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Andrew Kuhn

NACCO (NC): A Contract Coal Miner with Stable Inflation Linked Profit Per Ton, a P/E of 10, a Strong Moat, and No Leverage

by STEPHEN GAMBLE

by STEPHEN GAMBLE

OVERVIEW 

NACCO is primarily a services company, in the guise of a coal mining company, deriving all of its revenues from its US operations. It provides the service of managing mines and delivering raw materials – coal and limestone – to several large customers on a cost-plus basis on long term contracts. It has mines in several southern US states, HQ in Texas, and its two largest coal mines by coal volume, are in North Dakota. In the Q1 19 earnings call, it changed its reporting structure, to now report its business in three segments:

1.       Coal Mining (coal extraction)

2.       North American Mining (limestone extraction, and one sand/gravel mine just opened)

3.       Minerals Management (oil and gas royalties)

Coal and limestone/limestone are mined in two distinct ways: Consolidated mining means that NACCO owns the mine, pays all the costs, assumes the liability for reclamation, and sells the coal on the open market and so is subject to the coal spot price. There is now only one consolidated coal mine: the Mississippi Lignite Mining Company (MLMC), after the shutdown of various mines under the Centennial Natural Resources subsidiary at the end of 2015. Unconsolidated mining means that NACCO operates the mine, and is paid a fee per tonne of coal/cubic yard of limestone mined, under cost-plus, inflation-linked long term contracts. The customers assume most of the risks and the long-term obligations of operating the mines, paying for equipment, mine reclamation responsibilities, and all other costs. Therefore, NACCO is not exposed to the coal spot price or the price of limestone under these contracts. The gross profit/tonne for these mines is very stable – less than a standard deviation of 6% over the last seven years. Most of NACCO’s profits come from unconsolidated mining, and most of these from coal mining rather than limestone mining. Other coal companies may hedge their exposure to the coal spot price: instead NACCO avoids this risk by selling to the customer for an agreed profit margin. This also reduces the price variations for NACCO’s customers. The image above shows the gross profit/ton of unconsolidated coal over the last seven years, and also the tons of unconsolidated coal mined/share, which has been increasing due to an expansion in unconsolidated coal mining.

In the last seven years, an average 76% of profits came from long term contracts for mining principally coal and limestone (unconsolidated mines), 15% of its profits from royalties for oil/gas extraction on land it leases/owns, and 9% of profits from consolidated coal mines. There are various types of coal: NACCO almost exclusively mines lignite, which is the lowest quality coal, with a low energy density per ton. Therefore, it does not pay to transport it any significant distance, so coal fired power stations tend to be co-located with the lignite mines. This is the case for most of the mines that NACCO operates. Coal is mined exclusively from surface strip mines – this creates large open scars in the landscape that have to be reclaimed after mining has ceased. This might be the target of further future environmental regulations.  NACCO’s customers assume this responsibility for reclaiming the unconsolidated coal mines, setting aside money each year for this, which removes significant risk from NACCO. A key factor in the bankruptcy of other coal companies has been the cost of insuring their guarantees that this reclamation would be performed. These companies, e.g. Arch Coal, typically self-guarantee that these liabilities will be covered – a process called ‘self-bonding.’ They are then required to have insurance to back these guarantees. However, as the company’s financial strength reduces, e.g. through debt, the cost of the insurance rises, which puts further pressure on their financial position, and becomes a vicious circle. Several of these companies, e.g. Peabody Coal, have therefore used the Chapter 11 bankruptcy process in the last five years to shed themselves of these liabilities. Self-bonding is particularly a problem if a mine becomes non-cost effective to operate due to the price of coal declining – then the company is left with the mine and the reclamation costs, but without an income stream to compensate for this. Therefore, this insurance can be thought of as additional leverage or risk that coal companies which are exposed to the coal spot price have, beyond that coming from normal financial leverage (debt). NACCO largely avoids this risk, since its customers assume the coal mine reclamation responsibilities – therefore if it loses a contract to operate a coal mine, then it can walk away from the coal mine without further liability beyond writing off its investment in the mine. 

For this MLMC consolidated mine, NACCO assumes the risks and long-term obligations of operating and retiring the coal mine, and is exposed to the coal spot price. In 2014 and 2015, NACCO made an operating loss, partly due to the low coal spot price, which hit a multi-year low of $40-$55/ton in this time period, after peaking at $70-$80 in 2011, and also due to one-off costs associated with its closure of the Centennial consolidated coal mines. NACCO’s strategy is to reduce exposure to the coal spot price over time by gradually diversifying away from consolidated coal mining– its 2018 10-K states that, ‘Outright acquisitions of existing coal mines or mining companies with exposure to fluctuating coal commodity markets, or structures that would create significant leverage, are outside the Company’s area of focus,’ i.e. NACCO will not acquire new consolidated mines under the current management strategy.

Royalty profits are more volatile, ranging from 6% of gross profits to 29% of company gross profits in the last seven years, and they make up an average of 15% of the profits in this time period.

There is concentration risk due to large customers: about 75% of NACCO’s profits depend on relatively few large power generation customers, therefore the greatest risk to the profits is the customer deciding to close their coal using plants and terminating the service contract to provide coal. This has occurred, e.g. when the Liberty gasifier station operated by Mississippi Power closed in 2017 and led to the closure of the Liberty mine. However, deliveries commenced only a year earlier, so NACCO only ever delivered a very small amount of coal to the project.

NACCO’s top two customers account for 64% of the tons of coal mined; for coal from Falkirk and Coteau mines respectively, in North Dakota.

