NC - NACCO Industries: Cheap Valuation But Beware Of The Risks

2023-10-24 09:24:52 ET

Summary

• NACCO Industries is currently trading at a cheap valuation level but it has some risks.
• The company has benefited from the war in Ukraine, but the global energy market has absorbed the effect of the war and the price of coal has plunged.
• NACCO Industries is investing in a major lithium project to diversify its business and hedge against the decline in coal.

NACCO Industries ( NC ) passes under the radar of the vast majority of investors, who prefer to avoid exposure to the industry of coal, which is characterized by a secular decline over the long run. However, the stock has shed 38% in the last 12 months and thus it is currently trading at a trailing price-to-earnings ratio of only 7.9x. This is a cheap valuation level, which may attract some value-oriented investors. However, NACCO Industries also has some risks, which justify the seemingly attractive valuation level.

Business overview

NACCO Industries is the largest producer of coal in the U.S. and one of the top 10 coal producers in the world, with a history of more than 110 years. It produces coal from mines in North Dakota, Texas, Mississippi, Louisiana and New Mexico and sells its output to power generation companies via multi-year contracts. Each mine is the exclusive supplier to the facilities of the customers.

NACCO Industries has greatly benefited from the war in Ukraine. Shortly after the invasion of Russia in Ukraine, the U.S. and the European Union imposed strict sanctions on the exports of oil and natural gas of Russia. Consequently, the prices of oil and natural gas skyrocketed last year, to 13-year highs. Due to the insufficient global supply of natural gas, the global use of coal surged and thus the price of coal skyrocketed to a 15-year high last year.

NACCO Industries boasts of operating with a fee-based model, which somewhat protects the company from the wide fluctuations of the price of coal. However, the company has enjoyed a double tailwind thanks to the sanctions of western countries on Russia; an increased demand for coal and much higher prices. As a result, NACCO Industries grew its earnings per share 50% last year, from $6.69 in 2021 to an all-time high of $10.06 in 2022.

However, the global energy market has almost fully absorbed the effect of the Ukrainian crisis this year, partly thanks to an abnormally warm winter in the beginning of the year. As a result, the price of coal has plunged 68% off its peak of $431 in 2022, to $138 now. The current price is still much higher than the normal range ($60-$100) before the Ukrainian crisis but the steep decrease of the price signals that there may be more downside ahead.

The latest earnings report of NACCO Industries was certainly much worse than the reports in the preceding quarters. In the second quarter, the company saw its earnings per share plunge 93% over the prior year’s quarter, from $5.07 to $0.34. In addition, management stated that the earnings in the second half of 2023 and the full year are expected to decrease significantly over the prior year’s levels. Given this guidance and the 83% plunge of the earnings per share in the first half of the year, it is safe to expect the earnings per share to slump by at least 70% in the full year. To be sure, the company has posted earnings per share of $1.09 in the first half of the year and hence it is unlikely to post earnings per share above $3.00 in the full year, given the current business momentum.

Going forward, it is essentially impossible to forecast the earnings of NACCO Industries in the upcoming years, given the pronounced sensitivity of the company to the demand for coal, the sensitivity to the cycles of the price of coal and the unpredictable pace of the global transition from fossil fuels to clean energy sources (more on this below). It is also important to note that the stock is not covered by any analyst.

If one insists on forecasting the future earnings of NACCO Industries, one should note that the company posted 10-year low earnings per share of $2.10 in 2020 due to the impact of the pandemic, 10-year high earnings per share of $6.69 in 2021 thanks to pent-up demand after the pandemic and record earnings per share of $10.06 in 2022 thanks to the aforementioned sanctions. Therefore, the period 2017-2019 is the most recent period with normal business conditions for the coal industry. During that 3-year period, NACCO Industries posted average earnings per share of $4.93. Going forward and given the headwind from the ongoing energy transition, NACCO Industries is not likely to achieve sustainable earnings per share above $4.93.

