Coal Earnings Notes (Q1 2024)

Metallurgical coal prices have been a bit soft so far this year. Since coal miners have operating leverage as well as capital expenditure requirements, you would expect that their free cash flows have suffered more than the royalty owners' have. And as we pointed out in January, the royalty owners  - which hold the senior securities in the capital structure of mines - seemed cheaper than the producers.

It is a concern that the miners are expanding met coal production even while the commodity price has been weak and their own shares have been "cheap". Warrior's new Blue Creek mine is expected to produce 5 million tons per year and Peabody's North Goonyella / Centurion mine is supposed to produce 3 million tons per year. To put that in perspective, 8 million tons of new capacity is about equal to what Warrior produces in total now.

It seems like a possible "base case" is that the miners' predictable over-investment in capacity will result in the commodity price trending towards marginal cost. The miners will be able to earn a profit margin during times of strong steel demand, but we are not really seeing anything that would show us that mining has become a good business or that the executives recognize that they are not in a good business.

People are working on electrolysis of iron ore (which would be like aluminum production) as well as hydrogen based reduction for steelmaking. Either of those innovations would disrupt metallurgical coal and what they would mainly require is cheaper electricity. It does not seem prudent to invest capital in new coal mines without establishing long term sales contracts with financially sound entities to sell the output. The miners could idle the expansion projects and have the option to start them at such time that they could guarantee an attractive market for the output.

We follow four coal producers and three royalty owners. The miners are Alpha Met (AMR), Warrior Met (HCC), Arch Resources (ARCH), and Peabody (BTU). The mineral owners are Natural Resource Partners (NRP), Pardee Resources (PDER), and Beaver Coal (BVERS). Some notes on the results:

Alpha Met
The market capitalization of AMR is now $3.7 billion (at $285 per share), down quite a bit from $5.75 billion at the high in February. Results for March 31st (10-Q) show Alpha's current assets less total liabilities (ignoring deferred taxes) were $248 million (about the same as year-end 2023) which puts the enterprise value at $3.45 billion now.

For the first quarter of 2024, AMR's adjusted EBITDA was $190 million (down from $266 million the prior quarter) which puts the EV/EBITDA at 4.5x. AMR sold 4.4 million tons of met coal in Q1, down from 4.6 million in Q4. They got $167/t for met coal versus $184/t the prior quarter, and the cost per ton was down slightly to $116/t versus $119/t.

Cash from operations was $196 million and capital expenditures were $72 million for the quarter (including $8.5 million of contributions to equity affiliates), for $124 million of free cash flow, an annualized yield on the enterprise value of 14%. They paid $3 million of dividends for the quarter and bought back $116 million of stock, for a shareholder yield of 13% (annualized) on the current market capitalization. The share count was down 14.8% year-over-year.

Warrior Met
The market capitalization of HCC is now $3.3 billion (at $63.25 per share), down about 10% from a recent all time high of $70 in late April. Results for March 31st (10-Q) show Warrior's current assets less total liabilities (ignoring deferred taxes) were $422 million which puts the enterprise value at $2.89 billion now.

For the first quarter of 2024, Warrior's adjusted EBITDA was $200 million (up from $164 million the prior quarter) which puts the EV/EBITDA at 3.6x. Warrior sold 2.1 million tons of met coal in Q1, up from 1.9 million tons in Q4. They got $234/t for met coal versus $258/t the prior quarter, and the cost per ton was down slightly to $133/t versus $147/t.

Cash from operations was $104 million and capital expenditures were $102 million for the quarter. There was an adverse change in working capital (mostly paying down trade accounts receivable) that negatively affected cash from operations by $87 million. If you add that back, free cash flow would have been $89 million, which is a 12% yield on the enterprise value.

The company paid $31 million of dividends and did not buy back any stock, making the shareholder yield 3.8% (annualized). It seems like it would be a good idea not to be expanding production, as we have previously observed.

Arch Resources
The market capitalization of ARCH is now $2.8 billion (at $156 per share), down about 15% from the all time high in March. Results for March 31st (10-Q) show Arch's current assets less total liabilities (ignoring deferred taxes) at negative $104 million which puts the enterprise value at $2.9 billion now.

