Description

Recommendation: Short NRP with price target of $10.85 (upside of 46.7%).

Thesis: We believe that NRP’s current dividend is unsustainable given declining coal prices, rising mining operating costs driven by legacy liabilities and depletion of reserves, and potential regulatory headwinds. In the past 2 years, the company has had a dividend coverage ratio of 40-80%, and has raised significant debt to meet distributions. In our base case, with the current dividend trajectory, we believe that NRP will face technical default by Q1 2013 (breaching 4.0x Total Debt/TTM EBITDDA ratio for senior note covenant). A cut in the dividend will trigger a heavy sell-off by the 43% retail ownership base (~75% of actively traded shares), and lead to a mid-term PT of $10.85 on a sustainable $1.085 dividend (assuming 100% dividend coverage ratio). We believe that investors will correctly read the underlying motives should management significantly cut CapEx, liquidate assets, or undertake other creative maneuvers to postpone a dividend cut.

A Brief History
National Resource Partners, L.P. (NRP) is a master limited partnership (MLP) that primarily owns and leases coal properties in the United States. Based in Houston, Texas, the partnership collects a majority of its cash flow by leasing coal reserves to mining operators who mine and sell coal in return for a royalty per ton. As of December 31, 2011, NRP has approximately 2.3B tons of coal and mining operators produced roughly 50mm tons of coal in FY 2011 (or fewer than 2% of probable reserves).

NRP as a Master Limited Partnership (MLP)
As an MLP, NRP is a publicly traded limited partnership that pays out a large distribution to shareholders. NRP’s partnership agreement requires the company to distribute all free cash less funds required for current and future principal repayments. As a result of this legal structure, NRP pays no corporate taxes at the state and federal levels. It should not come as a surprise that a large percentage of unit holders are retail investors seeking regular dividend income. With institutional ownership at 13.31% and an insider share of 43.60%, this stock has 43.09% retail ownership, significantly above average in the modern equity era. With heavy retail concentration, we believe a dividend cut will signal investors to re-evaluate ownership, leading to a potentially significant sell-off.

Revenue Segments

Coal Royalties
A vast majority of NRP’s revenue is driven by coal royalties. These payments are derived from leases with miners in the three major U.S. coal-producing regions: Appalachia, the Illinois Basin, and the Western United States. NRP’s total coal reserves are largely situated in Appalachia (83.38% of total coal reserves), with 67.46% of this share based in Central Appalachia. NRP’s lessees make payments on either the percentage of the gross sales price or a fixed price per ton, in addition to minimum payments.

Coal is defined by its two end-use markets - metallurgical and steam. Of the two, metallurgical coal (input in steel production) commands a higher price than steam coal (input for energy generation). Met-grade coal requires a specific range of chemical properties, including lower sulfur content compared to steam coal. 19.7% of NRP’s reserve base is metallurgical coal grade. On the thermal side (steam coal), higher sulfur content coal often warrants prohibitive scrubbing costs to meet environmental regulations. The table below breaks down coal reserves and characteristics by region.

             Total Deposit (tons in 000s)      Sulfur (%)     % Met Coal    Royalty per Ton
Northern                  494,463                        2.73%              1.93%              $3.92
Central                  1,280,958                       0.89%             30.98%              $6.66
Southern                  123,467                       0.82%             34.88%              $6.91
Total                      2,277,473                       1.54%             19.74%              $5.68

Processing and Transportation
NRP has recently moved into adjacent segments by acquiring processing and transportation assets situated near reserves. NRP leases processing assets to operators who typically pay based on a percentage of the gross sales price or a fixed price per ton. Transportation fees are recognized based on a fixed price per ton basis for the coal throughput. These revenues are driven by volume of coal mined by operators.

(in thousands)
                                      4Q10    1Q11    2Q11    3Q11   4Q11   1Q12
Transportation Fees      $2,921  $4,098  $3,745  $4,765  $4,080  $4,108
Fees / Coal Royalties    5.16%  4.73%   4.55%   5.19%   4.80%   3.55%
Processing Fees            $2,924  $3,089  $3,173  $3,967  $3,246  $2,126
Processing / Coal Roy   4.04%   4.61%   5.13%   3.89%  4.55%   7.49%

Royalty Minimums
The final major revenue driver, minimums recognized as revenue, has increased over the past few years. Royalty minimums are unearned revenues realized due to miners closing up shop in properties they lease from NRP. Normally, operators would be credited this fee upon future production; however, recent declines in the coal industry have forced mine closures. Proper interpretation of this top line growth should alarm investors to impending declines in coal output. The chart below clearly describes this trend.

