Sunday, November 2, 2014

Analysis of Natural Resource Partners Part II of II



Please read the disclaimer here:http://greedydragoninvestment.blogspot.com/p/about-greedy-dragon.html. Enjoy the article, bitches!




Do you know what would be absolutely terrible for the environment? It’s if those environmentalist extremist assholes were in charge. They irrationally hate fossil fuels when fossil fuels are exactly the reason that the environment has never been better. I don’t judge an environment based on some trees and fresh air, I judge the environment based on the standard of living it allows me to have. And by that standard, the environment is much better because of fossil fuels. I mean I can turn on the air conditioning when I’m hot, I can drive to a good restaurant when I’m hungry and I can look at pictures of cute chicks on Facebook when I’m horny. All of these things are enabled by fossil fuels.   Anyway, in part II of this analysis I’ll be looking at the business divisions of Natural Resource Partners L.P. (NRP) and some of the risks involved with investing in the company. I will also try to value the company. Before I begin, I would like to point out that NRP’s natural resource reserves are located in the United States. So, I don’t think I need to worry about some crazy ass government seizing the company’s properties (at least that’s what I hope).

Note: I know that NRP is a partnership and not a company. I’m just so used to referring to businesses as companies when writing articles about them. So, whenever I refer to NRP as a company, just assume that I actually meant partnership.

Coal

As coal contributed 63.05% of the company’s revenue for the six months ended June 30, 2014, we’ll look at the company’s coal segment first. According to the U.S. Energy Information Administration’s website, coal contributed to 39% of energy generation in the United States. So, Obama can hate on coal as much as he wants. But unless he wants the lights to go out, coal is here to stay.

The price of thermal coal has taken a beating, partly because of cheap natural gas as it’s an alternative to coal for electricity generation. Natural gas prices may start to rise once the U.S. start increasing its exports of natural gas. This could result in coal prices getting some relieve. Like many other commodities, coal and natural gas prices are cyclical. Producers tend to overproduce when prices are high causing an oversupply and declining prices. When the price is low, producers cut capacity by too much eventually causing a shortage in supply and increasing prices. Anyway, even if I don’t know when coal prices will start moving up, I have the holding power. More importantly, I’m not investing in a company that needs significantly higher coal prices to be profitable. NRP is already making pretty good profits (relative to its market value). It may just make even better profits if coal prices increase.  

NRP doesn’t solely rely on thermal coal. According to NRP’s 2013 annual report, approximately 31% of the production and 41% of the coal royalty revenues from the company’s properties were from metallurgical coal. The price of metallurgical coal has also declined significantly from its peak. Metallurgical coal is also a cyclical commodity. And while I don’t know if we’re at the bottom of the cycle, I don’t mind getting exposure to it now since the price is low.            

Needless to say, the company earned lower royalty revenues from most of the regions where it has coal properties because of lower production from the properties and/or lower pricing realized by the lessees. The following is a list of the regions where NRP’s coal properties are located:

Northern Appalachia: For the six months ended June 30, 2014, royalty revenues from the properties in this region was $4.09 million which represents a decline of 55% over the same period last year. 4.47 million tons of coal was produced from the property in the period. As at December 31, 2013, the property had 507.78 million tons in proven and probable reserves. According to the U.S. Energy Information Administration’s annual coal report for 2012, the average recovery percentage at producing underground mines in the U.S. was 56.09%.Unless stated otherwise, we’ll assume that the recovery percentage for the reserves on NRP’s properties will be 56.09% as the majority of the company’s reserves are underground. So, with 507.78 million tons in proven and probable reserves, the property can still be mined for about 30 more years assuming constant annual production levels of 8.94 (4.47  annualized) million tons .

Note: The formula I use to estimate how many more years the company’s properties can be mined for coal is rather simplistic. It’s basically: (Proven & probable reserves * recovery percentage/current annualized production). I could very well be wrong in my estimates of how long coal can be extracted from the properties.     



Mistake update: I made the mistake of adjusting the coal reserves by a recovery percentage. The proven & probable coal reserves reported in NRP’s annual report are recoverable reserves which mean that the recovery percentage should already have been taken into account (at least that’s what I think from reading more about coal reserves). Therefore, the number of years coal can be mined from the company’s properties could be significantly longer than my initial estimates (assuming current annualized production remains constant).
 

