Coal miner Rhino Resource Partners (NASDAQOTH: RHNO ) has a debt light balance sheet. That makes good business sense in a difficult coal market. However, the plan to permanently finance investments by issuing new limited partner units when they are yielding over 14% is probably more costly than many unitholders realize.
The new issuance is for 1.1 million shares (not including additional shares that the investment bank can buy), priced at $12.30 a share. Based on the current quarterly distribution of $0.445 a unit, that equates to a yield of over 14%. It will cost the partnership almost $2 million a year more in distributions to support those units.
Proceeds from the unit sale will be used to "repay borrowings outstanding under [a] revolving credit facility." This isn't an unusual practice, so there's nothing inherently wrong with what Rhino is doing. In fact, as a limited partnership, the company pays out most of the cash it generates as distributions, so it has to use debt and units to fund growth.
However, if Rhino had issued bonds instead, it likely would have had to pay an interest rate between 5% and 10%. At 5%, the debt would have cost about $675,000 in interest annually. At the unlikely high of 10%, it would have cost around $1.35 million annually.
Even at 10% that's notably lower than the nearly $2 million in additional distributions for which Rhino is now on the hook. This gives credence to the annual report's warning: "We may issue additional units without unitholder approval, which would dilute existing unitholder ownership interests." Rhino is, in fact, doing just that.
The high end interest estimate comes from James River Coal (NASDAQOTH: JRCCQ ) . The company recently exchanged over $240 million in convertible bond debt yielding 3.125% and 4.5% for convertible bonds yielding 10%. The catch? The new bonds are only worth a touch under $125 million. So bond holders are getting paid more interest than they were before, but took a haircut on the value of their bonds.
That James River has had to undertake such a refinancing is a statement about leverage. With weak coal markets, the company is bleeding red ink and bondholders have been willing to take the capital loss to help ensure that the company has enough liquidity to remain solvent through coal's malaise. Long-term debt only makes up about 60% of the company's capital structure. Note that an accounting gain related to the debt exchange was the only reason the company was profitable in the second quarter.
Not in that boat
With Rhino's debt at about a third of the capital structure, it's highly unlikely that it would have to pay 10% to issue debt. Insolvency, meanwhile, seems a remote concern, at best. In fact, its main long-term debt costs around 5%, thus the low end of the spectrum.
Alliance Resource Partners (NASDAQ: ARLP ) , however, has debt outstanding with interest rates as high as 8.3%. Long-term debt accounts for about 50% of its capital structure, which isn't outlandish but isn't that far off of James River's total. That said, Alliance is probably the best performing coal miner in the industry. It reported record results in the second quarter and increased its distribution again—something it has done at least annually for a decade.
If the industry's standout player, and perhaps one of its best investment options, is paying more than 5% on its debt, it's reasonable to think that Rhino's actual costs would be higher than its existing debt. But more than 10% would be unlikely, and 14% is even less likely. From a unitholder's perspective, then, Rhino should have issued debt over shares, or least considered some combination of the two.
That it didn't shows an extreme aversion to debt. That's not completely unreasonable, particularly given coal's current travails. But the decision is costing unitholders money today and that is something that can't be forgotten.
A cautionary tale
Of course it's worth noting that Walter Energy (NASDAQOTH: WLTGQ ) loaded itself up with debt to fund an acquisition at the peak of the met coal market. It has since written off $1.1 billion, taken from shareholder equity, amended a credit agreement, and, perhaps more tellingly, trimmed its dividend to a token penny a share. That kind of post acquisition transformation probably wasn't what investors were hoping for.
That said, the shares now have notable upside potential after falling around 90% since early 2011. And its chances of muddling through to a coal rebound are much higher today than before the amended credit agreement and dividend cut.
So, perhaps, issuing new units isn't such a bad call for Rhino based on the market environment. That said, the decision increases the importance of a coal expansion project set to come on line in mid 2014 and the partnership's continued push into oil and gas drilling. While both should add to distributable cash flow, investors are shouldering a heavy burden today for the uncertain potential of improved results. You should keep a close eye on the progress of Rhino's expansion efforts and consider jumping ship if the partnership's outlook starts to sour.
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