| 2019 | 2020 | ||||||
| Price: | 38.84 | EPS | 12.66 | 13.76 | |||
| Shares Out. (in M): | 12 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 475 | P/FCF | 3.1 | 2.8 | |||
| Net Debt (in $M): | 978 | EBIT | 0 | 0 | |||
| TEV (in $M): | 1,453 | TEV/EBIT | 0 | 0 | |||
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Natural Resource Partners (NRP) trades at 3x free cash flow to common equity with growing cash flows, a rapidly improving balance sheet, and easily identifiable catalysts that will occur in a few weeks when they report their 4Q results, in late March when they (probably) refinance a big chunk of their most expensive debt, and in February 2020 when they (probably) refinance their even-more-expensive convertible preferred units. Following this balance sheet improvement, NRP’s earnings power should increase by 43% compared to the trailing level, net leverage (including the preferreds) should fall from 4.2x as of 3Q18 to 2.7x, and NRP could quadruple its distribution while still leaving half its cash flows to continue paying down debt. NRP was written up on VIC a year ago, but the significant positive news in the last few months and the coming catalysts make now an opportune time to buy the stock and merit a new write-up that details all these changes.
Last year’s write-up provides the necessary background and is worth reading in full. In brief, NRP is a limited partnership that until recently owned three businesses:
As is typical for this type of business, NRP goosed returns to equity by leveraging its earnings stream with a lot of debt. The debt load almost wiped out the equity value when operating cash flows collapsed during the 2015-2016 commodities apocalypse. NRP avoided bankruptcy by cutting the distribution to common unitholders by 90% and entering two financing deals that saddled it with very high cost debt and preferred units. The capital structure as of September 30, 2018, was as follows:
NRP’s operating cash flows rebounded as the underlying commodity markets recovered, and they have been relatively stable for the last year. The trailing 12-months cash flows are:
Distributions to common unitholders have stayed steady at 0.45/quarter. Management has been using every penny of remaining cash flow to pay down debt. Doing so has significantly decreased the interest expense and therefore significantly increased the cash flows, which has further increased the ability to pay down debt, etc., in a virtuous circle.
During 4Q18 the company announced two favorable developments that will accelerate this virtuous cycle. The first was a litigation settlement in October 2018. NRP has leases with Foresight Energy for coal operations at the Deer Run mine. Deer Run experienced safety problems, and Foresight shut down its operations “indefinately.” NRP alleged that Foresight over-extended the shut-down for economic reasons rather than safety reasons and that NRP was not receiving the minimum royalty payments to which it was entitled. The parties settled this litigation in October, and as a result NRP received (during 4Q) a one-time payment of $25m and will receive ongoing minimum royalty payments of $11m per year.
Second, in November 2018 NRP announced that it had sold its aggregates business for $205m. The aggregates business had decent EBITDA but also had relatively high capex, such that its trailing 12-months cash flow was only $7.5m. Thus the sale generated substantial proceeds without sacrificing much ongoing cash flow. In my modeling, I treat the addition of the $11m from Deer Run and the subtraction of the aggregates cash flow as a wash and assume steady operating cash flows.
Given the terms of its debt, NRP can use these proceeds and its ongoing cash flow to substantially improve its balance sheet and its ongoing cash flows over the next 13 months. Although the 4Q events were publicized in press releases, they have not yet shown up in reported financial results and do not appear to be reflected in the stock price. (This stock is a minimally-followed small-cap with essentially no sell-side coverage). The stock should react well to the coming sequence of catalysts:
Although management will not commit to any particular course of action, here is my best estimate of how events should progress:
#1 – 4Q EARNINGS RELEASE IN EARLY MARCH
The Deer Run settlement ($25m) and the aggregates sale ($225m) generated $230m of cash that has not yet been reported in its earnings releases or SEC filings. Distributable cash flow for 4Q, after preferred and common distributions, should be roughly $33m. Thus net debt should fall from $978m as of September 30 to $715m as of December 31. Net debt/EBITDA (including the preferreds) will fall from 4.2x to 3.1x.
The Opco notes require NRP to use 25% of any business unit sales proceeds to prepay principal pro-rata among all the notes. 25% of the $205m aggregates proceeds is $51.3m. The blended interest rate on the Opco notes is 5.7%. Thus the interest expense savings from this paydown is $2.9m per year.
#2 – 3/25/19 8.38% OPCO NOTE MATURITY
The next maturity date among the Opco notes is March 25. (The next one after that is in July 2020, after all of the steps detailed here.) Fortunately, this note has one of the highest interest rates among all the Opco notes, 8.38% versus a blended average rate for all Opco notes of 5.7%. As of September 30, $21.3m of these notes remained outstanding. $3.0m should have been repaid in 4Q as part of the aggregates proceeds paydown requirement, leaving $18.3m to mature on March 25. Paying off these remaining notes will save $1.5m in annual interest expense.
#3 – MARCH or APRIL – 10.5% HOLDCO BOND REDEMPTION
The 10.5% Holdco notes are the second-most onerous liability on NRP’s balance sheet. They become redeemable on March 15, with a 5.25% prepayment premium. The decision to pay the 5.25% premium should be a no-brainer given the likely interest rate savings, compared to either the interest rates NRP can receive on cash (~2%) or the rates NRP may pay on newly-issued debt (perhaps 6% given NRP’s drastically improved balance sheet and cash flows since the 10.5% financing).
