Natural Resource Partners Units Overvalued Due To Coal Price Strength

Jul.19.07 | About: Natural Resource (NRP)

Houston, TX-based Natural Resource Partners, L.P. (NYSE:NRP) is a master limited partnership engaged mainly in owning and managing coal properties in the Appalachian region, the Illinois basin, and the Powder River basin. The partnership generates the majority of its revenues by leasing coal reserves to mine operators under long-term contracts, which grant the lessee the right to mine coal in exchange for royalty payments.

As of December 31st, 2006, the partnership controlled approximately 2.1 billion tons of proved and probable reserves. This reserve level has risen from 1.2 billion tons in 2002. The partnership's status as a coal-royalty MLP reduces its exposure to the inherent risks involved in coal mining: worker accidents, land reclamation, etc. Also, it is sheltered from the capital-intensive nature of direct mining and thus, has very little operating expenses and working capital.

We have adjusted our target price upward to $33.00 per unit, from $31.75 per unit due to better than expected Central Appalachian coal pricing. NYMEX futures pricing was up 10% sequentially in the recently completed second quarter. Further, we see continued near-term strength for the remainder of the year. Despite the favorable pricing outlook however, we continue to maintain our Sell rating on the basis that NRP is trading well above our fair-value calculation (See Valuation section).

Further, the yield has dropped to 4.4%, significantly below the 5-year average of 5.1%. The units are up nearly 40% year-to-date vs. 12% for the S&P 500 and 35% for the Zacks coal group. We recommend that investors wait for better price levels. In the short term many factors can cause marginal coal price swings and these swings will have an impact on the valuation of NRP, either positive or negative. Examples of such factors that affect near-term coal pricing are reported coal storage levels, coal mine openings or closings, and electric power demand.

If unit price levels dip below our six-month target, we will consider an upgrade. The underlying business is still performing well and we continue to expect distribution growth going forward. Investors in the partnership are likely to receive a safe and growing yield and are well positioned to benefit from any additional acquisitions, lessee production gains, and long-term coal price increases.

INDUSTRY OUTLOOK
Our outlook for the coal industry is neutral. Coal's primary consumers are electric power generators (accounting for more than 90% of total coal consumption in the U.S.), manufacturers of steel products, and other industrial users. As a cheap source of fuel widely available, coal is the principal source of energy for U.S. power generation. In 2005, coal accounted for roughly 50% of the electricity generated in the U.S., compared to 18% for natural gas and 20% for nuclear power.

As the largest cost component in electricity generation, fuel cost is generally lower for coal than for other competing fuels, such as oil and natural gas. Coal does however, require large capital costs to burn due to material handling and pollution control requirements. Higher natural gas and oil prices serve as an incentive for utilities to fully utilize their coal-fired generation capacity and dip into their considerable coal stockpiles.

Continued strength in competing fuel prices has helped increase coal consumption by power plants. This has steadily brought down utility stockpiles and put upward pressure on coal prices. From an historical viewpoint, U.S. coal production has roughly doubled in the last 30 years and totaled 1.1 billion tons in 2005.

The primary producing regions are the West (45% of total, includes the Powder River Basin), Appalachia (35%), and the Interior (14%, includes the Illinois Basin). Production data collected as of year-end 05.

Coal quality and sulfur content can vary between regions. Coal produced in the western U.S. and in Central Appalachia has the much-desired feature of lower sulfur content compared to coal from North Appalachia and the Midwest. Further, western U.S. coal is produced through the less capital-intensive process of surface mining. Unfortunately, Western U.S. coal has lower energy content and the areas where it is produced are far from the main consumption centers in the East and the Midwest.

INDUSTRY POSITION
Natural Resource Partners lessees compete with coal producers in various regions of the U.S. for domestic sales. The primary competitive factors in the industry include coal price, coal quality (including sulfur content), transportation cost, and the reliability of supply. Demand and prices also are affected by the demand for electricity, environmental and government regulations, technological developments, and the availability and price of alternative fuel supplies, including nuclear, natural gas, oil, and hydroelectric power. Aside from NRP, the only other publicly traded coal-royalty MLP is Penn Virginia Resource Partners (NYSE:PVR), which also has operations in central Appalachia. As of year-end 2006, PVR had reserves of 765 million tons, while NRP s reserves were 2.1 billion tons.

RECENT NEWS
On May 21, NRP announced the acquisition of a coal preparation and loading facility. The total purchase price is estimated at $16.2 million, $8.4 million of which has been funded through the company s credit line. The facility is expected to be operational by 2008 and remaining payments will take place as ongoing construction objectives are achieved. The plant will be located in West Virginia and is being purchased under the company s memorandum of understanding with Taggart Global USA, LLC.

