Description

NACCO Industries (NYSE:NC)

Business Description & Thesis

NACCO Industries (“NACCO”) is a Cleveland, Ohio based platform company with three independently managed subsidiaries: i) North American Coal (“NACoal”), a surface miner of primarily lignite coal; ii) Hamilton Beach Brands (“HBB”), a designer and distributor of small electric appliances; and iii) Kitchen Collection (“KC”), an outlet and mall based kitchenware retailer.  Founded in 1913 as The Cleveland & Western Coal Company, NACCO operated exclusively within the coal industry before expanding into other businesses in the mid-1980s, including Hyster-Yale Materials Handling, which NACCO exited via a spin-off (NYSE: HY) in September 2012.  Currently, North American Coal remains NACCO’s largest segment (~50% of non-GAAP sales, which includes sales from unconsolidated mines), followed by Hamilton Beach Brands (~40%) and the Kitchen Collection (~10%).

Reasons for Mispricing & Investment Setup

At first glance, NACCO appears as a hodgepodge of unrelated businesses in secularly declining industries with obscure financials and no sell side coverage.  The company has experienced a variety of issues, including a costly metallurgical coal acquisition, volume issues at a large power plant, and a tepid economic recovery impacting consumer household goods.  Furthermore, the turnover of the shareholder base following the spinoff of Hyster-Yale, which is nearly three times larger than the parent, and an overall negative investor sentiment regarding coal, result in a neglected and misunderstood company with shares trading near its September 2012 post-spinoff lows.

However, the exit of a money-losing metallurgical coal operation, the resumption of normalized coal demand from a major customer, and the ramping production of five newer mines will reveal NACCO’s true earnings power.  Given the long-term, fixed price nature of NACoal’s contracts, no rebound in spot coal prices is needed for its earnings power to emerge.  We believe NACCO has a highly visible, low-risk pathway to achieving $96 in EBITDA in 2016 (~50% greater than 2014 levels) valuing the company at $72 per share, or 47% upside.

North American Coal

In this section, we’ll walk through NACoal’s misunderstood business model, issues facing the consolidated mines, and the untapped earnings power of the unconsolidated mines.  We will focus on NACoal more than the other two segments, as this is where the bulk of the earnings potential lies.

Business Model

U.S. coal companies have faced a plethora of issues—falling natural gas prices, unpredictable environmental regulations, suboptimal rail capacity, declining Chinese steel production, and excessive balance sheet leverage—resulting in major coal indices declining over 80% since the summer of 2014.  These issues have led to the perception that coal is in permanent decline, with demand, pricing, and profitability falling for all producers.  However, these issues generally do not apply to NACoal.

Unlike metallurgical coal production, which is driven primarily by steel production, NACoal focuses on the production of lignite coal used for power generation.  The lignite is surface mined using draglines then carried via conveyor belt to its power generation customers’ adjacent plant, reducing the transportation related issues faced by many traditional coal producers.  Additionally, customer relationships operate under long-term profit per ton or cost plus management fee sales agreements eliminating exposure to spot price risk.  Furthermore, NACoal has a set of captive customers with most building their plants atop NACoal’s mines, which serves as their sole fuel source.

NACoal’s 10 mining operations are divided into two types: two consolidated mines and eight unconsolidated mines, which meet the criteria of variable interest entities.  Because of this accounting treatment, NACCO, the holding company, only recognizes revenues for its two consolidated mines, which understates the size of NACoal relative to HBB, leading to the company being categorized as a Consumer Discretionary (Household Appliance) name.  It is at the two consolidated mines, Centennial Natural Resources (“Centennial”) and Mississippi Lignite Mining Company (“MLMC”), where NACoal’s issues persist.

Issue 1: Centennial Metallurgical Coal Acquisition

In Q3 2012 NACoal strayed from its stable business model of long-term profit per ton or cost plus management fee contracts by acquiring Alabama-based metallurgical coal producer Reed Minerals, which has since been renamed to Centennial Natural Resources.  At the time, management viewed the deal as opportunistic—a distressed high quality mining reserve on the expectation of a rebound in met coal prices—and hoped the acquisition would provide NACoal with a platform for international coal exports.

Source: Bloomberg

Unfortunately, prices never rebounded, the met coal export market collapsed, and the acquisition turned out to be a costly mistake, resulting in a $105M write-down in Q4 2014.  While the purchase price of $69M seems reasonable, the erosion in value stems primarily from the negative return on the millions in capex spent to improve mining efficiencies, reduce costs, and increase production capacity at Centennial.