For the first quarter of 2024, Arch's adjusted EBITDA was $103 million (down from $180 million the prior quarter) which puts the EV/EBITDA at 7x. Arch sold 2.2 million tons of coal in Q1 (both met and thermal coal), down from 2.3 million tons in Q4. They got $166/t for met coal versus $196/t the prior quarter, and the cost per ton (both met and thermal combined) was up to $94/t from $87/t. Note that the cash margin per ton was thus down one-third just from the prior quarter.

Cash from operations was $128 million and capital expenditures were $45 million for the quarter, resulting in $83 million of free cash flow, an 11% yield on the enterprise value. The company paid $44 million of dividends and bought back $14 million of stock, making the shareholder yield 8.3% (annualized).

Peabody
The market capitalization of BTU is now $2.8 billion (at $22.50 per share). Results for March 31st (10-Q) show Peabody's current assets less total liabilities (ignoring deferred taxes) at negative $263 million which puts the enterprise value at $3.1 billion now.

For the first quarter of 2024, Peabody's adjusted EBITDA was $161 million (down from $345 million the prior quarter) which puts the EV/EBITDA at 4.8x. Peabody's seaborne thermal earned $94 million of EBITDA for the quarter, the seaborne met earned $48 million, Powder River Basin earned $16 million, and other U.S. thermal earned $46.5 million.

Cash from operations was $120 million and capital expenditures were $68 million for the quarter, resulting in $52 million of free cash flow, a 6.7% yield on the enterprise value. The company paid $10 million of dividends and bought back $83 million of stock, which resulted in a 3% share count reduction.

Natural Resource Partners
The market capitalization of NRP is now $1.16 billion (at $90 per unit) and as of March 31st (10-Q) the partnership has $175 million of long term debt and $72 million of convertible preferred stock, for net liabilities of $220 million. The enterprise value is thus $1.39 billion.

NRP generated $72 million of free cash flow in the first quarter of 2024 and $312 million of free cash flow over the trailing twelve months. The first quarter figure, which annualizes to $288 million, is a 20.7% yield on the enterprise value.

After the end of the first quarter, NRP settled the remainder of its warrants and bought back more than half of its convertible preferred units. Our best guess now is that the partnership has an enterprise value of $1.35 million. Assuming an annualized free cash flow of $280 million, that would still be a yield of greater than 20% on the enterprise value. Also, it would mean that estimated remaining net liabilities of $175 million could be paid off in about 2.5 quarters, which would mean the end of this year. The stated intention of management is to begin distributing cash to shareholders once all liabilities are paid off. That would indicate a possible annual distribution of $20, which would be a 22% yield on the current unit price, assuming that current level of free cash flow holds.

Pardee Resources
Pardee is interesting because it owns a huge amount of land in West Virginia, both the surface with timber and also the mineral rights. The current market capitalization (at $250 per share) is $166 million and the company reported $35 million of current assets net of all liabilities at March 31, which gives an enterprise value of $131 million. That is $845 per acre, which seems quite low compared to what timberlands are worth, not to mention the mineral rights and other assets.

Pardee earned $5 million of EBITDA in the first quarter, which was down 17% y/y. The coal royalty per ton was down (because of lower commodity prices received by their lessees), but the lessees' production levels were up. That gives a yield of 15.5% on the enterprise value (annualized).

Beaver Coal
Beaver Coal is a partnership that also owns land in West Virginia (only about one-third as many total acres as Pardee) and unlike Pardee is also getting ground lease income from real estate tenants, in addition to coal royalties and timber sales. At $2,750 per unit, the market capitalization of the Beaver partnership is $68.4 million. Subtracting the $6.6 million of net current assets, the enterprise value is $61.8 million. 

Beaver's coal royalties were $8.9 million in 2023 vs $9.6 million in 2022. Total revenue was $12.9 million vs $14.4 million. Expenses were $2.3 million vs $2.1 million. Operating income was $10.5 million vs $12.1 million. The enterprise value is $1,246 per acre and the OCF yield on the EV (ignoring working capital changes) is 17%. Shares are trading for under 7x net income.

