Description

Nacco is among the least expensive stocks I’m aware of, in large part reflecting a coal mining business that is likely to decline over time, as well as being a controlled small cap with limited investor awareness. The company is transitioning its business from coal mining to the mining of aggregates, phosphate and lithium. Nacco also owns oil and gas royalties dating back to its prior ownership of Appallacian coal mines. I think the current share price undervalues the company’s newer businesses. The current EV is $215 million, and I think the company will generate more than $70 million of EBITDA and $50 million of free cash flow when natural gas prices recover to $3/Mbtu. Even in this period of low gas prices I estimate the company should generate at least $50 million of EBITDA, much of which converts to free cash flow prior to investments in royalties and new equipment for mining expansions.

That said, this is an illiquid micro-cap ($230 million market cap, trades 10K to 15K shares per day, or about $300,000 dollar volume). Executives and founding family members (the Rankin family) own 30% of A shares outstanding and 82% of B shares outstanding. Class B shares have ten votes versus a single vote for class A shares. There are 5.9 million class A shares and 1.56 million class B shares giving the 82% class B holders 68% of total company votes. The CEO, JC Butler, who has a long tenure with the company, is married to a Rankin family member.

A risk with controlled companies is self-dealing. The CEO and board are well paid relative to the size of the company. However, I’ve found management to be thoughtful about how they allocate capital, and they appear to be effectively expanding beyond coal mining. The company also pays a dividend and buys back shares. Despite having lost a third of its coal production to closures over the last six years, Nacco is tracking towards record earnings next year. That excludes earlier spin-outs; Nacco spun Hyster Yale (ticker HY, fork-lift trucks) in 2012, and Hamilton Beach (ticker HBB, consumer products) in 2017. Much of the company’s historical value was in Hyster Yale, and that stock, inclusive of dividends, has performed relatively well.

Nacco’s coal mining business contracts with nearby utilities to mine and deliver coal on a fee basis. Of its four operating mines only one (Mississippi Lignite and Mining Co, or MLMC) is consolidated and responsible for capital outlays. The company is finishing a major capital project at MLMC which should improve profitability on completion. Note that MLMC’s revenues are currently understated because its customer, Red Hills Power, which supplies power to Tennessee Valley Authority (TVA), is operating with one of two boilers down. This should be fixed later this year with production returning to normal. I estimate normal EBITDA of this fully owned asset of around one to two million per quarter, as opposed to a current operating loss of roughly $5 million per quarter. MLMC’s contract with Red Hills expires in 2032 at which point the contract could be extended or the mine closed. For now, TVA needs the power. The direct owners of Red Hills have faced financial pressures in the past, I think in part due to fixed price contracts with Nacco and variable resale margins. TVA would potentially backstop that plant should it be required, at least in the current environment where they need baseload power. 

In addition, Nacco has three standing coal contracts with North Dakota power plants, Falkirk, Coyote Creek and Coteau. I estimate these plants currently contribute roughly $7 million per quarter of EBITDA. Note that these assets are held as VIEs and reported as unconsolidated income, although there is some consolidated SG&A. The Coteau plant is on track for a price improvement later this year, which relates to the sunsetting of a prior concession related to that asset’s sale.

While some or all of these plants will eventually be replaced with gas or retired, for now North Dakota has litigated on behalf of coal production, the state needs the power, new natural gas plants face long lead times, and EPA regulations are tied up in litigation. Also, with the exception of MLMC where Nacco will be on the hook for reclamation costs, the company will likely receive several years of payments to restore and remediate the land around its three VIE mines post closure. That is what happened when Sabine, which was also operated under a fee contract, closed. The fee income paid for land restoration starts around the level of the operating mine fee income and then declines over several years – from a modeling standpoint I assume it adds two years to the project life.

The coal business is capital light. For the unconsolidated operations Nacco operates on a fee basis and is reimbursed for capital costs. For MLMC the company is at the tail end of a capital outlay and has no incentive to invest further given the 2032 contract expiration.

I value this part of the company on a terminal NPV basis assuming that all operations end in 2032 but that the company receives two more years of reclamation fee income for the VIE assets, less five million of annual reclamation expense in 2033 and 2034 at MLMC.  Once MLMC is fully online this year I estimate the four coal mines will earn roughly $9 million in EBITDA per quarter or $36 million per year, with 75% of that converting to after-tax free cash flow. This equates to roughly a $150 million NPV at a 13% discount rate.

That brings us to Nacco’s three other businesses which are expanding and have long earnings runways ahead of them.

North American Mining

NA Mining provides mining and excavation for aggregate mines. The company also recently signed contracts to mine phosphate and lithium. Nacco has unique expertise operating and maintaining draglines, massive excavators used to mine aggregates and phosphates among other materials. The company works on a fee basis with multiple aggregate producers including Cemex (its largest customer) and Martin Marietta, and recently signed its first phosphate contract, which could provide a growing source of new business. This business has grown rapidly, expanding from $11 million EBITDA on $90 million of revenue last year to run rate EBITDA of $18 million on $100 million of revenue as of last quarter.

That growth should continue given recent awards, which include a new phosphate mining project as well as Nacco’s lithium contract at Thacker Pass in Nevada for Lithium America (LAC). This activity is closer to the company’s coal mining activity, involving a blend of mining and earth moving equipment. This contract should more materially revenue and earnings producing in 2027, when I forecast it could contribute $5 to $10 million in EBITDA taking total division EBITDA above $30 million per year. Nacco will also be reimbursed over five years for capital expense related to this work, which will add to free cash flow. As of year-end 2023 Nacco had invested $23 million on equipment for the project.  

