Description

Summary and Thesis:

At current levels, we believe that Nacco (NYSE:NC) represents a compelling risk/reward opportunity and possess a near term catalyst that will simplify the business and, we expect, start the path towards value realization. We believe NC is mispriced because of its relative complexity and because it’s a controlled company (subpar trading liquidity and zero sell-side coverage further contribute to the discount). We believe those externalities create a compelling opportunity where fundamental downside is minimal and fair value is 40%-80%+ above current levels.

NC is composed of two wholly unrelated businesses:

1)     Hamilton Beach Brands (HBB) – a leading brand for various kitchen/cooking small appliances

2)     North American Coal (NACoal) – largely a contract coal mining business that operates under secure LT contracts that insulate NACoal from commodity price risk

(NC also owns The Kitchen Collection (http://www.kitchencollection.com/), a retailer of cooking/kitchen appliances and accessories, but we value this business at $0 and won’t spend any time discussing it. It might be worth something more than $0, but likely not materially more.)

There are zero synergies between the businesses. Moreover, on a run-rate basis there is ≈$8mm of corporate costs. We believe those costs would swiftly go away were either/both businesses acquired by strategic owners and there would be material synergies beyond that (also, a not insignificant amount of corporate expenses are pure public company costs).

For further background on NC, I’d highly suggest the Company’s Presentation (http://s2.q4cdn.com/648240483/files/doc_presentations/NC-Investor-Presentation-Final-32717.pdf) and of course 10K, both of which do a solid job of providing historical background on NC, good explanatory detail on the Company’s businesses, and lay out the financial objectives referenced in this memo.

Our investment thesis for NC can be summarized as follows:

1)     Shares are undervalued

2)     The announced spin-off of HBB is likely the first step towards full value realization

Shares are undervalued:

NC currently has an enterprise value of ≈$550mm. On an LTM basis, NC generated EBITDA of $90mm and EBIT of $71mm, yielding EV/EBITDA and EV/EBIT multiples of ≈6x and ≈8x respectively. Those multiples are appropriate for capital intensive, highly cyclical, or declining businesses – not for capital light, very moderately cyclical, and fundamentally healthy businesses.

More to the point: we believe that the current EV of NC is supported by HBB alone. Specifically, HBB generated $49mm of LTM EBITDA and $44mm of LTM EBIT. Based on appropriate public market and private transaction comparables, fair value is north of 10x EBITDA with optionality to a much higher multiple.  At its current EV, NC trades at ≈11x HBB EBITDA. Additionally, the significant majority of NC’s gross debt is non-recourse debt specific to individual projects within NACoal. In the theoretical scenario where NC lets NACoal die, the residual EV would imply ≈9.5x EBITDA for HBB.

And we believe that NACoal is a good business reasonably worth $40+/share (gross of allocated debt).

A spin-off of HBB is likely the first step towards full value realization:

On August 21, 2017, NC announced that it would spin-off HBB (http://nacco.com/news-room/news-releases/news-releases-details/2017/Hamilton-Beach-Brands-Holding-Company-Files-Registration-Statement-Relating-To-Proposed-Spin-Off/default.aspx).

We believe that the HBB spin will simplify the situation and ultimately result in an acquisition of HBB and a MBO of NACoal. In the interim, we expect shares to generally move in the right direction as the newly emerged pure play companies attract increased investor attention and both businesses continue to execute and grow.

HBB:

HBB sells well regarded cooking/kitchen appliances. In addition to the referenced Company presentation, I suggest a perusal of the Company’s website to get a sense of their products (https://www.hamiltonbeach.com/). Products are typically oriented to the middle-market consumer, but HBB also has higher end products, a growing commercial presence, and fairly robust Int’l sales.

The business model is asset light as 100% of products are manufactured by 3^rd parties.

We’ve spoken with a number of participants in the industry and HBB has consistently been described as a high quality operation. It’s the Toyota of the small appliance world – nothing flashy, but well-engineered and affordable.  HBB management has a good reputation. Industry contacts have also noted HBB’s strong AMZN presence, a benefit of having been an early mover in the space to take e-commerce seriously.

That said, HBB hasn’t grown over the past decade (though it has shown a remarkable degree of steadiness). HBB isn’t alone in that department with other mainstay brands benefiting little from the fairly impressive growth the small appliance industry has experienced over the past decade which has largely gone to newly new brands and products. Presented below are HBB’s summary results since 2010:

Based on our work, we believe LTM results are sustainable and that HBB can improve upon them.

HBB’s financial objectives are $750mm in revenue and 10% EBIT margins. Our base case assumes LTM/run-rate earnings and our bull case assumes modest improvement beyond that. To the extent HBB can approach its objectives, there is significantly greater upside than our scenario analysis implies.