(in thousands)
                                       4Q10         1Q11          2Q11        3Q11          4Q11        1Q12
Revenue                          $77,003      $4,098       $3,745       $4,765       $4,080       $4,108
% Growth                         16.84%      33.31%      13.72%      27.65%      25.97%     8.96%
Rev sans Minimums         $73,378      $84,067     $89,474    $102,189    $91,782     $80,436
% Growth                         11.68%      39.95%      16.38%       31.84%      25.08%    -4.32%

Other Revenue Segments
In addition to the segments mentioned above, NRP has more recently acquired mineral reserves (aggregates), oil and gas reserves, and other natural resources. The royalties generated from leasing these resources only accounted for roughly 5% of Q1 total revenues.

Industry Conditions
The current industry conditions can be characterized by the following trends:
1) Significant increase in natural gas supply and decrease in price driven by fracking innovation, power generation efficiencies, and pipeline build-out
2) A resulting shift in power generation from coal-fired plants to natural gas generation assets fueled by declining prices of natural gas and regulatory constraints
3) A historical decrease in coal imports and increase in coal exports, a trend which reached an inflection point in early 2012

As a competing input, the boom in natural gas has been a significant secular headwind for the coal industry. As of June 2012, inventory levels were at an estimated 3.1 trillion cubic feet, a roughly 23% increase year over year. Forward contracts confirm that natural gas prices should remain at depressed levels for at least the next 12 months.

      Avg Coal Prices      NatGas Price
             ($/ton)         (HH, $/MMBtu)

2002      17.98                  2.95
2003      17.85                  5.22
2004      19.93                  6.02
2005      23.59                  7.04
2006      25.16                  5.97
2007      26.20                  6.37
2008      31.25                  13.28
2009      33.24                  3.72
2010      35.63                  4.68
2011      39.43                  4.34
2012E   32.29                   2.87

The domestic ramp up in natural gas has left mine operators with excess production; this structural change has driven miners to export significant quantities of coal. From 2009 to 2011, coal exports increased from 59 to 107 MM tons (81%+), yet imports tanked from 22 to 13 MM tons. The table below details this trend.

Year       Exports (000s tons)              Imports (000s tons)
2006     49,647                                        36,246
2007     59,163                                        36,347
2008     81,519                                        34,208
2009     59,097                                        22,639
2010     81,716                                        19,353
2011     107,259                                      13,088

With the advent of a global slowdown and transportation costs steadily rising, the Energy Information Administration predicts a 14% YoY decrease in 2013 exports. The unabated rise in coal inventories shown below ensures that no catalyst for increased production will emerge over the next 3-4 months.

Million tons                  1Q11    2Q11    3Q11     4Q11     1Q12
Total Coal Inventory    197.6   198.0    177.6       204.3      222.3

The Good, the Bad, the Regulation
Regulation forcing retirements of coal power plants poses a significant headwind for the mining industry. Slated to go into effect in 2015, this legislation will take a toll on coal production throughout West Virginia; precisely where NRP derives much of its revenue. Consensus estimates call for more than 100 of the 500 coal plants in the United States to close in the coming years. This trend is already underway, as coal currently generates only 36% of U.S. electricity versus a 44.6% share one year ago.

Costs: Up, Up, and Away
Within Appalachia, the company operates in northern (NAPP), central (CAPP), and southern (SAPP) regions. Regional production is dependent on the maturity, quality, and operating costs associated with the corresponding coal reserves. While Appalachian coal has among the lowest sulfur and highest heat content, operating costs in the region have surged over the past decade. The table below shows the cash cost per ton for various miners in CAPP.

