nosedive in 2012, has stabilized a bit but is still showing no signs of real upward momentum.

CSR won’t announce fiscal 2013 first-half results, for the six months ending Sept. 30–its reporting year runs from Apr. 1 to Mar. 30–until early November.

Roger: I think it might be a good idea to book a partial gain, such as we did with another pick from Down Under that popped quickly, OneSteel Ltd, which is now Arrium Ltd (ASX: ARI, OTC: OSTLF). You agree?

David: Well, it is trading above our USD1.35 buy-under target, so by no means should any new money step into this one.

I have two trains of thought rushing through my brain right now: September and October are, historically, rough months for equities. And this year there are a lot of potential catalysts for a particularly treacherous fall, including the US presidential election, a German court’s consideration of European Central Bank efforts to prop up economies on the “periphery” and the looming-larger threat of an Israeli strike on Iran’s nuclear facilities.

But then I read about the minutes from the most recent meeting of the Open Market Committee of the US Federal Reserve and the raised expectations for a new round of quantitative easing. And I read about the HSBC Flash China Manufacturing PMI, which came in at a nine-month low, suggesting, strongly, that Chinese officials will get even more aggressive with its own stimulus ahead of a really crucial leadership transition that will start late this year.

So, yes, to answer your question, I think it makes a lot of sense to book a gain on CSR by selling half of the original position.

But I also think we could see USD1.56, at least, should we see more stimulus, which would boost the Australian dollar. And if the Middle Kingdom primes the pump in a big way, the Australian economy will be that much better off, as will CSR.

Roger: OK, so we advise everyone to take a partial profit on this one. Now, I think we have a nice, natural segue to our discussion of Natural Resource Partners.

David: Well, let’s cut right to the company’s second-quarter earnings report, then.

Total revenues were down 6 percent year over year to USD90.7 million. Coal production remained flat compared to the second quarter of 2011, but coal royalty revenues decreased 12 percent on a sequential basis to USD62.9 million.

The decline in coal royalty revenues was partially due to a greater proportion of production coming from the MLP’s Illinois properties, which is largely thermal coal that sells at lower prices, some new production from properties on old leases with very low royalty rates and some decline in overall prices.

This decline was partially offset by a USD2.5 million, or 10 percent, increase in non-coal royalty revenues to USD27.8 million. This was mainly due to increases in infrastructure fees resulting from additional throughput, increases in oil and gas revenues due to lease bonuses and an increase in gain on sales of assets.

The partnership’s average coal royalty per ton was above expectations, more than offsetting lower than anticipated coal royalty production.

And earnings before interest, taxation, depreciation and amortization (EBITDA) were USD78.7 million, down from USD86.1 million in the second quarter of 2011. EBITDA was better than analysts’ estimates, however, on better-than-expected results from the coal royalty business and much higher than expected revenue from other sources such as oil and gas royalties and infrastructure fees.

Roger: But that’s not the key measure for an MLP, is it.

David: Yes, sensei, there is a more important figure.

Roger: And what is that figure?

David: Distributable cash flow…and dividend coverage ratio.

Roger: Right and right.

The MLP reported second-quarter distributable cash flow (DCF) of USD70.7 million, or USD0.66 per unit. That’s down from USD84.9 million, or USD0.79, a year ago, but DCF covered the distribution paid for the quarter by 1.19 times. That left excess cash flow for the quarter of USD11.1 million.

That distribution coverage should not be discounted given what’s happened to coal prices. It sets National Resource Partners apart from other coal royalty master limited partnerships, which actually did not cover their distributions with cash flow during the quarter.

I also think those other revenue sources you mentioned are big selling points, as is the company’s royalty stream from metallurgical coal. The market is clearly not giving them credit for these stabilizing influences, and that’s why we’re seeing value here.

David: OK, here’s something that’s not so bullish. On Jul. 9, 2012, Patriot Coal Corp (NYSE: PCX), which is a key lessee on Natural Resource’s coal lands in the Central Appalachian region, filed bankruptcy. Royalties from its production represented approximately 5 percent of the partnership’s coal royalty revenue and 3 percent of total revenue in the first quarter of 2012. Patriot has been up to date on payments to Natural Resource but bankruptcy could allow the company to undertake a comprehensive financial restructuring.

That means there’s a risk that Patriot could alter its contracts with the MLP, depending on how the Chapter 11 filing proceeds and/or coal market fundamentals develop going forward.

