Pardee Resources: 4% Yield From Hard Assets And Upside To A Met Coal Recovery

Summary

• Non-operated business model means earnings are very high quality.
• 2016 appears to be the bottom of the coal market, suggesting upside to come.
• 40% upside to sum-of-the-parts valuation.

Pardee Resources (OTCPK:PDER) is a unique company. It had its genesis in timber and mining fortunes in Appalachia and still owns many of those same assets today. The difference is, all those years ago, the founders realised that many of these businesses are incredibly cyclical, so they decided on a non-operating business model.

Thus, the company owns assets, but does not operate them, preferring to collect royalty and other income from their ownership without taking operating risk. This reduces the downside when the market for the commodities that are produced from their various land holdings decline. As an example, they collect royalties when coal or natural gas is produced from their lands, and stumpage fees when timber or pulpwood are cut. They also sell land for residential uses at higher per-acre prices, and have diversified into owning solar panels. They also own some California farmland that has been planted with premium table grapes by an operator, that should begin producing revenues this year. The company had a poor showing in 2016, primarily due to the state of the coal markets, as royalties on coal are its largest source of revenue and income, as it has significant landholdings in the Central Appalachian [CAPP] coal areas. The company has stuck with its non-operating strategy for generations, and has earned strong returns doing so. They pay a 4.25% yield, so there is a reasonable return on holding these shares even if no catalyst plays out, which is an important consideration for a tightly held microcap, as a takeover would be unlikely even in the event of severe undervaluation due to significant ownership by descendants of the founding families. That being said, a return on capital is only something useful if you're also getting reasonable value for your initial capital investment, so I will value the entire company as well. I believe a sum-of-the-parts valuation is appropriate here, as some of the assets have better long term prospects than others.

Coal

I will start with the coal valuation, as that has historically been the company's biggest earner, and is probably the key to a rebound here. The company's land contains both high quality thermal coal and metallurgical coal. There are two markets for coal: metallurgical for making steel and thermal for burning in power plants. The company receives royalties from mines producing both types of coal, but metallurgical coal is much more durable, in this author's opinion. Thermal coal from Appalachia is likely to be entirely replaced by natural gas from the Marcellus and cheaper coal from the Powder River Basin. Thus, the thermal royalties are likely to have a shorter lifespan. Metallurgical coal has recovered although prices are very volatile, and it is not obsolete, so low cost producers are likely to survive to pay royalties. There has been some recovery in coal mining. For instance, Logan County, home of their Pardee tract which is operated by Coronado II LLC is seeing recovery, including signing bonuses for miners. More importantly to the company, mines are being expanded and new mines developed. Their Blackwood tract has a new surface mine expanding on to their land in 2017. They have also leased portions of three other tracts to 2 different operators for the expansion of an existing mine and a new metallurgical coal mine, so you can expect volumes to actually grow going forward. It is always dangerous to catch a falling knife in any market, but the 2017 Q1 results suggest that the bottom is in for Pardee's coal division. While they had $8.8 MM of total coal revenue in 2016, of which 76% was from metallurgical coal. That was down substantially from 2015, but has recovered with $3.0 MM of coal revenue in Q1 2017, of which 88% is metallurgical. This confirms my valuation decision from my article in spring 2016 to use a much lower multiple for thermal revenues, as they are declining much faster. For conservatism, I am using the same 7X earnings for met coal and 3X earnings for thermal coal. Given the recovery here and mines opening in 2017, I think annualizing the Q1 results is reasonable. I will also apply their tax burden here, as I believe it is mostly generated from this division. They only report depreciation by segment in their annual report not in their quarterlies, so I have subtracted 2016 operating expenses (ex depreciation, which is non-economic given they don't do any capital spending). I believe using 2016 expenses shouldn't be an issue, as functionally all their divisional costs are fixed overhead type costs as they don't run any operations. As evidence of that, I would note that their coal division expenses changed by only 1.4% from Q1 2016 to Q1 2017. I split expenses and income taxes between the two types of coal based on revenue. Source: Author's Analysis, company disclosures, 2016 Annual Report As you can see from the table above, the company's coal division has a conservatively estimated value of $59.3 MM. For the first time since I started following this company, I believe there is potential for significant upside from the coal division. If prices hang in there for metallurgical coal and the new mines come on stream, revenue could expand significantly. Since I believe the majority of their costs are fixed divisional G&A type costs (they don't vary much year-over-year) there would be significant operating leverage if revenue improves.