Source: SEC Filings

Following the acquisition, capex at NACoal reached unprecedented heights, exceeding $50M in both 2013 and 2014—more than twice the long-term average of $22M per year.  In the past 10 quarters alone, NACoal spent $106M in capex, and while management does not break out how much of this was dedicated specifically to Centennial, we know it was significant.  During this same 30 month period, Centennial lost $46.3M in gross profit (Net and operating profits/losses have not been consistently disclosed.  We cite the last 10 quarters not to cherry pick but because it is the only consistent time period based on management’s selective disclosure).  In total, we estimate the value destruction (purchase price, losses, and capex) attributable to Centennial amounts to at least $200M, which is 60% of NACCO’s current market capitalization.

Earlier this summer following less than three years of ownership, NACoal decided to permanently discontinue operations at Centennial by the end of the year.  With Centennial no longer weighing on results, NACoal’s true earnings power will emerge beginning in 2016.  Moreover, as capex normalizes closer to its long-term average, NACoal will return to generating a significant amount of free cash flow.

Issue 2: MLMC Customer Plant Outage

NACoal’s other consolidated mine, MLMC, operates the Red Hills Mine in Ackerman, Mississippi and produces three to four million tons of lignite coal annually for the Red Hills Power Plant.  The plant, which supplies electricity to the Tennessee Valley Authority, was purchased by the Southern Company in 2002 from Choctaw Generation LP, a GDF Suez subsidiary, via a sale-leaseback arrangement finance with debt[1].  Due to a series of ongoing operational struggles, primarily related to a turbine design flaw, Choctaw Generation LP faced solvency issues and was forced into restructuring its lessor notes in 2013[2].  As part of the restructuring, the Southern Company agreed to a $60M equity investment to improve operations at the Red Hills Plant and GDF Suez, which had operated the asset through Choctaw, sold its interest to PurEnergy LLC, a Syracuse, NY-based firm specializing in turning around troubled energy assets.

The operational issues at the Red Hills Power Plant resulted in a series of outages and had decreased MLMC’s coal deliveries.  From 2002 to 2010 (2002 was MLMC’s first full year of production), MLMC delivered an average of 3.5M tons annually to the Red Hills Power Plant.  However, volumes declined precipitously in 2011 from operational issues and have remained below the historic average.

  Source: SEC Filings, EIA

In 2014, additional capital investment resulted in two extended planned outages: one in Q1 and one in Q4.  With the improvements and upgrades of plant equipment, the absence of outages in 2015, and the operations now under PurEnergy, the Red Hills Power Plant is expected to improve its operational performance and reliability, which should result in normalized levels of coal purchases from MLMC.  NACoal is seeing these improvements taking place with 1H 2015 tons delivered up 8% year-over-year and with 2H 2015 tons delivered expected to exceed 2H 2014 as well.

Unconsolidated Mines

The majority of NACoal’s earnings power resides within its eight unconsolidated mines, which show no revenue on the P&L but contribute the majority of the subsidiary’s profits.  Despite owning and operating 100% of these mines, NACoal’s equity capital is not considered sufficient to finance these operations, as they are capitalized primarily with debt backed by the utility customer.  As a result, the unconsolidated mines meet the criteria of variable interest entities, so NACoal only recognizes their pre-tax profits on its P&L.  We believe this to be an excellent structure for five key reasons:

1.    Mines are formed with the sole intent of supplying coal to a specific customer, providing NACoal with steady long-term demand.

2.    Sales arrangements are long-term (30-plus years) contracts with profit per ton or cost plus management fee terms, eliminating exposure to volatile spot prices.

3.    Customer backed-debt financings are without recourse to NACCO and NACoal, reducing balance sheet risk.

4.    Contracts require customers to cover the ongoing costs for mine equipment and maintenance, resulting in reduced capex requirements for NACoal.

5.    Asset retirement obligations for closed mines are the responsibility of the customer.

The result is a stable, cash generative set of contracts which consistently grow profits over time with minimal mine closing liabilities.

                                           Source: SEC Filings

In the past decade, NACoal’s unconsolidated mines have grown its pre-tax profits—the profits which appear on NACCO’s P&L—at a 4.6% CAGR on a per ton basis.  This compares to 1.9% annualized inflation rate during the same time period.

Lastly, NACoal’s low risk profile is bolstered by its reputation as a best-in-class operator, maintaining the lowest incident rates among all publicly traded coal companies.  Below is a slide taken from Cloud Peak Energy’s most recent investor deck.