NACoal:

While NACoal isn’t AMZN, it is also very far from a typical coal business. NACoal is an industrial services business which happens to be operating in the coal industry. But it’s absolutely not a coal business that should be lumped in with other miners.

NACoal operates under LT contracts signed with strong counterparties and structured to fully insulate NACoal from commodity price risk and material financial risk. As a result, earnings have demonstrated remarkably consistent growth (adjusting for the losses stemming from an ill-fated decision a few years back to mine coal with actual price risk, a decision NACoal is in the later stages of unwinding).

NACoal produces lignite coal for power plant customers co-located at the mine site. Because of its low energy density, lignite coal is not economically efficient to transport. However, a power plant located at the mine site can lock in low cost feedstock, resulting in a captive mine with a captive customer. The financing for each project is provided by the customer and the debt – which technically sits on NC’s balance sheet – is non-recourse to the parent company (NC). Reclamation costs are also borne by the customer. NACoal set up a bunch of such situations and signed LT contracts where the customer bears all direct financial risk and NACoal simply provides a service for which it is compensated on a cost plus basis.

NACoal’s earnings from its contract mining business is reported on the P&L in the line ‘Earnings of unconsolidated mines’ (the Company also provides full reconciliation to adjusted EBIT in its 8Ks). AS the table below presents, Earnings from unconsolidated mines have grown consistently through a range of macroeconomic and regulatory environments: 

The risks that NACoal faces are: 1) reduced volumes; 2) plant shutdowns. Although the plants NACoal serves are typically baseload plants, when natural gas prices are low enough volume displacement can occur. Additionally, because of natural gas price competition and because of regulatory issues, there always remain the risk of plant shutdowns. That said, we believe NACoal’s run-rate earnings level is very secure. Additionally, NACoal has visibility into the opening of new projects which will further boost earnings for the NACoal segment. NACoal has a stated goal of increasing ‘Earnings from consolidated mines’ by 50% above 2012 levels by 2020/21. Lastly, the Company has some similarly structured contract mining operations for other commodities (lime rock specifically) and is optimistic about the growth potential. Our base case assumes LTM/run-rate earnings and our bull case assumes modest improvement beyond that. To the extent NACoal can approach its objectives, there is significantly greater upside than our scenario analysis implies.

Corporate governance and path to value realization:

Setting aside the actual businesses, the biggest issue with NC is the controlled nature of the Company – members of the founding family control the Company through super-voting shares. (The controlled nature also results in poor trading liquidity which in turn results in the Company having zero sell-side coverage). Simply put: like other controlled companies, minority shareholders don’t have a say in the direction of the Company.

Although long-time CEO Al Rankin (grandson of NC’s founder) will be stepping down from his role following the spin, he’ll stay on as Chairman of both NC and HBB. And while HBB will be run by an independent CEO, NC’s new CEO will be JC Butler, a long-time NC executive who also happens to be Al’s son-in-law.

So there is no question that corporate governance issues are a large reason for the discount. Of course, without that issue the opportunity wouldn’t exist.

Importantly, the Company has taken various shareholder friendly actions in the past including repurchasing material amounts of stock, spinning-off its most valuable business Hyster-Yale (NYSE:HY) in 2012, and now announcing the spin of HBB (following the strong urging of shareholders – see 3Q16 CC for example).

In our experience, controlled companies may offer highly attractive opportunities when the discount is sufficiently large, the businesses are healthy and well managed, and there is a history of relatively friendly shareholder actions. Good things tend to happen and we think that’ll be the case with NC.

Based on our work, HBB needs to go down one of two directions: either it needs to sell itself, or it needs to buy other companies. We expect that HBB may try the latter (and indeed that was noted on the spin-off CC) but will ultimately end up going the former. We think it’ll garner a high price. There are many buyers for the business (both strategic and financial). We would not be surprised to see keen interest from Chinese manufacturers looking to vertically integrate and move up the value chain – HBB’s brands and distribution would offer substantial opportunities.

With regards to NACoal, while we believe there are buyers for the business, we don’t expect the family to sell it. NACoal is the original business of the family’s empire and we expect it to say in the family. We expect that following a sale of HBB the family will take NACoal private.

We believe that full value realization is realistic over 18-36 months. And during that time, we expect shares to generally move in the right direction as the situation is simplified and both businesses continue to execute and grow.

Valuation and Risk / Reward Profile:

The table below presents our bear/base/bull cases for NC. In our bear case, we materially stress earnings and assume absolutely low multiples. Our base case assumes run-rate/LTM earnings and reasonable / low-end peer multiples. We believe that our bull case is eminently achievable over a 18-36 month period and if either business achieves the targets it has outlined, there is further material upside.

Risk:

-         HBB – macro and competition

-         NACoal – volumes and regulatory

-         Governance

Catalyst

See above