The partnership has had a cash build from $5.2 million (YE 2022) to $6.1 million (YE 2023), which is an increase of $34 per unit. There has been a net current asset build from $5.1 million to $6.6 million, now standing at $266 per unit of current assets net of all liabilities (excluding deferred revenue).

They had $889k of proceeds from sale of property and equipment (also had $511k expenditure for purchase of property and equipment). The financial statements do not say what the sale or purchases were. This will perhaps be explained in the shareholder letter when they mail the annual report.

Review of Material World: The Six Raw Materials That Shape Modern Civilization

Ed Conway is a journalist who has gotten interested, in Vaclav Smil fashion, in the materials that underlie our civilization and world. Hence his new book, just published in November: Material World. While Vaclav Smil has argued that the "four pillars of modern civilization" are cement, steel, plastics, and ammonia, Conway focuses on six raw materials that he thinks are underrated: sand, salt, iron, copper, oil, and lithium.

It's not entirely clear that "underrated" is Conway's organizing concept for choosing these six, and one thing we quickly see is that he is not as logically organized, thorough, or data driven as Smil. But his argument seems to be that these are underrated and overlooked since on the one hand they are so important, but on the other hand they are cheap relative to the value they create (copper is under $4 per pound), they are used in enormous volumes (big, bulky, yet overlooked flows), and because they are bulky, producing them requires displacing even more enormous amounts of overburden and ore. Tearing down mountains, and that sort of thing.

Another point that Conway raises is that these raw materials less fungible than the casual observer might realize. Sand, for example, comes in different varieties with important differences in grain size and shape and mineral composition. The sand that is needed for making high quality optical glass is different than the sand that is acceptable for use in making concrete. Sand is also turned into silicon for making semiconductors, but that has more to do with the refining and ingot producing process than the raw ingredient sourcing. If you have ever thought, "how can sand be rare, or important?," the answer is in these idiosyncrasies that make the different types non-fungible.

The iron chapters got our attention because we have been thinking quite a bit about iron, steel, and metallurgical coal. Conway observes that iron accounts for 95% of the metal that we produce and use, and that it is "so fundamental to our lives that it is just as good a measure of living standards as GDP." The most developed countries in the world have an installed base of steel of about 15 tons per capita. (As he puts it, "iron is the bones of our society.") The per capita figure for China is only about half as much. His back-of-the-envelope calculation is that if everyone in the world were to come up to the developed country amount of steel per capita, it would be an additional 144 billion tons - four times the amount that has been already produced in human history.

We had already been thinking lately that, if the GDP per capita of India keeps growing then their use of steel per capita (and oil too, of course) should as well. India is already the largest importer of U.S. metallurgical coal for making steel. India is the second largest steel producer but its per capita consumption and per capital installed base lag far behind the rest of the world. The straightest path forward would be for steel production to continue to grow, resulting in increasing demand for imported metallurgical coal. (Every ton of steel produced requires almost a ton of metallurgical coal to go in the blast furnace alongside the iron ore.)

The writer "Coal Trader" argued recently that "emerging markets appear to be approaching a level of self-sufficiency and mutual support. They no longer seem to rely heavily on the investment and consumer demand from major Western corporations." If Coal Trader is right and their economies are decoupling from the U.S. (the "training wheels are starting to come off," he says) we should see it in their GDP growth figures (e.g. India). And if they decouple it should make demand for these raw material commodities less volatile. (Coal Trader had an interesting observation: "I believe we need to invest as if our offices were in Singapore, or perhaps even Jakarta.")

If these countries continue to develop, they should soon begin consuming much more oil per capita too. Enough to make a big difference to total world oil demand. India is currently something like 5% of world oil demand with per capita usage that’s only about one-third of China. If India develops just to the level of China, it would cause incremental increased oil demand of around ten million barrels per day. An astonishing figure, it dwarfs any possible near-term savings from electric vehicles in richer countries, and the incremental demand would be almost as big as total U.S. oil production. And note that it will take machines built of steel to burn this oil.

People who are short commodities are betting against the up-and-to-the-right GDP trends of countries like China and India. Maybe those trends will continue and maybe they won't, but they are the status quo. Which brings up another point from the book. 