CAPP Cash Costs/Ton       2004      2005         2006        2007        2008         2009        2010      1Q11        2Q11         3Q11        4Q11        1Q12         2Q12E
Patriot                                                                $45.02      $50.83      $57.91       $57.13     $59.22      $64.46      $69.15       $79.36       $72.80      $74.16        Filed BK
Arch                                    $32.82    $41.01      $42.37      $40.16      $43.77       $48.12     $49.43      $59.07      $58.16       $67.62       $63.80      $70.95        $69.38
Alpha                                  $36.34    $44.35      $46.51      $47.45      $58.14       $58.00     $70.00      $71.30      $81.10       $81.74       $86.22      $77.50        $78.71
Massey Energy                  $29.11     $34.01      $40.90      $41.15      $46.61       $50.41     $60.05                              Merged with Alpha                                                        
James River                       $31.55     $38.14      $42.97      $44.60      $52.45       $63.87     $68.00      $76.82       $91.91      $86.35       $93.20      $85.81        $84.58  

Given that CAPP represents 86% of royalty revenues earned in Appalachia (equivalently, 71% of coal royalty revenues across all regions or 52% of total consolidated revenue), we will focus heavily on this region. Part of this cost surge has to do with maturity - CAPP is the oldest mining region in the country, and reserves have naturally been depleting over time. Additionally, CAPP has ballooning costs of legacy liabilities associated with mines. The mine workers in CAPP are heavily unionized and have negotiated lush benefits contracts that are pushing costs upward. Among these, operators have pension costs, workers compensation, black lung/health funds, and mine closure/reclamation costs. Patriot’s recent bankruptcy (which we discuss below) had much to do with these legacy liabilities.

Scaling Back the CAPP Footprint
At $3/MMBtu, natural gas is actively destroying demand for CAPP coal. Southeast power plants -the traditional customers of CAPP product - are now being supplied by gas pipelines. So what we have is a situation of rising costs and falling prices, with no meaningful catalyst for a trend reversal. Miners have been responding to these unfavorable conditions by closing high cost mines in CAPP. These closures are reflected in the Q4 2011 vs. Q1 2012 decline in cash costs per ton (see table above). From these numbers, it is pretty obvious that Alpha has been actively shutting mines in the region. We expect this trend to continue and accelerate due to the Patriot BK - miners are worried that further margin contraction will lead the market to reassess their overleveraged balance sheets. Alpha is at the forefront of these concerns, and we anticipate (in line with recent guidance) aggressive CAPP closures through the remainder of FY2012.

Unfortunately for NRP, Alpha alone represents 28% of total consolidated revenue (103MM of 378MM). While NRP management would have you think (see the 10-K and investor presentations) that ‘you get leverage to coal without the risks of a miner,’ that is certainly not the case. NRP is nothing but a coal pass-through which relies on the cash flows of miners for its coal royalty stream. These royalties are highly susceptible to declines in coal prices and increases in operating costs - both of which are at work here. As CAPP profitability erodes and the wave of mine closures intensifies, NRP will see a substantial decline in free cash flow.

The Proof is in the Pudding
From the basic production data, it is often difficult to conclude whether changes in output are being driven by temporary coal price volatility or structural shifts in the industry. NRP’s lessees vary their output based on steam and metallurgical coal demand (from power plants and steel producers, respectively). Given that consumption exhibits seasonal changes, we must take that into account in the production data. Below is quarterly CAPP output and the corresponding YoY percentage change.

NRP CAPP Output (Tons)  
                          4Q10     1Q11      2Q11      3Q11     4Q11      1Q12
CAPP Tons          6,638    7,327       8,023     7,406     6,799      6,535
YoY Change        9.40%  14.60%   15.10%   5.00%    2.40%   -10.80%

Tough to conclude anything here - though it seems like the decline might have begun in Q1 2012, output in prior quarters increased on a YoY basis. We would argue that a bump up in mid-year CAPP coal prices masked closures of high cost mines.

CAPP Coal Price/Ton
                          4Q10   1Q11     2Q11    3Q11    4Q11     1Q12
CAPP Price        $71.15    $75.2   $79.65  $80.15   $75.25   $65.85

A sanity check of this claim comes from a feature embedded in NRP’s lease contracts. When a miner idles production on NRP’s land, they must pay a quarterly minimum royalty. This fee can be recouped through future production within a designated time period. Minimum royalties are thus deferred revenue that is recognized on the income statement 1-2 quarters later only if the mine remains out of operation. These fees represent an excellent proxy for long-term mine closures and generally won’t catch a temporary stoppage of production. Below is a table of minimum royalty revenues as a percentage of total coal royalties.