                Source: Cloud Peak Energy 2Q 2015 Investor Presentation

Earnings Power

What we find attractive about these unconsolidated mines is that they are earning nowhere near their full potential.  In fact, of the eight total mines, only three are producing substantial volumes, with the remaining five new/developing mines expected to ramp production through 2017.

Source: SEC Filings

In 2014, Coteau, Falkirk, and Sabine delivered 26.7M tons of coal to its customers, accounting for over 99% of all tons sold by the unconsolidated mines.  Based on a full run rate production capacity of 39.9M tons, the unconsolidated mines can potentially sell 50% more coal.  This is consistent with management’s longer-term financial objective of growing earnings from unconsolidated mines by roughly 50% by 2017 from 2012 levels.  As development mines commence coal deliveries, we envision the ramp up to look something like the following:

Source: SEC Filings, Internal Analysis

With the exit of Centennial combined with improvements made at MLMC’s customer power plant, NACoal’s earnings power will normalize from significantly depressed 2014 levels.

            Source: SEC Filings, Internal Analysis

We believe under very conservative assumptions that NACoal can generate normalized EBITDA of ~$60M in 2016.  We bridge to 2016 EBITDA using the following assumptions:

1.    We use 2014 as our based year where NACoal generated $33.8M in adjusted EBITDA excluding impairments, gains on sale of assets, and two smaller non-recurring expenses.

2.    We reduce Royalty & Other by $5.0M.  This consists of payments NACoal receives for leasing its non-operating mineral reserves to others.  Royalty & Other generated $21.1M and $10.7M in sales in 2013 and 2014 at $19.6M and $9.0M in gross profit, respectively.  Since there is essentially no opex associated with these sales, we believe gross profit is a close enough proxy for EBITDA in this case.  Based on current market prices for coal, we expect a continued decline in Royalty and Other, expecting sales and profits to decline by roughly half by 2016, or approximately $5.0M in EBITDA.

3.    We increase Centennial EBITDA by $18.0M, to reflect incremental $23.0M in EBIT offset by a $6M decline in D&A.  As a reference, Centennial generated a gross profit loss of $22.4M in 2014, and we ascribe approximately $1M in opex, which results in roughly a $23.0M operating loss.  The reversal of this loss is the incremental EBIT we refer to above.

4.    We increase MLMC EBITDA by $4.0M to reflect normalized volumes.  Due to two extended outages, tons delivered by MLMC in 2014 fell over 20% below its historic average.

5.    We increase unconsolidated mines by $8.7M to $57.1M in 2016 from $48.4M in 2014, driven by additional volumes from five new/developing mines as well as from contractual price increase at all mines.  Given management’s target of $67.9M in earnings from unconsolidated mines by 2017, we believe our assumptions are conservative.

Hamilton Beach Brands

HBB designs, markets, and distributes a variety of small electric household appliances as well some commercial products for restaurants and hotels.  The brand has top three market share positions in over 20 categories in the U.S. and Canada with broad distribution through mass merchants, department stores, and wholesale distributors, including Target, Walmart, and Amazon.

What we like about the business model is that HBB is able to maintain a leading market share position by focusing on design and distribution, while outsourcing manufacturing in its entirety.  This results in minimal capex with very attractive returns on capital.  HBB consistently generates 30%-plus returns on assets compared to low to mid-teens return for its peers.

           *Segment EBT is used for Electrolux                       

           Source: SEC Filings, Internal Analysis, S&P Capital IQ

We assume HBB can grow sales at a 3-4% CAGR while maintaining operating margins flat at roughly 6.0%.  For 2016, we assume EBITDA of $43.2M compared with EBITDA of $40.2M in 2014.

  Source: SEC Filings, Internal Analysis

This compares to management’s longer-term target of $750M in sales by 2018-2019 at a 10% operating margin, which implies a five year sales and operating profit CAGR of 6.0% and 14.9%, respectively.     

Kitchen Collection

KC is comprised of two store formats: the Kitchen Collection, a primarily outlet based specialty retailer of kitchenware, and Le Gourmet Chef, a similar format focusing on higher-end housewares which NACCO purchased out of bankruptcy in 2006.

Due to financial pressures facing the mass consumer, intense competition, and weak traffic at KC’s outlet mall locations, the stores have been comp’ing negatively on a same-store sales basis for the past four years and have posted operating losses in the past three.  To address these issues, management has closed underperforming stores and is focusing on the Kitchen Collection format.