Gas

Natural gas is a fuel source with a much better future than coal, as it is much cleaner burning. The company's lands include both shale gas and coal bed methane, both of which have very long tail production, so I don't have depletion concerns regarding their total resource. Of course, the existing wells on their land will deplete, but that was offset in 2016 by new production from operators drilling coalbed methane wells in Virginia. Prices rising enough to stimulate new drilling on their shale lands would be most welcome, but the fact that production is stable even in a low price environment is very encouraging. There is also potentially significant upside potential from the Rogersville Shale. While little work has been done on it so far (vertical tests only) the shale is deep (so its high pressure) and has reasonable total organic content, so it has potential. The company has significant acreage covering it, and some Utica acreage as well, so if natural gas prices rebound there is significant upside here. The decline here has been very shallow, and my estimate for production in 2017 based on past performance is 3.0 bcf for the year. Using their reported Q1 revenues and the NYMEX strip pricing, I estimate they will have $9.0 MM in revenues from this division in 2017. There were $6.0 MM in operating expenses associated with the division, suggesting earnings of $3.0 MM in 2017. I'll use 12X operating earnings, valuing the division at $36 MM. It is worth noting that these earnings are very high quality, as depletion is included in the expenses and is non-cash, and also essentially non-economic, as they are not spending capital to replace the reserves, rather their lessees are spending capital to drill the new wells on their land.

Timber and Land

Probably the best assets the company owns are their timber assets. They are the ultimate renewable asset, as the trees grow back and the forest can be harvested again. The company sells the rights to harvest both softwood and hardwood timber off its lands, as well as leases hunting rights for the land. Finally, they sell subdivide residential land and sell it as rural lots. The company's land base is 170.8 thousand acres, and they had it appraised a few years ago and the appraisal came back at $999 per acre. Since then, they have high-graded the portfolio by selling land with unfavourable topography and purchased high quality softwood timber plantations. The highest and best use of the land is definitely subdividing it into residential lots, for which they receive thousands of dollars per acre. These sales have been accelerating, as they sold $733k worth of land in all of 2016, and nearly matched that with $692k worth of land sold in Q1 of 2017. I will use a 30% discount to the appraisal per acre value. That should provide a reasonable amount of conservatism given the upgrade of the land base and the sales of land well above that level. That suggests a value of $119.4 MM for the land and timber division. There are some potential catalysts for this division outside of land sales, primarily a return to higher housing starts. That would benefit both their hardwood sales, where high end species are used for everything from hardwood flooring to kitchen cabinets. But housing starts would also greatly benefit their softwood pine plantations, as they are maturing at present, and will be ready for harvest of saw timber for dimensional lumber. Recent softwood sales have been of pulpwood, which is thinning the smaller trees allowing for some to grow large enough for timber sales. If housing starts continue to rise, there is significant potential for lumber prices to peak just as their plantations are reaching maturity. Also, the ongoing trade saga with Canada has the potential to boost timber prices, as imports are constrained.

Alternative Energy

The company's alternative energy division invests in solar systems, both photovoltaic panel based and solar hot water collectors. Generally they buy the system from a developer and sell the resulting energy to the host business or institution on a long term contract. This business is quite stable, and cash flow (earnings + depreciation) was up slightly in 2016 to $3.4 MM, from $3.3 MM the previous year. As in the past, I will use a 12X multiple for this cash flow stream, which values these investments at $40.8 MM. The company also makes tax equity investments in solar partnerships. Essentially, they contribute part of the upfront capital in exchange for the tax benefits generated in the early years of a project. I will value these at their carrying value, which is conservative as they use equity method accounting, and they presumably made the investments with the intention of recovering more than their total costs. That adds $2.3 MM to the valuation, for a total of $43.1 MM for this segment.

Agricultural Land

The company has a diversification effort purchasing freehold and leasehold California agricultural land for the production of table grapes. They have invested $5.6 MM into these efforts, and given the first harvest on the first (smaller) parcel isn't due until August 2017, I'm going to value this at their cost. While they are unlikely to have a competitive advantage here initially, they have experienced partners and are buying long lived hard assets which will probably appreciate, so cost seems reasonable. They have a long history of making savvy investments, so I am willing to give them the benefit of the doubt here that they have not overpaid for this land. Once the investments begins to bear fruit I will switch to an income based analysis of these assets.

Debt and G&A

Given I have done a sum of the parts valuation, it is important to subtract both the debt and a capitalized value of their G&A expenses. General and administrative expenses not otherwise allocated to one of the business units were $7.1 MM. That was down $100k in 2016, and down another $100k in Q1 2017 from Q1 2016, so the trend is good. I will use the highest multiple of anything in my analysis for the G&A, which was 12X. Therefore, I will deduct $85.2 MM for G&A. After subtracting their cash balances, the company has $4.0 MM of net debt, which I will also deduct from their valuation.

Valuation and Conclusion

Source: Author's Analysis, Company Disclosures I have included a table above summarising my estimates of all the various sources of value to the company. In all cases, I have tried to be conservative, and the $252 target price is well above the company's current share price of $179 per share. Things are looking up for the company, and it appears 2016 may have been the bottom. Everything from met coal prices to Trump's trade policies on the lumber file seem to be going their way, so there is potential for upside surprise here. The company pays a 4% dividend, which helps provide patience. That is important here, as the company is controlled by descendants of the founding families, so I would not expect a takeover to be a potential catalyst. This article is part of Seeking Alpha PRO. PRO members receive exclusive access to Seeking Alpha's best ideas and professional tools to fully leverage the platform.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long PDER. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.