Minimum Royalty Revenues
                                       1Q11    2Q11      3Q11      4Q11      1Q12
Minimums Revenue           $507    $1,841    $1,582   $5,218    $11,714
Mins/Total Coal Roy.         0.8%      2.6%       2.1%      7.7%       19.6%

It’s tough to brush aside the above trend; not to disappoint, NRP stated that the above spike reflected a one-off “agreement by Gatling Ohio, LLC to relinquish its recoupment rights, resulting in current year revenue recognition” (see 2012 Q1 10-Q filing). To its credit, NRP freely acknowledges that “production in the Central Appalachian region decreased due to some lessees choosing to idle mines” (ibid). We believe that these ‘temporary stoppages’ will morph into permanent closures over the next few quarters.

Illinois Basin: A Ray of Hope
Before we continue on with the CAPP gloom and doom thesis, we should take a moment to discuss NRP’s growth in the Illinois Basin. First, some background: the Illinois Basin is one of the major US coal mining regions, and has been continuously mined since the 1800s. In the 1970s, the area was producing some 140MM tons of coal; output fell to under 100MM tons in the 1990s (even as overall coal demand increased) due to the implementation of Clean Air Act regulations. For decades, the problem in Illinois was the high sulfur content of its coal; environmental restrictions ensured that burning the coal was untenable. However, with the advent of anti-pollution scrubber technology, Illinois coal can be burned in compliance with environmental statutes. Ironically, the stricter pollution laws have forced power plans to install scrubbers to burn any type of coal - now, the sulfur content difference between Illinois and Appalachia (its primary competitor) has become a moot point. With costs in the $20-30/ton range, Illinois coal is far more attractive to mine than CAPP coal with costs of $70+/ton. In Q3 2009, NRP signed a definitive agreement to acquire 200 MM tons of coal reserves near Hillsboro, IL (total purchase price of approx $255 MM). This significant acquisition will provide NRP with a strong foothold in the Illinois Basin with an additional production ramp-up of 2 MM tons in Q3 2012.

Risk in Concentration
A major risk to NRP’s cash flow stream - and therefore the dividend payment - is the lack of diversification in revenues. This might seem like an odd claim since the company has diversified revenues away from coal royalties (other revenue has risen from 25.67% of total revenue in Q1 2010 to 34.98% in Q1 2012). Don’t be fooled, as this other revenue statistic is highly misleading. The vast majority of the ‘other’ revenues come from processing, transportation, minimum royalties, and property taxes (which NRP in turn remits to the government). These revenue streams are derivatives of coal output and thus highly susceptible to production cutbacks. True non-coal revenue (defined as oil & gas and aggregates) currently amounts to 5.05% of total revenue, roughly where it was in early 2009.

Negative trends in coal pricing and output clearly raise the possibility of a free cash flow decline and subsequent dividend cut due to risk of breaching the 4x TTM EBITDDA debt cap (see later discussion on senior note covenants). The more alarming risk, however, is NRP’s complete lack of diversification among lessees. The table below presents the annual coal output and revenue associated with each of NRP’s major lessees.

                          Alpha        Arch      Patriot      Cline      BIG 4
App Total            12,740     4,266      3,260           -          20,266
NAPP                       -            366            -              -            366
CAPP                  12,740*    3,900      3,260*         -          19,900
Illinois                     -            363            -           8,600       8,963
Total Tons          12,740      4,629      3,260       8,600      29,229
% of Output        25.9%      9.4%       6.6%       17.5%      59.5%
% of Revs            28.4%      7.7%       5.7%       17.2%      59.0%

*Reflects a joint venture between Alpha (55%) and Patriot (45%) at the Dingess-Rum mine.
**The Big 4 have no exposure to SAPP or Powder River Basin

Given the last several weeks of turmoil in the coal industry, this level of lessee concentration is extremely troublesome; problems at Alpha or Arch could have dramatic consequences for NRP (Patriot BK effects on cash flow are detailed in the model section). As the market digests the Patriot restructuring and re-prices risks associated with coal miners, operators may be forced to begin a cycle of deleveraging and accelerate mine closures. Alpha’s levered balance sheet will likely become unattractive to Mr. Market; look for the company to slash CapEx and close CAPP mines. We have already received our first sense of Alpha’s Q2 CAPP production from the Mine Safety and Health Administration’s recent data release. With 6% of total expected output reported, production is down a hefty -19.8% Q/Q (see UBS MSHA Quarterly Production Playbook). While we don’t expect this to be the ultimate decline, a drop of 5-10% Q/Q seems inevitable.