Central Appalachia: Royalty revenues from this property were down by 23% to $ 43.81 million for the six months ended June 30, 2014. 9.66 million tons of coal was produced during the 6 month period. The property had 1.254 billion tons in proven and probable reserves as at December 31, 2013. Assuming constant annual production levels of 19.32 (9.66 annualized) million tons, the properties can be mined for about 35 more years.

Southern Appalachia: The Company’s properties in this region earned royalty revenues of $10.33 million for the six months ended June 30, 2014 which is down 31% from the same period last year. The properties in this region produced 1.93 million tons of coal during the period. The properties had 111.60 million tons in proven and probable reserves as at December 31, 2013. The properties can be mined for about 15 more years assuming constant annual production levels of 3.86 (1.93 annualized) million tons.    

Illinois Basin: Royalty revenue received by NRP’s properties in this region was up by 4% to $ 26.55 million for the six months ended June 30, 2014. 6.53 million tons of coal was produced from the properties during the period. As at December 31, 2013, the properties had proven and probable reserves of 354.76 million tons. The properties can be mined for about 14 more years if annual production levels remain constant at 13.06 (6.53  annualized) million tons.

Northern Powder River Basin: The Company’s properties in this region received royalty revenues of $2.97 million for the six months ended June 30, 2014; a decline of 33% over the same period last year. 1.05 million tons of coal was produced from the properties for the six months ended June 30, 2014. The properties had proven and probable reserves of 97 million tons which are all at the surface as at December 31, 2013. According to the U.S. Energy Information Administration’s annual coal report for 2012, the average recovery percentage at producing surface mines in the U.S. is 90.12%. By assuming a recovery percentage of 90.12% and constant annual production of 2.1 (1.05 annualized) million tons, the properties can be mined for about 40 more years.

Gulf Coast: For the six months ended June 30, 2014, royalty revenues from the properties in this region was $ 1.52 million which represents a decline of 22% over the same period last year. 0.43 million tons of coal was produced from the properties during the period. As at December 31, 2013, the properties had proven and probable reserves of 3.73 million tons which are all at the surface. If annual production levels remain constant at 0.86 (0.43 annualized) million tons, the properties can be mined for about 2.5 more years.  

Transportation and processing assets: NRP received $11.09 million in transportation and processing fees for the six months ended June 30, 2014.This is up 1% from the same period last year. The following is a description of the company’s infrastructure business taken from its website:

In addition to our royalty business, we also manage infrastructure assets. These include coal preparations plants, beltlines for transporting coal, coal load-out facilities and other transportation facilities as well as infrastructures for the aggregates business. We work with our lessees to determine their needs and with the assistance of Taggart Global and others, construct the facilities, contract someone to operate the facilities on our behalf and then, much like our royalty business, we collect either a percentage of the gross selling price or a fixed fee per ton”.

There’s just something so awesome about a business that generates cash from its assets without having to deal with the headaches of operating those assets. I’m as fascinated with such businesses as I am with Elsa in Once Upon a Time. That blue dress is just so perfect on her.  Anyway, back to business..

Wheelage: According to NRP’s website, “wheelage is the term used to describe a fee that we charge other coal companies for transporting their coal across our property in route to their end-user or market”. For the six months ended June 30, 2014, the company’s wheelage revenue was $1.78 million which is down 10% from the same period last year.

Aggregates

If you are wondering what the fuck are aggregates (I know I did), they are crushed stone, sand and gravel that are used in construction. The company earned $ 2.12 million in aggregates royalty revenue for the 6 months ended June 30, 2014. The company’s properties produced 2.14 million tons of aggregates during the period. According to the NRP’s 10-Q report for the quarter ended June 30, 2014, the company owns approximately 500 million tons of aggregate reserves. I don’t know what the recovery percentage is for aggregates. But with only 4.28 (2.14 annualized) million tons in annual production and 500 million tons in estimated reserves, I think that aggregates can be produced from the company’s properties for quite some time.

Trona mining and soda ash production

According to NRP’s 2013 annual report, the company owns a 49% non-controlling equity interest in OCI Wyoming, L.P., an operator of a trona ore mining operation and a soda ash refinery in the Green River Basin, Wyoming. The company’s share of profits from OCI Wyoming’s trona mining and soda ash production business was $19.2 million for the six months ended June 30, 2014. For the six months ended June 30, 2014, NRP received $25.6 million in cash from its investment in OCI Wyoming’s trona mining and soda ash production business.

Oil & Gas

For the six months ended June 30, 2014, the company generated 16.31% of its revenue from its oil & gas division. I currently do not have enough knowledge to evaluate an oil & gas business. I will try to learn more about the oil & gas business as I hate not knowing about something that I have a financial interest in.