Mineral Management (royalties)

Nacco’s royalty business started with its legacy coal assets in Appalachia. The company has other legacy reserves in the Williston Basin in North Dakota. As it became clear fracking was going to vastly increase the value of natural gas reserves on these landholdings the company formed Catapult Mineral partners as a subsidiary to manage royalty interests. Since then the company has invested roughly $100 million in royalties over the last several years, adding to both oil and gas reserves in the Permian basin, Powder River Basin, and Gulf Coast. The company currently has 63,000 net royalty acres across those basins.

Nacco is currently earning roughly $25 to $30 million in annual royalty income, however this understates the potential of this business because the portfolio is unhedged and skews towards natural gas, currently at multi-year lows. In 2023 the portfolio generated $28 million of EBITDA on $33 million of revenue. Assuming similar go-forward fixed costs, and a 50% increase in gas prices (roughly consistent with forward curves), the division would be earning roughly $45 million of EBITDA. As of 1Q24 the division was run-rating $36 million EBITDA, although the company guided to modestly lower rest of year numbers.

Note that Nacco’s management describes its Appalachian reserves as mature, although not a lot of detail has been provided. The company’s investor deck indicates that privately held Ascent Resources is one of three primary operators on its leasehold land. Nacco’s total royalty acres are about 10% of Ascent’s leasehold acres, so it’s possible that Nacco’s acreage is the worst part of Ascent’s land.  In any case, Ascent lists 13 years of inventory in the Utica and 5 years of inventory in the Marcellus. Nacco management implied on a recent call that through its continued investment in royalties it is growing its overall oil and gas reserves, even as it depletes the Appalachian reserves.

Land Remediation, Solar  The company has leveraged its coal mine restoration expertise to expand into mine and other land remediation more broadly. This business line is expected to become profitable in 2025. Nacco is also using this expertise to prepare abandoned mines for solar fields. It’s still too early to guess at the profitability of reclamation activities, which are largely realized through environmental credits. That said, this will be additive to profitability over time.

Valuation

Coal: I estimate a ten-year life with EBITDA of $36 million per year over the next decade and fully taxed free cash flow of $20 million in 2024 rising to $27 million in 2025-2034. Using a 13% annual discount rate I estimate NPV of $150 million.

Royalty interest: With current royalty income run rate north of $30 million, even with natural gas at current lows, I estimate $240 million of value using an 8x multiple. Hard to find a true comp here – some trusts have more oil exposure, so they are pricing off better commodity price. BSM, which is a larger more liquid stock, trades around 9x cash flow but is benefitting from hedges. San Juan Basin Trust is trading at a low double digit multiple on run rate earnings. 8x seems reasonable given those comps and the likelihood the division is underearning -- I forecast royalties around $45 million on $3/mmbtu natural gas.

For North American mining, I estimate $25 million 2025 EBITDA and I think this will go higher in 2026 with Thacker Pass coming online. I’ve applied a 6x multiple of EBITDA to this division, implying $150 million in value. That seems reasonable given the business is steadily growing, the contracts are long term, and cash conversion is high.

Finally corporate costs are roughly $20 to $25 million per year. I’ve capitalized this at a blended company multiple of 6x, for a negative value of $150 million.

Sum of parts values:

North American Mining: $150 million

Mineral Management at 8x current royalties: $240 million

Coal mining: $150 million

Less capitalized corporate expenses: ($150 million)

Total value: $390

Current EV (net of $15 million net cash): $215 million

I’d note also that I expect the company to generate a substantial amount of cash over the next few years, which could lift the fair value projections – ie, the NPV is front end loaded. Before growth capital, I estimate NC could generate most of its current EV over the next few years. And that’s without assuming significantly higher natural gas prices.

Where I could be wrong:

1. Controlled entity, insiders could get greedy and take more share-based comp, or eventually take private on unfavorable terms. While this bears monitoring I think a significant change in policy is unlikely given how long the company has been in operation with an established corporate culture. Nacco’s recent earnings calls provide some context in this regard.
2. Coal assets could decline or shut sooner than I model. Coal is close to half of my sum of the parts value, and so this would have an impact. That said, I think the risk my calculation is off by more than $20 million or so is low. The NPV is front end loaded, and nothing is likely to happen over the next few years. Power demand is growing faster than power generation, NC’s customers need baseload power, and even if plans were made today to replace all the generation with gas and renewables it would take four to five years to build. Combine that with a couple years of reclamation/remediation revenue and you’re already close to my NPV.
3. Royalty assets could deplete faster than I think. Nacco has said its Appallacian acreage is mature. They have added a lot of acres in other plays, but they don’t provide much detail on those investments. Anecdotally they have indicated they continue to grow long term reserves for both gas and oil.
4. The expansion of mining revenue could be less dramatic than I’m assuming. I need to learn more about how the company is gaining contracts in this division given the customer base is mature – Cemex isn’t opening a lot of new aggregate mines. That said, my assumptions seem fairly reasonable given recent results and with Thacker pass coming online in 2026.
5. MLMC’s Red Hills customer is undercapitalized and recently restructured its debt. TVA is the end customer for that power and might at some point be required to provide financial support, which creates some contractual uncertainty.
6. The company will incur retirement costs for MLMC when it ceases operation, potentially in 2032. These, in combination with residual costs on other mines, are currently estimated at $53 million. I haven’t included these in my sum of the parts, but I also haven’t included substantial non-cash net working capital. Currently the company is incurring  around $2 million per year cash costs on asset retirements.
7. A big question is how well the company allocates its substantial operating cash flow. I think the track record in recent years is encouraging but we’ll only know in hindsight if they bought royalty stakes well, grew their mining relationships, and realized substantial cash flow from their coal mines.

Catalyst

Time, time, and more time.