As we have elsewhere observed, there is a great tension between physics-based pessimism (Malthusian) about natural resources and economics-based optimism (some might say cornucopianism) about the ability to respond to higher prices with substitution and invention. As an example, the new lithium-iron-phosphate (LFP) battery chemistry seems like a major point in favor of the cornucopian, economist viewpoint. We would not have thought it possible a few years ago to make a battery with just lithium and iron. 

In the book, Conway points out that even as the ore concentration of copper has plummeted over the past century, the price has fallen in real terms. There have been huge fluctuations, having to do with the capital cycle in copper mining, but worse ore grades have not caused prices to rise. The Malthusian and Cornucopian forces have held in balance. (Perhaps the long-run destiny is for these forces to always remain in balance?)

It therefore seems prudent for an investor to make not highly leveraged bets ("torque") on much higher commodity prices, but rather to find ways of benefiting from the status quo of growth, development, and human invention.

So let us talk about ways to do this. As we have observed in the past, owners of royalties on natural resource production make money in status quo conditions, they do well if prices rise, but they can even benefit if the producers foolishly over-expand their capacity and drive down their commodity price (which they have a marked tendency to do throughout history), at least as long as they own a royalty on the new production too. 

The opportunity that we have seen is that these royalty interests in hydrocarbons are bond-like assets priced to give equity-like returns because of ESG investing and because of a brutal bear market, and subsequent investor disinterest, in natural resource production.

We have mentioned both Natural Resource Partners and Pardee Resources in past writing. NRP derives a significant portion of its revenue from royalties on metallurgical coal production, but also from thermal coal production as well as an interest in a soda ash business in Wyoming. While the partnership owns 13 million mineral acres, it does not own any surface acres. In contrast, Pardee owns about 155,000 surface and mineral acres, mostly in West Virginia, with active metallurgical coal production. 

The current market capitalization of NRP at $96 per share is $1.2 billion. NRP has a more complicated balance sheet, with debt, preferred stock, and warrants. (The liabilities keep going up as the share price goes up, because of the warrants.) Depending on the valuation assumptions you make, they probably have $371 million of additional liabilities, less around $80 million potentially earned during Q4, for an estimated current enterprise value of $1.5 billion. 

Assuming the recent level of $80 million of quarterly free cash flow, the FCF/EV yield would now be about 21%. Amazingly, this is higher than the FCF yield of the coal miners, who have to reinvest a significant portion of their cash flows back into production as capital expenditures. It is surprising that the royalty, which is the senior security in the capital structure of the mine, seems cheaper than the producers' equities. 

There is a slide in NRP's investor presentation showing annual free cash flow figures for NRP since 2015. For the year 2016, which was when the coal market crashed and most of the miners in the industry went bankrupt, the partnership still had free cash flow of $76 million. If that were to happen again (a 75% decline from current level), the FCF/EV on the current valuation would still be 5%.

Recently, the producers' cash cost per ton of met coal has been around $100 per ton, with Arch at $97/ton and Warrior at $114/ton. In 2016, the cash cost of met for Arch was only $53/t. With the producers' costs per ton having doubled since 2016, it ought to be difficult for the market-clearing price to drop as low as it did in 2016 (at least for a protracted length of time), and hence it ought to be difficult for free cash flow to drop that much again.

Then there is Pardee, which has a market capitalization of $164 million at $250 per share. Factoring in the end of year special dividend and estimated fourth quarter free cash flow, their enterprise value is probably now around $130 million. (That's $830 per acre of surface.) Pardee generated around $7.6 million of EBITDA in Q3, so that would be an annualized yield of 23% on the enterprise value.

The edge perhaps goes to Pardee at this point based on valuation, as well as the fact that it is "two-pillar" since it is trading (arguably) below the value of the surface. In fact, one thought experiment would be to consider that Pardee could theoretically sell the surface and timber for an amount in excess of the current enterprise value, while retaining the mineral rights (meaning coal royalties) as well as other assets. (Pardee is very unlikely to actually do this; it is just a thought experiment.) Not to say that the land is of exactly the same quality, but Weyerhaeuser just bought land for $2,685/acre in the southeastern U.S.. It is very difficult to find any land with timber in the U.S. for less than $1,000 per acre. Land prices of three digits per acre tend to be swamp or desert.

4/5.