Wednesday, August 9, 2023

Natural Resource Partners L.P. ($NRP) - Q2 2023 Earnings

[Previously: Natural Resource Partners L.P.]

Natural Resource Partners L.P. (NRP) is a limited partnership that owns mineral rights throughout the U.S. (totaling 13 million acres) as well as a 49% minority interest in Sisecam Wyoming, a trona ore mining and soda ash production business located in the Green River Basin of Wyoming. 

NRP does not produce any minerals - they lease acreage to operators in exchange for royalties. The majority of their mineral rights revenues come from royalties on Appalachian coal production, with additional amounts from coal royalties in the Illinois Basin and the Powder River basin. They also derive revenue from minimum lease straight-line charges, wheelage charges, and oil and gas royalties.

The market capitalization of NRP (at $68) is $860 million. Total liabilities net of current assets and deferred revenue were $146 million at the end of the second quarter (10-Q). There are 121,667 units of Class A Convertible Preferred Units after the (significant) year-to-date redemptions. The terms governing the liquidation preference are:

The “liquidation value” will be an amount equal to the greater of: (1) (a) the per unit purchase price multiplied by (i) prior to March 2, 2020, 1.50, (ii) on or after March 2, 2020 and prior to March 2, 2021, 1.70 and (iii) on or after March 2, 2021, 1.85, less (b)(i) all preferred unit distributions previously made by NRP and (ii) all cash payments previously made in respect of redemption of any PIK units; and (2) the per unit purchase price plus the value of all accrued and unpaid distributions.

The partnership has been able to redeem 128,333 preferred units year to date for $128 million ($1,000 per unit). The partnership has some leverage in negotiating these repurchases because only 1/3 of the units can be converted in any 12 month period, and only when the unit price is above $51. We will use $1,000 per unit for the remaining units while realizing that the actual cost of redeeming the remaining units could vary (and be higher) than this. That puts the enterprise value now at $1.13 billion.

Royalty revenue for Q2 was $61 million compared with $76 million for Q1. Earnings from Sisecam Wyoming were $27 million, up from $19 million the prior quarter. Cash from operations was $73 million in Q1 and $81 million in Q2. So the YTD cash from operations of $154 million is a 27% yield on the enterprise value.

For the entire year-to-date, capital expenditures have only been ten thousand dollars. The partnership borrowed $14 million, paid $51 million of distributions to unitholders, paid $15 million of distributions to preferred unitholders, and paid $128 million to redeem preferred units. 

You'll notice that 81% of revenue was converted to cash from operations (YTD), and all cash from operations was used to either pay claims senior to the common unitholders or to pay distributions to the common unitholders. (The preferreds have a 12% cumulative coupon and the credit facility where the partnership borrowed to help repay preferreds has an interest rate in the 8% range.) Also, note that even though only $50 million has been distributed to unitholders year-to-date, a significant fraction of the $150 million of net income YTD is likely taxable and will be reported to unitholders via K-1.

If coal prices and production levels as well as earnings from the Sisecam interest hold up, then the partnership could pay off its remaining $268 million of net liabilities in just over three quarters from now. Paying off liabilities is management's stated intention - from this quarter's call which actually had some questions:

We intend to continue to pay down our preferred and debt as rapidly as we can to the extent we can borrow on our credit revolver at a lower cost than the 12% on the preferreds and to the extent that we can have the preferred holders waive the make-whole premium, which is called a MOIC, M-O-I-C, so that we're able to buy those bonds back at par.

If we can replace 12% obligations with something more like 7% or 8% obligations, we're going to do that as much as we can and then immediately begin paying down the revolver with cash that we generate as well. And our goal is to pay down the preferreds, the bank revolver and then of course continue paying down our private placement notes, which are on an amortization schedule and also by the time they settle in first quarter of 2025, settle our warrants that are outstanding. We're going to want to get rid of all of those obligations as soon as we possibly can. [...]

Our strategy is to eliminate all of these obligations we have the preferreds, the debt and settle our warrants before such time as we begin to raise the distributions or look at consider raising the distributions. And the reason for that is that we have learned firsthand that it would be imprudent for a company such as ours with our business profile to rely at all on sourcing capital from banks or from capital markets to fund our business in the future. So when you can no longer rely on rolling forward or refinancing your credit obligations, you have to assume that you operate with no permanent debt in your capital structure.

So we want to clean everything up, stay on the same path we've been on now for quite a while. And once we have the capital structure fully clean, then we will evaluate capital deployment strategies. It's not going to be too long in the grand scheme of things, we see light at the end of the tunnel. But early 2024, is too soon. Because remember even when we take out those preferreds, we're simply switching the obligation from preferred units to debt. So that's our philosophy. And when we look at it, we think in the long run on a risk-adjusted basis this is going to maximize value for common unitholders.

If we look out a year from now, assuming that cash from operations holds up, they are able to pay off these liabilities, and the unit price remains the same, then the same ~$300 million of annualized cash from operations would be available for distribution to common unitholders with a market capitalization of $860 million. Potentially a 35% yield, or $20+ per unit on the current $68 price.

The royalty model is just so superior to the producer model. When we looked at coal producer earnings this quarter, we see that they are cheaper on EV/EBITDA than NRP, but they have vastly larger capital expenditure requirements. (They are also more leveraged to the coal price, for better and for worse, since they have production cost and a royalty owner doesn't.) 

Something fantastic about royalty companies is that they can benefit if the producers foolishly over-expand their capacity and harm their commodity price. Here's the math: suppose that a producer making a 100% margin (cost is half of selling price) expands production by 25%. Their projection was that they would use the lower volumes to drive cost down by 20% thanks to higher volume, and so the greater amount sold at a lower cost would result in 50% higher profit, a huge return on the expansion capex. 

However, everybody else in the industry has the same idea and inflation causes the cost of production to stay the same (instead of the projected decrease) while at the same time the selling price falls 10% because of the increase in supply. The result is that profits are flat. The expansion capex was completely wasted.

But look what happens to the royalty owner: the selling price is down 10% but a 25% production volume increases results in a 12.5% increase in royalty revenue, since the royalty owner has no cost of production. And it happens with no capital expenditure on the part of the royalty owner. (Keep in mind, of course, that the selling price could fall more than enough to offset the production increase, whether because of the increased supply alone or because of other economic factors. But if that happens, the producers will really be hurting.)

If it is a tough call whether to invest in the royalty or producer based on valuation, the tie has to go to the royalty owner. The reason is that the royalty stands to benefit from the classic producer management mistake (expanding).

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