The silver lining is that even if Natural Resource received no royalty payments during the third and fourth quarters of 2012 from Patriot, distribution coverage for the partnership should remain solid. It’s the challenges of the metallurgical and thermal coal markets that will weigh more on Natural Resource than any potential impact from the Patriot bankruptcy.

Roger: I agree, and that’s why this is a Big Yield Hunting pick and not a portfolio recommendation in one of our other services.

But let me share with you one more very positive detail about Natural Resource Partners.

This week the company completed the acquisition of the Deer Run mine near Hillsboro, Illinois, from Colt LLC, an affiliate of the Cline Group. The acquisition was funded through the partnership’s credit facility.

Deer Run is capable of producing approximately 7 million to 9 million tons annually and this deal, coupled with others made recently, adds 200 million tons of reserves at a cost of USD255 million. Its addition is a clear sign that NRG is not only bullish on its future but that it has the financial power to follow through on its ambitions. And it’s buying these assets at a time when rivals are distressed, so it’s getting them cheaply.

As you know, I’m a big fan of distribution growth. A dividend boost is the best possible sign that a dividend is safe and that the underlying company is growing. Being able to complete a major acquisition in a troubled industry while rivals are floundering is a similar vote of confidence.

Yes, clearly there’s trouble in coal country. Natural gas is replacing coal in power generation and will continue to long as prices stay this low, which will be until we see some meaningful export capacity. Obviously, a Romney victory in the presidential race this November would mean an easier road for coal on the regulatory side, while an Obama win would bring more attempts at reducing emissions faster. But it’s also clear that environmental regulations are going to tighten going forward as well and will further discourage coal use.

I think anyone who buys Natural Resource Partners now on our recommendation needs to recognize these facts. The reason we’re buying here is not that we see coal prices making a comeback or Washington loosening regulation on air pollution. It’s that all this and more has been priced into Natural Resource Partners.

Companies are still going to use coal to generate electricity for a long time to come. And this MLP has metallurgical coal and other mineral assets besides the thermal coal used in power production. It’s also one of the most conservatively run companies you’ll find, demonstrated by the fact that it covered distributions handily even in the most recent quarter.

Based on all that, I’m willing to bet this company is going to hold and even increase its distribution in the next 12 months. That’s extraordinary for a company yielding more than 10 percent.

I should also point out that I attended management’s presentation at the Greenwich, Connecticut MLP Conference this past May. And they continue to measure up to the guidance they gave then and previously.

Again, this isn’t a low-risk bet for conservative income seekers. But it’s a great high-yield bet that could really roll up some capital gains in the next few months, especially given its recent pullback.

David: Looks like we have this month’s pick. We should point out to investors that as a master limited partnership, National Resource Partners will send out a Form K-1 at tax time rather than the standard 1099 common stocks do. The downside there is that will add some complication to tax returns. The company does provide instructions for its K-1, and in any case any competent accountant should be able to do the proper filing without charging anyone an arm and a leg for their services.

Also, a good chunk of the distribution is likely to be declared as a return of capital. That means investors won’t have to pay tax on it in the year received. Instead, that amount will be deducted from cost basis and taxes will only be due when Natural Resource is sold, and at the capital gains rate.

Roger: Another added benefit of master limited partnerships. Thanks David. Until next time.

David: Thank you.

Natural Resource Partners is a buy under USD22 for investors who appreciate the value proposition but who also understand that although coal will remain a big part of the energy equation its kingdom is under assault on several fronts.

Open Positions
  • October 22, 2010: Otelco (NYSE: OTT)–SELL
  • December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
  • April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < 7
  • July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Hold
  • October 21, 2011: PetroBakken Energy (TSX: PBN, OTC: PBKEF)–Buy < USD10
  • November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD19
  • December 16, 2011: Telefonica SA (NYSE: TEF)–Buy < USD15
  • February 16, 2012: OneSteel Ltd (ASX: OST, OTC: OSTLF, ADR: OSTLY)–Buy < USD0.80
  • April 20, 2012: QR Energy LP (NYSE: QRE)–Buy < USD21
  • May 17, 2012: Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF, ADR: TACBY)–Buy < USD3.15
  • June 22, 2012: Data Group Inc (TSX: DGI, OTC: DGPIF)–Buy < 5
  • July 20, 2012: CSR Ltd (ASX: CSR, OTC: CSRLF)–Buy < USD1.35, SELL half of position
  • August 24, 2012: Natural Resource Partners LP (NYSE: NRP)–Buy < USD22
Closed Positions

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