Downside Protection?
The counter to this argument focuses on minimum royalties, as management frequently notes. In a recent industry conference, NRP’s COO remarked that “The minimum royalties that we would receive total about $110 million a year, which is about a third…of our total income” (see transcript for 2012 BB&T Commercial & Industrial Conference). Management views these minimum royalties as a hedge against coal price and/or output declines; retail investors (43% of shares outstanding, or 75% of actively traded shares) have interpreted this to mean the dividend stream is secure despite deteriorating macro coal conditions.

These minimums will certainly not replace the cash flows lost due to mine closures, and at best serve as basic floor for earnings generation. Pressure on future cash flows from reduced output puts the dividend stream at risk. Moreover, this forces the company to further leverage its balance sheet to sustain the large payouts (something which we view as untenable in the post-Patriot BK environment). Even if Mr. Market permits the company to continue piling on debt, the 4x Debt / TTM EBITDDA covenant on the senior notes negates this possibility. Reduced royalty payments (despite an increase in minimums revenue) will ensure that free cash flow does not cover the dividend payout; this forces NRP to initially increase its debt load, and ultimately cut the dividend or risk breaching the 4x covenant in Q1 2013. Below we present a table of dividend coverage and debt levels. Note that we assume NRP draws down from the revolver to pay off principal payments. Though there is plenty left to draw down from the revolver (~$300 MM with accordion feature of up to $500 MM), we highlight that this amount of leverage would breach the senior note covenant.

A few key observations to note: 1) It has been quite some time since the coverage was 100% or greater; NRP has been spending heavily on acquisitions to replace reserves and grow in the Illinois basin. 2) NRP has continued to grow the dividend despite deteriorating coal industry conditions. 3) Had it not been for the uptick in 2011 coal prices and a temporary reduction in acquisition spending, NRP would likely have breached the covenant in 2012. 4) As we discuss in the model section below, we were extremely generous with regard to future CapEx; we assume that NRP takes spending well below historical averages. 5) There is little margin of safety for NRP - EBITDDA does not need to decline substantially to cause a covenant breach. Several quarters of weak operating results are more than sufficient to draw down excess cash and reach the debt cap. Note that EBITDDA declines to late 2010 levels, but total debt has risen from 637.6MM to 995.7MM due to the consistently sub 100% coverage rate. 6) While our EBITDDA (and thus levered FCF, coverage, etc.) estimates may seem somewhat pessimistic, keep in mind the substantial deterioration in CAPP/general coal conditions (see previous discussion). In fact, the coverage ratio from Q2 2012 to Q4 2012 mirrors the actual Q3 2010 to Q1 2011 results; given the industry turmoil of the past few weeks, we feel these projections are more than reasonable. 7) To maintain a sustainable dividend, NRP’s coverage ratio must remain at least 100%. Coverage well below the 100% threshold can only be financed through increasing leverage; this possibility has been removed by the 4x EBITDDA debt covenant.

Post dividend cut, assuming a reasonable TTM EBITDDA run-rate of 270mm, distributable cash flow will be 115mm (100% coverage is implied here). With 106mm shares outstanding, the dividend comes out to $1.085 per share; using the current 10% yield, we arrive at a $10.85 target price. Though this is our base case scenario (see table in the model section), we would argue that this yield may approach the historical maximum of 13-14%. As coal increasingly falls out of favor, there should be substantial multiple contraction (and thus increasing yields) for related companies; NRP is at the forefront of this unfavorable long-term trend.

Detailing the Downfall
With only a handful of brokerage firms covering this predominantly retail owned MLP, we constructed a detailed model pulling a combination of mine-by-mine data from government agencies & mine operators, management guidance, and historical patterns in business operation. We took an extremely granular look at production estimates, impending mine closures, operating costs, coal prices per region, and CapEx needed to maintain the asset base. Our model clearly shows that under almost any scenario, NRP will either breach their 4.0x Total Debt/TTM EBITDDA covenant, significantly cut their dividend, or risk exhausting their asset base needed for future royalty cash flows. While the company can pull questionable maneuvers in the short-run (liquidation of assets, drastic reduction in CapEx run-rate, etc.), we believe that investors will recognize the underlying motives in these actions and their aberration from the norm, and quickly correct the stock price. In our base case, we believe NRP will cut their dividend in Q1 2013. Shortly after, we believe NRP will lower their dividend to $1.085 leading to a price of $10.85 per share. We constructed our model with very conservative assumptions that gives NRP the complete benefit of the doubt for any questionable inputs.

