Natural Resource Partners (NYSE:NRP), the coal-related master limited partnership, has traded with a distribution yield of 10%+ for most of the past two years. This is unusual. Typically, when a MLP's yield languishes at 10%+, that company is experiencing difficulties and is forced to cut its distribution.
Distribution safe, but not growing in the near term
Natural Resource Partners is stuck in the middle, by no means in a bad place operationally or financially, but not yet ready to increase distributions either. The company has maintained the same quarterly distribution for the past nine quarters. At $20 per unit and a $2.20 annual distribution, the yield is a hefty 11%. With a cash balance over $100 million, nearly enough to cover two full quarterly distributions, I believe Natural Resource Partners is a relatively safe investment.
Compelling risk/reward vs. coal producers
By relatively safe I mean Natural Resource Partner's units are far less volatile and have far less downside than coal producing peers like Walter Energy (NASDAQOTH:WLTGQ), Peabody Energy (NYSE:BTU), Arch Coal (NASDAQOTH:ACIIQ) and Alpha Natural Resources (NASDAQOTH:ANRZQ). Each of these four producers have seen meaningful rallies in their stock prices. However, they remain loaded with debt from poorly timed acquisitions in 2011. Margins have been squeezed as per unit costs have declined less than coal prices. Coal prices would have to rise 15%-20% to support another substantial spike in these stocks. Natural Resource Partners did not rally and does not require a spike in coal prices to be a star performer.
Last month I spoke with a senior executive at Natural Resource Partners about the company's active diversification strategy, the state of the coal markets, and America's growing energy production. I also spoke with Steve Doyle, Founder and fearless leader of Doyle Trading Consultants, or DTC. Steve has over 30 years of coal market experience and has followed Natural Resource Partners closely since the mid-2000's. [Disclosure: Steve Doyle is a longtime owner of units in NRP].
The following Q&A session is between myself (Peter Epstein) and Steve Doyle.
Peter Epstein: Steve, thank you for your time and expert opinion. Broadly speaking, why does Natural Resource Partners get no respect?
Steve Doyle: Very few investors understand coal, let alone coal MLP Natural Resource Partners. Too few take a long look under the, 'coal hood'. I can understand why investors would value publicly traded coal companies where they are currently trading. They pay little or no dividends, have large workforces, their debt ratios are high and credit ratings low, they have significant operational and margin risk and they have loads of poorly understood reclamation and legacy liabilities.
On the other hand, Natural Resource Partners derives the bulk of its revenues from the coal sector, but has a tiny workforce, yields 10%+, has no legacy liabilities and takes no margin or operational risk. The company owns coal and non-coal reserves as well as operational infrastructure, but its revenues come from royalty and usage payments. In addition, the company has made giant steps in diversifying its revenues into industrial materials and Oil & Gas.
Peter Epstein: Are you implying NRP is risk-free?
Steve Doyle: Of course not. In the case of coal, if the price is so low that the company's lessees cannot operate, the coal-related royalties dry up. That risk is mitigated in five ways: 1) Diversify by coal basin; 2) Diversify by coal type-coking coal vs. thermal; 3) Diversify by making sure you're the bulk of the lessees will be among those that can survive in a downturn; 4) Diversify by dividing your coal sector revenues into royalties on coal sales and payments for usage of logistics infrastructure; 5) Diversify into non-coal revenues, so that the cyclical nature of the coal sector is evened out.
Peter Epstein: What's the significance of NRP's investment in OCI, and of OCI's intentions to become a MLP?
Steve Doyle: Natural Resource Partners has diversified over the years into oil & gas, aggregates and industrial minerals. In Q1, the company acquired Anadarko's 49% interest in Wyoming-based OCI, which mines and refines trona (soda ash), which has solid economic fundamentals. This was a very material investment, a cash outlay of $292.5 million. plus up to $50 million in earn-outs. OCI recently announced it would create a MLP from its holdings. This is great news because as a MLP, OCI's interests will be completely in line with that of Natural Resource Partner's.
Peter Epstein: In what key ways does NRP's coal reserve revenues hold up better than that of coal producers? How about its coal infrastructure revenues?
Steve Doyle: The coal royalties are based on the price of coal, not the coal miner's operating margin. Cost creep actually works in NRP's favor as long as the market can absorb the full costs. The bulk of NRP's infrastructure is located in one of the most attractive coal basins in the world – the Illinois Basin.
Foresight Energy's longwalls produce enormous volumes of low-cost coal that flow through washing plants and rail/barge load-out facilities owned by NRP. Those revenues are not as sensitive to the coal price as coal royalties.
Peter Epstein: Do you have a sense as to whether NRP's coal reserve and coal infrastructure revenues have bottomed?
Steve Doyle: I would reckon its infrastructure revenues will continue to increase in tandem with Foresight Energy's production. The coal royalty revenues might tick down a bit as thermal shipments decline in Central Appalachia, as higher-priced legacy contracts with utilities expire and as the final bottom to the coking coal revenues flows through its lessees' books. On the other hand, DTC is forecasting utility demand to increase by 50 million tons in 2014, which means NRP might lose some business in Central Appalachia and gain some in the other coal basins.
Peter Epstein: How big a contribution might the company's industrial minerals business make to the overall story?
Steve Doyle: I believe the coal royalties and coal infrastructure will continue to serve as the primary revenue generator, but I would not be surprised to see the non-coal revenues grow to more than a third of the total.
Peter Epstein: Non-coal related MLPs trade at distribution yields of about 5%-8%. Do you have a view on what distribution yield bucket NRP should be in?
Steve Doyle: Let me put it this way, I bought most of my units in Natural Resource Partners when they were in the $25 range, yielding about 8.5% at the time. Back then I could hardly believe that I could own such a solid company and earn 8.5%! Before I sign-off, I want to touch on one important factor-- the management team.
I can tell you from personal experience that outstanding assets don't necessarily perform in an outstanding manner unless stewarded by talented people. CEO Corbin Robertson and President & COO Nick Carter have sterling reputations and have an uncanny ability to identify value and successfully execute transactions. That provides me with a high level of comfort.
An 11% yield is hard to find. Junk bond yields are below 7%, the 10-year Treasury is under 2%, blue-chip telecom and utility stocks 3%-5%, and energy-related MLP's 5%-8%. If one is comfortable like I am that this 11% yield is safe, then Natural Resource Partners offers a compelling risk/reward opportunity. I believe the company's quarterly distribution will begin to grow again within 12-18 months.
Once the market sees a modestly growing distribution, the hurdle rate to own NRP units should fall dramatically. From 11% a decline to 9% implies a unit price of $24.5, 22% above the current price. Therefore, over the next two years investors could pocket 11% x 2 = 22%, plus an additional 22% in capital appreciation = 44%.