Action by natural resources partners: the upside remains limited (NYSE: NRP)

Introduction

In the event of a calendar rewind to early 2021, distributions from natural resource partners dependent on thermal coal (NYSE: NRP) seemed to be living on borrowed time, as my previous article warned. To my surprise, the coal prices rose sharply as the global economy came back to life after the severe Covid-19 recession in 2020, offering good fortunes that saved their distributions, such as my previous post discussed. Despite their help, they still saw the risks of the clean energy transition, but fast forward to the present day and they now see a lifeline from sanctions in Eastern Europe ban imports of Russian coal following their widely publicized wartime atrocities in Ukraine, although the upside remains limited for their moderate 4% payout yield due to another obscure issue.

Executive summary and ratings

Since many readers are likely short on time, the table below provides a very brief summary and scores for the main criteria assessed. This google doc provides a list of all my equivalent ratings as well as more information about my rating system. The following section provides a detailed analysis for readers wishing to delve deeper into their situation.

*Instead of simply assessing distribution coverage through distributable cash flow, I prefer to use free cash flow as it provides the strictest criteria and also best captures the true impact on their financial position.

Detailed analysis

High coal prices finally materialized in the fourth quarter of 2021 and, as a result, pushed up their cash flow performance. This saw their operating cash flow end 2021 with a result of $121.8 million and therefore nearly double their results of $66.6 million seen in the previous nine months. If annualized, their operating cash flow in the fourth quarter of 2021 was a very impressive $220.8 million, which if continued would be their best result in recent history since at least 2018. More importantly, this strong financial performance has seen their leverage ratio decline well below the level required to restart their preferred distributions and thereby save their common distributions, consistent with management commentary included below.

“However, as the business performance of our Mining Rights and Soda Ash segment improved in the fourth quarter of 2021, our leverage ratio fell well below this 3.75x threshold and ended the year at 2 Accordingly, in February of this year, we fully redeemed all outstanding paid-in-kind preferred units at par and announced and paid cash distributions which included $0.45 per common unit and 7. $5 million to our preferred unitholders.”

– Q4 2021 Natural Resources Partners Conference Call.

After a scary run in 2021, this now sees the risk of a distribution suspension formally resolved, as predicted in my previous analysis at the end of 2021. By my calculations, their paid-in-kind units in circulation would cost $24, $9 million to redeem. and while this would hamper their future free cash flow in the first quarter of 2022, their cash flow performance can absorb this one-time impact. This aspect has been discussed in more detail in my two previously linked articles for any interested new reader. Looking to the future, the recent sanctions against Russian coal exports to Europe are a lifeline for producers in the United States and, by extension, for thermal coal production which comprises a significant portion of their mineral rights, as shown in the table below.

It can be seen that in 2021 just over half of their mining rights production was thermal coal, with the Illinois basin accounting for nearly two-thirds. While recent geopolitical events have driven thermal coal prices up in virtually every basin, the Illinois basin has seen one of the biggest increases, as seen in the chart below.

Following events in Eastern Europe, the price of thermal coal from the Illinois Basin rose to highs not seen in over a decade, which was driven by its ease of export and is therefore expected quickly see more cargo heading to Europe in the future. Looking ahead, this essentially amounts to a lifeline that offsets a degree of risk surrounding the clean energy transition that was clouding their outlook. Although the exact extent remains impossible to quantify, not only due to the inherent volatility in commodity prices, but also the highly uncertain geopolitical backdrop associated with this sudden change in fortune. It will also be equally important to see how management uses this windfall as this event only delays the impacts of the clean energy transition and so, therefore, they still have to build their revenue elsewhere to compensate for its long term loss. .

After seeing their cash performance increase during the fourth quarter of 2021, it was no surprise to see their net debt continue to decline in tandem to end the year at $298 million and therefore significantly down from its $334.5 million when performing the previous analysis following the third quarter. This is now the first time their net debt has fallen below $300 million in recent history since at least the end of 2018 and, going forward, it could even end 2022 below $200 million. if these very high coal prices persist.

Unsurprisingly, their strong financial performance and low net debt translated into lower leverage, with their net debt to EBITDA and net debt to operating cash flow both ending in 2021 at 1.74 and 2.45 respectively, thus dividing into weak and moderate territories. . Although only one quarter has passed, this still marks a strong improvement from their results of 2.47 and 3.51 respectively when conducting the previous analysis after the third quarter of 2021. While this would give normally give rise to prospects of impending distribution growth, especially given their very high hedging and prospects of declining net debt in 2022, unfortunately there remains yet another obscure issue lurking in their liquidity which throws the proverbial key into the works.

At first glance, their strong liquidity seems to provide sufficient support for higher distributions with their current ratio of 2.53 and a relatively very large cash balance which results in a cash ratio of 2.10. Although the risks to their distributions due to their leverage ratio are resolved, it still creates a new problem that limits their ability to deliver growth, according to the quote below.

“The maximum leverage clause under Opco’s revolving credit facility will be permanently increased from 4.0x to 3.0x if we increase the distribution of common units above the current level of $0.45 per unit ordinary per quarter.”

-Natural Resource Partners 2021 10-K (previously linked).

It can be seen that if they increased their distributions beyond their current quarterly rate of $0.45 per unit, their credit facility covenant would permanently reduce their leverage ratio limit from 4.00 to only 3.00. Admittedly, their current leverage ratio of 2.70 remains below this limit, but going this route would leave virtually no margin of safety and would therefore require the persistence of high coal prices in the future, which is a very risky assumption. . While they currently have no balance drawn on their credit facility, closing and therefore losing access to the facility would hamper the medium to long-term resilience of their liquidity should they face future downturns. This would cause them to maintain a higher cash balance than otherwise to compensate, which, in turn, would further limit their ability to fund distribution growth.

Since their leverage ratio is defined by their total indebtedness and not by their net indebtedness, any excess cash they generate in the short term does not necessarily solve this problem because they are forced to wait for the scheduled maturities of their debt, as the table below displays. Ironically, normally a nice and stable debt maturity profile is desired and supports distribution growth, but in this rather unique situation it actually limits their ability.

Conclusion

Even though the atrocities of the war in Eastern Europe are devastating, the resulting sanctions against Russian thermal coal exports provide a lifeline to U.S. thermal coal and, therefore, are likely to improve their short to medium term financial performance, despite the inherent volatility of commodity prices. prices. Despite this more favorable backdrop that offsets a degree of risk surrounding the clean energy transition, the murky nature of their credit facility covenants once again creates a problem that limits their ability to reward unitholders with a distribution growth and therefore I only believe that upgrading to a holding rating from my previous sell rating is appropriate.

Notes: Unless otherwise stated, all figures in this article are taken from Natural Resource Partners’ SEC Filingsall calculated figures were performed by the author.