Revenue Drivers
We have assumed that Patriot’s 3,260 tons will be wound down over the next 2-3 quarters. As per the Patriot bankruptcy filing, the company will accelerate closure of its high cost CAPP mines. While we can’t be certain that NRP’s reserves fall under this category, Patriot’s mines at Dingess-Rum (1.26MM tons - reflects 45% joint venture with Alpha) and D.D. Shepard (2MM tons) have little met coal exposure and thus slim margins. Accordingly, the Patriot BK will drop annual revenue 18.6mm (3.26MM tons at $5.70/ton CAPP royalty rate) and cause a 16MM hit to EBITDDA (assuming historical EBITDDA margin of 86%).

Coal royalties were modeled using a bottoms-up methodology that forecasted quarterly coal production and royalty rates by geographic region. In terms of production estimates, we first went back to FY2011 output data and normalized the numbers for any one-off events. The following are the primary adjustments to 2011 results: 1. Q1 2012 NAPP output was taken down to 1,140 tons vs. 2,400 actual, since this was caused by one-time production on a 1960s era lease (see 2012 Q1 10-Q filing). 2. Q2 2011 - Q1 2012 SAPP output was adjusted upward due to a lessee’s preparation plant being damaged by a tornado (see 2011 10-K filing). 3. We bumped up Q2 2011 Illinois Basin output due to a stoppage at the Williamson mine caused by Mississippi river flooding (see 2011 Q2 10-Q filing).

Using these normalized 2011 output results as our basis, we drove future production by estimating YoY changes. For Q2 2012 estimates, we utilized actual Energy Information Administration (EIA) reported output data by region. We adjusted these numbers based on mine by mine Q2 results from the Mine Safety and Health Administration, with particular emphasis given to Alpha and Arch CAPP mines. For Q3 2012 and beyond, we take EIA quarterly output projections and scale them according to NRP-specific circumstances. Embedded in these forecasts are the Patriot BK output hit and the opening of the Hillsboro mine.

To project royalty rates, we ran multivariate regressions of historical royalty per ton against coal prices and output (this was done on a regional basis). Using the production estimates detailed above and coal price futures, we were able to come up with future royalty rates. Any situation specific factors were then taken into account by adjusting these regression outputs.

For transportation and processing revenues, we ran regressions and found these numbers had a high correlation with coal royalty revenues. This intuitively makes sense as revenues from these assets are dependent on the volume of coal mined by operators. We used this relationship to model transportation and processing revenues. Based on our estimates for mine closures, we modeled minimums royalty revenue; in our bear case, we assumed receivables would be uncollectible due to miners experiencing financial distress. For oil and gas as well as aggregate royalties, we combined management commentary surrounding forward production with pricing data to derive revenue estimates. Lastly, for override and other royalties, we used a combination of sell-side research and management commentary. Note that these last two segments are somewhat volatile and only contribute to a small part of total revenues.

We present the revenue breakdown in the tables below as a reference to readers:

*For this data points and other large changes, please see “Revenue Drivers” section under “Detailing the Downfall”

EBITDDA Margins
TTM EBITDDA margins have historically been extremely stable in the 86-87% range with a standard deviation of 192 bps. As a company with revenues consisting primarily of coal royalties, margins are very high. While the street consensus calls for a FY12 EBITDDA margin of 83%, we modeled margins at 86.6% with quarterly variance stemming from seasonality.

Working Capital
Though the net change in working capital is a small adjustment, we took care in estimating this account as the contribution/deduction can ultimately determine in which quarter liquidity issues are realized. There is seasonality in this metric, and we modeled this accordingly.

Capital Expenditures
As a company that generates a large majority of revenues by leasing out natural reserves to operators, maintaining the size of the asset base is important for the sustainability of future cash flows. Though there is some volatility in Capex due to the large acquisitions of certain reserves, NRP constantly replenishes its exhausted reserve base by acquiring additional revenue generating assets. Of late, management has diversified the business away from Appalachian coal reserves toward transportation assets, preparation plants, and processing facilities; reserves in the Illinois Basin; aggregates; and oil and natural gas reserves.