                 Source: SEC Filings, Internal Analysis

KC exited its sole remaining Le Gourmet Chef location in Q3 2015, closing more than 80 stores since 2008.   With the vast majority of underperforming stores now closed, KC expects to earn breakeven results in 2015 and is targeting 5% operating margins longer-term.

Given the KC’s relatively small contribution to NACCO’s overall profits, we would be happy even with breakeven results.  As a result, our valuation ascribes zero value to the Kitchen Collection.

Valuation

We value NACCO using a Sum of the Parts analysis based on our assumptions for normalized 2016 EBITDA, which we outlined for each subsidiary above:

1.    NACoal: $59.8M based on a full exit of Centennial as well as from normalized volumes at MLMC.

2.    HBB: $43.2M assuming modest top line growth with margins near historic averages.

3.    KC: We ascribe zero value to this business.

4.    Corporate: -$6.6M, which is consistent with long-term averages.

Source: SEC Filings, S&P Capital IQ, Internal Analysis.  For full list of peers used, please see appendix

Applying EBITDA multiples ranging from 6.0x to 9.0x to our estimate of normalized 2016 EBITDA results in a share price ranging from $58to $86 per share, representing 19% to 74% upside from the current share price.

Management

Management is led by Chairman, President, and CEO Al Rankin, who has led the company since May 1991 and has been very active in managing the business for long-term profit growth.  Despite recent unsuccessful acquisitions, management has a proven history of prudent capital allocation.  A proper assessment of management requires an evaluation of successes—not just failures.  More importantly, we don’t necessarily view the end result as being the sole criteria of good capital allocation.  Rather, we consider whether or not each capital allocation decision had merit at the time it was made.  In this sense, management has been quite opportunistic, purchasing both Le Gourmet Chef and Centennial—both of which were very much within its circle of competence—out of distress with an actionable plan in place.  Management has created shareholder value via spinoffs, most notably of Hyster-Yale, which is roughly three times the size of NACCO’s market capitalization today.  Management has also returned capital to shareholders via special dividends and share repurchases, returning $250M to shareholders in the past decade.  Lastly, management has exercised prudence, walking away from deals, such as the Applica deal in which NACCO essentially entered a bidding war with Applica’s largest shareholder Harbinger Capital.  The takeover resulted in a series of lawsuits based on Applica’s violation of its no-shop provision and eventually resulted in NACCO receiving a $60M settlement from Harbinger.

Risk

NACoal: Environmental Legislation

Environmental policy poses the biggest risk for NACoal.  However, we believe that the risk of a customer’s power plant shut down is mitigated due to these being large, highly efficient, baseload power generating facilities that have undergone substantial capital investment programs to meet environmental standards.  The closure of these plants would require a multi-billion dollar investment in a natural gas powered facility that would take years to approve and construct.  Furthermore, the onerous asset retirement costs associated with power plant closures are assumed by the customer, which negatively impacts a new power generation investment return.  We are encouraged by NACoal’s customers continued reinvestment into their plants as well as the development of cleaner technologies, such as the Kemper Integrated Gasification Combined Cycle project, which is supplied by NACoal’s Liberty mine.  Environmental legislation is a real risk; however, we believe any impact would not be seen for at least 5 years, in which time NACoal would generate in excess of $200 million in after tax free cash flow.

HBB: Customer Concentration

HBB’s five largest customers account for 56% of its revenues, with Wal-Mart accounting for a third.  A loss of a single customer can result in a significant reduction in sales to HBB.  However, this is an industry with few new entrants and stable customer demand.  Furthermore, given HBB’s depth of products, its recognizable brands, and larger reinvestment in product development, we believe that the risk of wholesale customer losses is unlikely.

Appendix

1.       Peer Multiples & Precedent Transactions

Source: SEC Filings, S&P Capital IQ, Internal Analysis

2.       Precedent Transactions

Source: Bloomberg, S&P Capital IQ, Internal Analysis

[1] http://www.businesswire.com/news/home/20131122005879/en/Fitch-Rates-Choctaw-Generation-Limited-Partnership-LLLPs#.VhP-h_lVhBd

[2]https://www.moodys.com/research/Moodys-withdraws-ratings-of-Choctaw-Generation--PR_264935

http://choctawplaindealer.com/2013/05/31/red-hills-operations-held-celebration/

Catalyst

1. Exit from money-losing met coal business, revealing the true earnings powerof the business

2. Development of additional unconsolidated mines, which have no spot price exposure