The customer of the Coteau (Freedom  Mine) is the Dakota Coal Company, which sells the coal to three plants operated by the Basin Electric Power Cooperative, and the customer of Falkirk mine is The Coal Creek power station, operated by Great River Energy. In most cases, the coal mine is located adjacent or near to the power plants, so the coal can be delivered at the lowest possible costs. Great River Energy has a plan showing that coal will remain part of their mix until at least 2030 in the same proportion as 2017 – but their 10 year plan says that any new generation will come from renewables, or other non-fossil fuel sources, so coal demand will not increase in the future from this customer (unless their capacity factor increases, i.e. the percentage of time the coal plant is operational in any given time period). The Basin Electric Power Company asked Coteau Mine to reduce its costs, which it was able to do by increasing use of draglines, thus reducing smaller vehicle movements, and using waste heat to improve the thermal value of the lignite produced by drying it prior to use- the ‘dryfining,’ process. They have a close working relationship to reduce costs. Basin Electric Power company reduced staffing at the coal power plant by 12% in 2018 to save money, and state that although this will reduce baseload availability of their coal plants, this can be compensated for by being part of the Southwest Power Pool, which gives a better ability to buy power on the market if necessary to meet demand. Therefore, the two largest customers have no current plans to close their coal plants. However they both have a stated strategy of reducing their carbon emissions over time, and diversifying into renewables – so the amount of coal purchased may not increase over time from these customers.

The current contracts for the Falkirk mine runs until 2045, and the, ‘Coteau agreement,’ was originally set to expire in 2007, but is renewable for six 5 year periods until 2037 (source: NACCO 1999 10-K), therefore the next renewal date is 2022. The terms of this latter agreement were also changed for reimbursement of actual costs, to reimbursement of a fixed amount per ton for general and administrative costs, when the agreement was restated in 2007. Therefore, this transfer some risk onto NACCO and gives them another incentive to carefully control costs.

Durability

NACCO is durable only as long as demand for the coal it is producing continues, it can continue to replace any mining contracts lost, and it continues with the current strategy of avoiding consolidated coal mining.

Limestone contributes a smaller percentage of profits compared to coal mining. Royalty income from oil and gas produced on its properties fluctuates considerably – 43% variation over the last seven years. Therefore royalty income will not ensure alone the long-term durability of NACCO.

Coal consumption for electricity production has declined in the US significantly in the last decade, halving from 2008-2018, according to the US Annual Energy Outlook report, from the Energy Information Administration.  In this period, there have also been about 45 GW of coal generating capacity closures, which have been replaced by oil and gas, solar and wind capacity. In the last four years specifically, the majority of added capacity has been solar and wind. A significant number of further coal power station closures are predicted in the next ten years, but the share of electricity produced from coal is not expected to fall significantly further in the next decade. Furthermore, there are no new coal power stations expected at any point in the future, so in order for NACCO to maintain or grow its coal mining business, it must take market share from other coal producers. NACCO makes up a very small part of the US coal market: 38.5 million tons of the 755 million tons mined in 2018 = 5%. It has taken share from competitors – the Bisti unconsolidated coal mine was an existing mine taken over from another company in 2017, which in 2018 produced 3.4M tons or about 10% of NACCO’s coal production.

The stability of NACCO’s margins on unconsolidated coal mined is very good – less than 6% variation over the last seven years. Margin variation comes from consolidated coal mining, and also from oil and gas royalty variation. NACCO also has an advantage over other coal producers in that it is providing a service to its customers, which is a reliable supply of fuel for power plants, at an agreed price over the cost of production. The advantage is that the customer is getting a more stable price for their coal than if they buy on the open market, which helps the economics of their power station. One customer, Basin Electric Power Co-operative (Coteau Mine) is actively engaged in working with NACCO to lower the cost of production – by optimising the use of draglines to bring coal from the mine to the power station, and reducing coal plant staffing. Due to the nature of the relationship, both NACCO and the customer are incentivised to work together to lower the cost of production – this benefits both the customer (lower cost of fuel), and NACCO (increased likelihood of customer retention, increased customer fuel usage which means higher profits). NACCO comments in its 10-K that the dispatch cost for coal fuel is the main driver of demand for the coal-fired power stations.

NACCO may be compared with another company: Westmoreland Coal which also operated a ‘mine mouth,’ model, where some of its coal production was mined adjacent to customer’s coal power plants. Westmoreland, like NACCO, focused almost exclusively on thermal coal. However, the company suffered from customers closing coal plants: the Conesville (American Electric Power Company) plant which accounted for 11% of their revenue closed in 2017, the San Juan plant which accounted for 36% of their revenue closed half its generating capacity at the end of 2017, and the Colstrip coal power plant which accounts for another 36% of their revenue, notified them in 2017 that they would shut down by the end of 2019. With $1.4 billion in debt from a series of coal mine purchases in the last decade at a time when coal prices were higher, Westmoreland coal could not meet its obligations so it filed chapter 11 bankruptcy in Oct-18. Like NACCO, Westmoreland had cost-plus contracts (Colstrip), but unlike NACCO also had contracts with a mixture of fixed price per ton, plus some variable costs (San Juan). This story highlights the main risk to NACCO – its customers deciding to close their coal plants due to competition from natural gas, renewables, or other factors. However, NACCO has been actively seeking to a) find new contract mining customers and b) diversify away from coal mining to industries with a more certain future, such as limestone mining.

 

Quality

NACCO is fundamentally more stable than its coal mining peers due to the services business model, and is diversifying into activities which should further stabilise its earnings.

NACCO’s return on capital is 23% in 2018, and 17% in 2017, where return on capital is calculated as: operating margin*asset turnover, (where operating margin is EBIT/sales, and asset turnover is sales/assets).

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