In Q1 2012, NRP acquired a load railout, associated infrastructure assets, and a contractual overriding royalty interest in the Sugar Camp mine in Illinois for $58.9 MM. In Q1, they additionally bought 6,000 acres of Oil reserves in Mississippi for $20 MM. In Q3 2009, NRP signed a definitive agreement to acquire 200 MM tons of coal reserves at the Deer Run Mine in Illinois through several transactions for a total purchase price of $255 MM. As of Q1 2012, the company has acquired 118.1 MM tons for approximately $215 MM, including $40 MM paid in Q1.This final closing of this deal will occur in Q3, and will cost an additional approximately $40 MM. As the recent transactions above and the slew of historical acquisitions suggest, NRP has been historically committed to continually acquiring assets and diversifying their business away from Appalachian coal.

From NRP’s IPO in 2002 to the end of 2009, 34 out of 38 acquisitions have been coal related. Since then, NRP’s focus has increasingly been on smaller non-coal related resources, acquiring timber, slate, silica, dolomite limestone, natural gas & oil, and other natural resource reserves. We believe that management is aware of the need to diversify away from coal related revenues; however, it is evident that this shift is still in its nascent stages with only 5.05% of revenues derived from true non-coal assets.

In the past few years, NRP has spent, on average, $37.5 MM per quarter ($150 MM per year) in Capex to replenish their asset base. We predict that this run-rate will continue in the future and most likely increase as low coal prices and increasing operating costs force mines to shut production, especially in the Appalachia region. The company has committed to spending $40 MM in Capex in Q3 to close the Deer Run Mine deal. We’ve been generous in modeling average Capex as $30 MM for each subsequent quarter with variance surrounding the deal in Q3. We believe that this Capex amount is substantially lower than necessary to replace depleted reserves and revenue loss from idled mines.

Minimum Cash Balance
Since 2010, NRP has kept a minimum of at least $63.8 MM of cash & equivalents on their balance sheet with an average amount of $116 MM. The company must keep a minimum amount of cash each quarter for future repayments of principal as well as to fund quarterly operations and Capex. We make the very conservative estimate that NRP will keep $94.5 MM in cash at the end of Q2 (due to $40 MM payment to close Deer Run Mine deal in Q3) and $60 MM for each subsequent quarter. In the last 12 months, NRP has always had more than approx $115 MM in cash and has even raised significant amounts of debt to hold the dividend distribution. In our model, NRP can use excess cash on the balance sheet to meet dividend distribution targets up to the point where they do not dip below the minimum cash balance. The remaining difference between the distribution target and available cash for distribution (levered free cash flow + cash in excess of minimum balance) can be met by drawing from the revolver. We show that with this trajectory, NRP will breach its covenant by Q1 2013 and will be forced to cut its dividend or revert to other means that destroy shareholder value and will lead to price correction in the stock.

Key Model Outputs:

Below, we have shown a sensitivity analysis detailing price targets and corresponding returns.

*All of these mid-term cases assume that dividend coverage must equal one. Below, we have shown a sensitivity analysis detailing price targets and corresponding returns.

Postponing Judgment Day
Though NRP could pursue a variety of actions to try to delay a distribution cut or covenant breach, we believe that the stock price will be corrected in any possible scenario as investors and sell-side analysts will pick up on the unsustainability of the trajectory of the business.

Cutting Capex
As detailed in the discussion of our model, NRP has had a consistent track record of acquiring natural resource reserves to replace the depletion of existing assets. We believe that investors will see a cut to Capex as delaying the inevitable and strong evidence of a weakness in underlying operations. Furthermore, unforeseen mine closures should prompt higher CapEx to replace these assets as the monetizable reserve base decreases. While it may be possible that NRP can slightly cut Capex (as detailed in the conservatism of our estimates), the company will nevertheless face liquidity issues in Q1 2013. If management decides to cut Capex and maintain the dividend, we believe price correction in the stock will still be realized in or around Q1 2013.