Corporate structure, taxation

NRP is a master limited partnership (MLP). One main benefit of MLPs is that double taxation is avoided. According to NRP’s website, “instead of the partnership paying taxes on its profits (like a corporation), each limited partner is responsible on his or her individual income tax for a proportional share of the MLP's income”. I don’t know about you, but I feel like a badass being called a limited partner when I invest in a MLP; being called a shareholder is so common.
  
From my understanding, as a non-corporate foreign partner I would incur withholding taxes of 39.6% (the U.S. highest marginal individual tax rate) on NRP’s distributions. I don’t think the Malaysian government imposes taxes on foreign dividends, so the withholding tax rate of 39.6% should be my only tax expense. Please note that I’m not a tax expert, and I could very well be wrong. I also don’t really know how U.S. investors are taxed on their income from MLP’s, and I don’t want to get a migraine trying to figure it out. Both U.S. and foreign investors should seek the advice of a tax expert before investing in MLPs.

Risks

There’s a risk that investors could lose more than their capital when investing in MLPs. The following excerpt is taken from NRP’s annual report: “Under Delaware law, however, a unitholder could be held liable for our obligations to the same extent as a general partner if a court determined that the right of unitholders to remove our general partner or to take other action under our partnership agreement constituted participation in the “control” of our business. In addition, Section 17-607 of the Delaware Revised Uniform Limited Partnership Act provides that under some circumstances, a unitholder may be liable to us for the amount of a distribution for a period of three years from the date of the distribution.”

Coal prices could fall even further which could result in the company receiving lower royalties. NRP’s lessees might also decide to reduce production or shut down their mines on the company’s properties if they find that they can’t operate profitability if coal prices fall further (or maybe even if coal prices stays at current low levels). This could also result in the company earning lower royalty revenue. The lessees may also reduce production because of tough regulations.

There’s a risk that taxation laws could change and some MLPs might have to pay income taxes at the corporate level. This could have a significant impact on MLPs’ ability to maintain high distributions to unitholders.  

There are a number of other risks faced by NRP’s businesses. I strongly suggest that you read the discussion of risks in the company’s annual report.

Valuation

The net income after general partner’s percentage interest as reported on NRP’s income statement for the six months ended June 30, 2014 was $ 62.732 million. An important metric for MLPs is the “distributable cash flow” which is the amount of cash a company generates that can be paid out as distributions to unitholders. You can read more about distributable cash flow in this article here. The following is my calculation of distributable cash flow for the six months ended June 30, 2014 (which is a bit different than the conventional distributable cash flow formula): 

Net income
$64,012
Add depreciation, depletion & amortization
$30,997
Less acquisition of plant and equipment
$135
Less oil and gas capital expenditures
$8,123
Less general partner’s percentage interest (2%)
$1,735.02
Distributable cash flow
$85,016

Dollar figures in the table are in thousands

After the next quarterly distribution is paid, NRP’s gross distributions for the year would come in at $1.4 per unit (4 quarterly distributions of $0.35 per unit). As at June 30, 2014, the company had 110,869,513 units outstanding and an annualized distributable cash flow of about $ 170 million. This will give us an annualized distributed cash flow per units of $1.53 and a distribution coverage ratio of 1.09.This might not give the company a large room for error to both maintain distributions at current levels and replenish its natural resource reserves. However, the official distributable cash flow reported in NRP’s quarterly report was $103.87 million for the 6 months ended June 30, 2014. If you annualize the official distributable cash flow, the coverage ratio would come in at 1.33 which I think is decent.     

Looking at the historical yields of MLPs, I think I made a good deal investing in NRP. Based on quarterly distributions per unit of $0.35 and a unit price of $11.19 (the price I paid for my units), NRP would have a gross dividend yield of 12.51%. According to the chart of Alerian MLP index’s historical dividend yield, it’s uncommon for yields to be above 10%. You can view the chart on the vector grader website. According to Alerian’s website, the Alerian MLP index is a float-adjusted, capitalization-weighted index that includes 50 prominent companies and captures approximately 75% of available market capitalization. If coal prices stage a significant rebound, NRP’s distributable cash flow should increase which will in turn allow it to increase its distributions. If that happens, then I think there’s a chance that I will make a lot of money from this investment.     

Fuck! I never expected this article to be so long. I hope you guys liked reading the article as I put a lot of effort into it. Thank you for reading. Take care and stay rational.

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