As of late March, before any Holdco note prepayment, NRP’s cash accumulation since 9/30/18 should be:
$345.6m of 10.5% Holdco notes were outstanding as of 9/30/18. With a 5.25% prepayment premium of $18.1m, the total refinancing obligation is $363.7m. NRP can use its $201m of new cash available and will need to sell $162m of new debt to fund the remaining prepayment. The gross interest savings from eliminating the 10.5% notes will be $36.3m. If new debt can be issued at 6%, the annual interest cost of the new debt will be $9.7m per year. The net annual interest savings from all the 4Q-1Q transactions will be:
Thus NRP’s earnings power will increase by $31m above what it was in 3Q18, as of the start of 2Q. On a trailing annual base of approximately $122m cash flow available to common, that is a 25% increase, to $153m.
#4 – FEBRUARY 2020 – CALLING THE 12% CONVERTIBLE PREFERREDS
After tackling its second-worst liability (the Holdco 10.5% notes) in March or April 2019, NRP can take out the worst liability, the $250m of 12% convertible preferreds, in February 2020. These preferreds are onerous on first look but give NRP a clear out that NRP should take, almost precisely a year from now and not a day sooner. The onerous terms are the 12% coupon rate, the potential dilution upon conversion to common units at a 7.5% discount to the units’ then-recent market price (using VWAP), and – most importantly – the premium required for NRP to call the notes
The headline call premium is currently 1.5x the face amount and rises to 1.7x after February 22, 2020. However, the premium gets reduced by the cumulative amount of all distributions paid to the preferreds. Because every dollar of distribution paid becomes a credit against the call premium, the preferreds are effectively zero-cost capital for NRP between now and the date that the premium multiple jumps. Thus NRP should choose to call the preferreds on February 21, 2020, just before the call premium multiple jumps to 1.7x. At that point NRP will have paid $90m in preferred distributions.
The call obligation as of February 21, 2020 will be:
From 2Q19 through 1Q20, NRP will generate roughly $130m of cash flow, after distributions to preferreds and common, that will be available for debt paydown. That leaves $155m of required new financing. At a 6% interest rate, the new interest cost would be $9m. NRP can thus replace a $30m annual preferred distribution obligation with a $9m interest expense, for a net savings of $21m. Cash flow available to common (after preferred distributions) will increase from $153m to $174m, another 14% jump and 43% above the current trailing-12-months level.
As of the end of 1Q20, 13 months from now, P/FCF will be down to 2.7x and net debt should look like this:
Net debt to EBITDA (including preferreds) will have fallen from 4.2x as of 9/30/2018 to 3.1x as of 3/31/2019 to 2.7x as of 3/31/2020. At that point, management should finally begin increasing the distributions to common unitholders. With cash flow to common of $174m, management could quadruple the distribution to $88m per year (a 20% dividend yield on the current price) and still leave half of the cash flow available for further debt paydown, with further distribution rises likely going forward. If the stock price hasn’t risen in anticipation by then, it would likely do so then to drive the distribution yield back down to something remotely reasonable.
RISKS AND ONE SEMI-HIDDEN COST
With 80% of operating cash flows now coming from coal, the obvious primary risk is that coal volumes or prices fall back down. This risk appears manageable and more than compensated for by the equity price. Coal producers (including NRP’s lessees) are far healthier than they were going into the 2015-2016 decline, industry excesses have been wrung out, marginal production has exited, and the underlying steel industry that buys 2/3 of NRP’s coal is itself much healthier. The likely catalyst for a coal downturn would be a recession, and we expect the next recession to be a garden-variety one and not a cataclysmic financial crisis like 2008-2009. NRP itself is much healthier and able to withstand a downturn, with net leverage down from 5.8x as recently as 1Q17 to 3.1x today.
Another risk is that credit markets freeze up and NRP is unable to refinance at the rates it could get today, if at all. Although NRP can simply wait out the credit markets for purposes of refinancing the 10.5% notes, it has a hard deadline of 2/22/2020 for the preferreds before the call premium jumps to 1.7x. Because the most obvious catalyst for a credit market event is the same catalyst as for a coal downturn -- a recession -- and because the current consensus estimate for the start of the next recession is right around 1Q20, these are very real risks. If I were NRP's management, I might issue the new debt required to finance the call at some point during 2H19, in advance of the call date. The surety of debt demand would be worth the few $million of one-time added interest expense.
The semi-hidden cost: As a limited partnership, NRP pays no income taxes and passes on the tax liabilities to its unitholders. Obviously a given level of cash flow or distributions from an MLP is not worth as much (after taxes) as is the same cash flow or dividends from a C-corp. In addition, NRP's GAAP net income, on which unitholders will owe taxes, is about $7.50/unit (in 2018) while unitholders are receiving "only" $1.80 in distributions. One of our VIC colleagues has characterized this arrangement as a sneaky form of negative carry. We are happy to pay that carry given the potential upside.
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