Ramp-up and/or Acquisition of Diversified Assets
In an attempt to shift cash flows away from coal royalties, particularly those sourced from the Appalachia region, NRP has undertaken a flurry of small acquisitions in other forms of natural resources. NRP sources only 5.05% of revenues from truly non-coal assets and the recent move to coal processing, preparation, and transportation assets are still highly dependent on coal volumes. We’ve been generous in assuming a ramp up in non-coal revenue streams with increased flows in subsequent quarters. Despite this conservatism, this small segment does not meaningfully offset the substantial declines in coal royalty revenues. Any further acquisitions of diversified assets will lead to an accelerated realization of liquidity problems (cash burn), and will take time to come online and materially offset coal royalty losses. We believe management has been prudent in acquiring varied assets, however, this strategic vision will not be realized in the short or mid-run.

Drawing Down Cash to Near-Zero
As discussed earlier, we believe the company must keep at least $60 million of cash on the balance sheet to fund liabilities and maintain business operations. Even if the company were able to push this balance meaningfully lower, our model shows that this may delay a liquidity crunch by at most one quarter.

Changing Covenants on Senior Notes
Though the terms and covenants on the revolver can be changed (see Alpha/ANR for an example of this), the senior note covenants are ironclad and virtually impossible to modify. As per the senior note agreement (which governs all outstanding notes), “the company will not permit…the ratio of Consolidated Debt…to Consolidated EBITDDA…to exceed 4.00 to 1.00” (see agreement dated 2003, section 10.6 (a) (iii), Limitations on Debt). A breach of this covenant represents an event of default, as defined under section 11 (c) of the agreement. Moreover, no method for modification of the senior note covenants exists; any violation could result in a technical default and dramatic reduction in price per share. As such, we believe a dividend reduction represents a far more palatable solution to NRP management than a covenant breach.

Issuing Equity to Fund Dividend
Management has the ability to dilute current unitholders by raising additional equity. Though management could use the proceeds of the offering to pay distributions for a few additional quarters, we believe that unitholders and the sell-side will question this dilution and ultimately correct the share price as these ‘temporary’ liquidity problems signal an underlying weakness in the core coal royalty revenue stream. Furthermore, this would be viewed as refinancing senior notes with more expensive equity - a move that is ultimately value destroying to unit holders.

Trade Execution
We reached out to several sales desks and the indicative borrow rate for a block of 20,000 shares is -0.9%. We believe execution will not materially impact returns. 

Case Study: SGU
In 2004, Star Gas Partners, an MLP based in Stamford, CT, declared that they would not be able to “meet the borrowing conditions under its working capital line” after it “advised lenders of a substantial expected decline in earnings.” In response to the news, Star’s stock price dropped from $21.60 to $4.32 within one day. Having cited this example, we do not expect NRP to completely remove its distribution (we see $1.085 as sustainable). Nevertheless, we see a significant cut would lead to similarly detrimental effects.

Conclusion
WIth declining coal prices, rising mining operator costs, and potential regulatory headwinds, we believe it is extremely likely that forward cash flows for NRP will decline and force the company to take actions that lead to a sharp correction in stock price. Natural gas prices continue to trend lower due to technological improvements and increasing build-out of infrastructure. Mining operators face increasing costs driven by significant legacy liabilities and harder to access reserves. With Patriot’s Chapter 11 filing and recent Q2 mine closure data, it is increasingly apparent that operators will shut-down production at unprofitable mines; the vast majority of these closures will occur in the Central Appalachia region.

With a 4.0x Total Debt/EBITDDA covenant on the senior debt, we believe that NRP will cut its dividend or be forced into technical default. Since 2010, NRP’s dividend coverage ratio has ranged between 40-80%, signaling long-term unsustainability of the current dividend at this trajectory. Though NRP has increased its debt in the last few quarters to fund the difference, we estimate the company will be unable to increase leverage as it is immensely difficult to modify the covenant terms. While management can cut CapEx, liquidate assets, issue additional equity, or take more creative measures to postpone the dividend cut, we ultimately believe that investors will correctly interpret the underlying motives and sell-off stock. Based on our estimated mid-term $1.085 dividend (assuming 100% dividend coverage), we believe that with a 10% yield (in-line with comparable MLPs in the space), NRP will trade at a price target of $10.85. We note that investors may demand a higher dividend yield (currently at 10.83%) due to elevated forward risks, which would further depress our base case PT.

Catalyst