On May 3, NRP reported First Quarter EPU of $0.28

  • Production down 4% comparably, Prices up 9% Weak quarter exacerbated by operating difficulties, EPU down 45% comparably
  • 07 EPU guidance reaffirmed at $1.50 per unit
  • Quarterly distribution of $0.455 per unit declared, up 15% comparably
  • Income down comparably on lower production, higher expenses. Total net income came in at $22 million, down 23% comparably. A weaker coal environment prompted the company's Appalachian and Illinois basin producers to curtail production. Further, the benefits from the company's recent acquisitions lagged even more than expected due to operational difficulties on both Cline and Dingess-Rum properties. While production was down, coal royalty revenues did increase 5% for the quarter due to improved realized pricing. Operating expenses, however, increased 46% comparably. This significant jump was mostly due to the company s recent acquisitions. EPU comparisons for the quarter fared much worse than those of net income due to recent acquisition related dilution. First quarter EPU was $0.28, down 45% comparably.

    Full-year earnings guidance reaffirmed. Despite the quarter's operational difficulties, management reaffirmed strong full-year guidance. As previously issued, this guidance calls for EPU within the range of $1.42 to $1.58, giving a midrange of $1.50 per unit. Acquisition benefits are likely to accelerate within the next few quarters as both Cline and Dingess-Rum operating conditions improve. Further, management noted that they believe pricing in the Appalachian region will improve during the remainder of 2007. During the first quarter, 90% of NRP s coal-royalty revenues were earned from Appalachian based coal. An improvement in the region could greatly enhance near-term operating performance.

    First quarter distribution of $0.455 per unit brings forward yield to 5.1%. The first quarter distribution is up 15% comparably and has a full-year run rate of $1.82 per unit, giving NRP a 5.1% forward yield. The distribution will be paid on May 14th to unitholders of record on May 1st.

    VALUATION

    To value NRP units, we have performed a discounted cash flow calculation using our forward estimates of net income per unit. We consider both NRP s lower risk level and favorable tax position when calculating our DCF valuation estimate. Due to our upward EPS adjustment for the year and more favorable near-term Appalachian pricing outlook, our six-month target price saw an increase to $33 per unit, from $31.75 per unit previously.

    Split Levels

    Going forward, the partnership will be paying a higher percentage of distributable cash flow to the general partner and holders of the IDRs. Holders of IDR units are entitled to 48% of distributable cash above $0.3813 per quarter (calculated based on total cash distributed). This will effectively split distributable cash growth going forward. Holders of NRP/NSP will receive 50% of the payouts above $0.3813 per quarter; holders of the IDRs and the general partner, will receive the other 50%.

    RISKS

  • Lower coal prices and lower production from lessees could adversely affect royalty revenue and distributable cash flow.
  • Future market prices for coal mining rights may not offer adequate returns on investment.
  • Being a yield-oriented security, NRP may come under pressure if interest rates trend upward.
  • We consider the payout on NRP units to be low-risk, i.e., payments are not likely to drop below the minimum of $0.2563 per unit, per quarter. However, the payment is likely to fluctuate in tandem with coal pricing and other factors that affect distributable cash flow.
  • We are maintaining our Sell rating on NRP units but have adjusted our target price upward slightly to $33.00, from $31.75 previously. The increase is due to recent strength in Central Appalachian coal prices. For the second quarter and full-year, we have revised our estimates upward and now expect $0.40 and $1.55 per unit, respectively, up from $0.39 and $1.51. Despite the more favorable near term pricing outlook, the units still appear overvalued. At current levels, we advise investors to wait for lower per-unit pricing.

    KEY POINTS

  • Units of NRP are trading just below their 52-week and all time high. They have run-up nearly 40% year-to-date vs. about 12% for the S&P 500 and 35% for the Zacks coal group (18 companies).
  • NRP is currently yielding 4.4% compared to its five-year average yield of 5.1%.
  • Central Appalachian coal futures averaged $44/ton in the second quarter, up 10% from the first quarter.
  • NRP has increased its payout in 15 out of 16 quarters since its IPO.
  • The partnership's revenues are generated through royalties, which insulates it from the risks of traditional coal mining operations.
  • The long-term outlook for coal demand is positive and NRP units will benefit from any sustained price increases.
  • The partnership has made several large acquisitions over the last twelve months. These acquisitions will further diversify the company's royalty stream through coal handling and transportation assets, among others.
  • Much of the partnership's growth going forward will need to be generated from acquisitions. As its debt-to-equity ratio increases, the company will need to issue additional units to fund purchases.
  • The total distributable cash per unit has reached the tipping point in terms of general partner compensation. Going forward, the general partner and other holders of IDRs will receive higher splits; 50% of all incremental distributable cash (see Valuation section for details).
  • NRP 1-yr chart: