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Why My Bullish Top Idea On Natural Resource Partners Played Out, And Why I Am No Longer Bullish

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About: Natural Resource Partners L.P. (NRP)
by: Tristan R. Brown
Summary

This article follows up on a September 2018 Top Idea article that presented Natural Resource Partners as an asymmetrical long investment opportunity.

The company's unit price delivered a total return of up to 59% after the article's publication compared to my targeted return of 50%.

My long thesis played out over eight months as an improved operating environment enabled the company to accelerate its turnaround while returning additional cash to investors.

The company's outlook has deteriorated in recent months, however, as slowing global growth expectations have led to lower commodity prices and three lessee bankruptcies.

The asymmetrical risk/reward profile that existed in September 2018 is no longer present due to factors that are outside of the company's control.

In early September 2018 I published a Seeking Alpha Top Idea article in which I proposed that mineral rights owner Natural Resource Partners (NRP) could see its unit price increase by 50% or more over a period of multiple quarters. My long thesis was based on a major turnaround that the company was undergoing following a period from 2015 to 2017 in which its investors saw the paper value of their holdings largely wiped out. Specifically, I noted that bearish investor sentiment at the time of writing was not justified by the improvements that the company's management was making to its finances amid a strengthening operating environment:

NRP has staged an impressive turnaround over the last year, however, by substantially reducing its debt load and leverage at the expense of distribution growth. This balance sheet discipline has resulted in a company that is in a much stronger financial position now than it was in late 2014 when energy prices began to collapse. Investor concerns over the exposure of U.S. coal exports to trade and climate policy are overblown given that several countries are responsible for rising exports and met coal has been a major contributor to export growth. Likewise, while dilution will eventually be a constraint on unit price appreciation, large gains are capable first.

Natural Resource Partners also offered investors an attractive distribution yield of almost 5.9% while they waited for market sentiment to improve.

The unit price of Natural Resource Partners has taken the company's investors on a roller-coaster ride over the subsequent 13 months. My total return target was achieved and briefly exceeded earlier this year following an impressive string of earnings beats and the release of a $0.85/unit special distribution in Q2 2019 (see figure). The unit price rally occurred as the price of coal in the Appalachian Basin, from which much of the company's royalties are derived, increased by almost 20%. The sale of its construction aggregates segment at an attractive price also boosted market sentiment, in the form of a rising valuation (see second figure), by allowing Natural Resource Partners to further reduce its leverage ratio.

Total return for Natural Resource Partners, October 2018 - October 2019. Based on historical daily closing prices. Dashed green line denotes my targeted return.

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Data by YCharts

The earnings growth that Natural Resource Partners was able to achieve due to its strengthening operating environment allowed it to increase the pace of its turnaround. The company continued to improve its balance sheet by reducing its debt load, in turn causing its interest expense to decline as well (see figure). The large reduction of its long-term debt load was especially notable given its special distribution payment and concurrent maintenance of its cash reserve over the same period.

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Data by YCharts

While my total return target was met by May, the unit price rally ended as quickly as it had begun and by September 2019 the gains had been completely retraced on a total return basis. The underlying cause of the subsequent unit price decline was renewed weakness in the global economy and consequent diminished expectations for future energy demand. In the U.S. Natural Resource Partners had to deal with two new headwinds as 2019 progressed: declining coal exports on weak international demand and a substantial downturn to the price of natural gas (see figure). Appalachian Basin coal prices fell sharply over the summer and, while they rebounded a bit in Q3, they remain lower now than they were in September 2018.

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Data by YCharts

The deteriorating operating environment in turn caused no fewer than three of the company's lessees to declare bankruptcy over the course of the summer. As the company's management described the situation in the Q2 earnings call:

Looking ahead fall in coal prices are likely to put pressure on our coal lessees in the coming months. While the impact of falling prices has not yet impacted our results we believe it’s because most of our lessees have been selling coal at higher prices locked in during the fourth quarter of last year. We also believe most of these sales contracts will be coming up for renewal between now and at the end of the year at which time sales prices were likely be reset at lower levels...

The current coal price environment together with continuing transportation and logistical challenges as well as limited access to capital are taking a toll on some of our lessees. Three of our lessees Blackjewel, Blackhawk and Cambrian have declared bankruptcy since our last earnings call.

Natural Resource Partners is partially insulated against commodity price movements due to its status as a leaseholder rather than coal miner, especially given that its leases are covered by minimum payment provisions. Bankruptcy is the primary threat to this model, which is why the company's unitholders took the news of the multiple bankruptcies poorly despite its large Q2 earnings beat. This has been reflected in the downward earnings estimates revisions for FY 2020 and FY 2021 in recent months (see figure), although investors should note that the "consensus" is based on a single analyst estimate.

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Data by YCharts

It is tempting to draw a parallel between the company's situation in September 2018 and that of today: coal prices and the company's unit price are all at approximately the same level now as they were then, yet its recent earnings have been strong and its financial turnaround has continued unabated. Its distribution yield of almost 7% at the time of writing is also quite attractive inasmuch as it provides an additional benefit to patient investors.

Similarities to September 2018 aside, though, there are two major factors that prevent me from expecting Natural Resource Partners to repeat its earlier unit price performance. First, the worsening global trade war is having an increasingly negative impact on the global economy, with the IMF writing over the summer that "risks to the forecast are mainly to the downside" in a projection that has also been made by the World Bank. The effects of this weakness on the company's operations have already been seen, making the negative outlook an important factor for investors to consider.

Second, there is a growing probability that the Trump administration's relatively friendly regulatory approach to the coal sector will be replaced by one that is substantially more hostile following 2020. As I noted last month, the Obama administration's "all of the above" approach to U.S. energy production has been thoroughly discarded by many of the leading candidates for the Democratic presidential nomination. Senator Elizabeth Warren, who recently overtook frontrunner and former Vice President Joe Biden in the national polls and is now being given a 53% probability of capturing the nomination by the betting markets, has pledged as president to impose a blanket ban on existing hydraulic fracturing operations and the construction of new nuclear power plants. While she has not explicitly mentioned her plans for coal mining yet, it is very reasonable to assume that she would impose similar restrictions on that sector given its large carbon footprint relative to both natural gas and nuclear power.

This is not to say with certainty that Natural Resource Partners will see its operations negatively impacted by national political developments in the foreseeable future. The probability that its operations will be affected in this way has rapidly increased in recent months, however, and cannot be entirely discounted either. Whereas the company's low share price a year ago did not reflect its relatively strong contemporary operating conditions, its share price today does account for a deteriorating operating environment. This environment can rebound, of course, but investors in Natural Resource Partners now run the risk that adverse regulatory developments will take effect before the commodity price situation improves. Simply put, the favorable risk/reward profile that existed in September 2018 for long investors is no longer present.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.