Energy transition

The coal industry is in a secular decline, as most countries (including the U.S.) are doing their best to shift from fossil fuels to clean energy sources. This is clearly reflected in the chart below, which shows that the consumption of coal in the U.S. has steadily decreased over the last 15 years.

Source: Statista

Despite the temporary bounce in the demand for coal in the last two years due to the aforementioned tailwind from the Ukrainian crisis, the long-term trend is clearly downward. In fact, the energy crisis caused by the war in Ukraine last year has led most countries to accelerate their efforts on shifting from fossil fuels to clean energy sources. As a result, according to the International Energy Agency [IEA], the global investment in clean energy sources surpassed the global investment in fossil fuels by about $700 billion last year. The global shift from fossil fuels to green energy projects is a major threat for the business model of NACCO Industries.

On the bright side, the company is doing its best to navigate through this shift. NACCO Industries has taken an interest in the Thacker Pass Project, which is expected to begin producing lithium in the second half of 2026. Lithium is a vital component in the global energy transition.

The global demand for lithium has grown at a breathtaking pace in the last three years, nearly tripling between 2020 and 2023. Moreover, it is not expected to take a breather anytime soon. Instead, it is expected to more than quadruple until 2030 thanks to the reliable growth in the sales of mobile phones and electric vehicles.

Electric vehicles are in the very early phases of their growth trajectory. The global sales of electric vehicles have more than doubled in the last two years and are expected to keep growing at a double-digit rate for many more years. It is also critical to realize that electric vehicles require 5,000 to 10,000 times as much lithium as mobile phones and hence lithium producers have exciting growth potential ahead. Overall, the participation of NACCO Industries in a major lithium project is certainly in the right direction, as it will enhance the diversification of the company and will somewhat hedge it against the secular decline of its flagship business.

Balance sheet

The management of NACCO Industries should be praised for maintaining a debt-free balance sheet. The company does not pay any interest expense while it has a net cash position (=cash + receivables – total liabilities) of $39 million . The net cash position is 15% of the market capitalization of the stock and hence it is material. A rock–solid balance sheet is paramount in the highly cyclical coal industry, which is characterized by a secular decline. The financial strength of NACCO Industries enables the company to easily endure unforeseen downturns in its business.

Valuation

NACCO Industries is currently trading at a trailing price-to-earnings ratio of only 7.9x. This earnings multiple is much lower than the 10-year average price-to-earnings ratio of 11.2x of the stock but it is equal to the 5-year average valuation level of the stock.

As the transition from fossil fuels to clean energy sources has greatly accelerated in the last three years, the 5-year average valuation of NACCO Industries is probably more representative of the current potential of the stock. It is also worth noting that NACCO Industries appears more expensive than its peer Peabody Energy ( BTU ), which is trading at a forward price-to-earnings ratio of only 5.4x .

On the one hand, the management of NACCO Industries is doing its best to protect the company from the threat related to the ongoing energy transition by investing in a major lithium project and by maintaining a rock-solid balance sheet. On the other hand, it is only natural that the stock is trading at a single-digit price-to-earnings ratio, given the long-term decay of its flagship business. Overall, the stock appears reasonably valued right now.

Upside

About a year ago, the stock of NACCO Industries peaked at $60, which is nearly double the current stock price. If another energy crisis shows up, e.g. due to an escalation of the ongoing tension in the Middle East, the price of coal may surge again. In such a case, the stock of NACCO Industries is likely to enjoy a relief rally. However, in the absence of a major geopolitical event, the use of coal is not likely to increase meaningfully. On the other hand, if the price of lithium enjoys a steep rally after 2026, when the Thacker Pass Project begins producing lithium, the stock of NACCO Industries will probably benefit.

Final thoughts

NACCO Industries is trading at a cheap valuation level but for a good reason. The company is doing its best in the parts of its business it can control but it remains sensitive to the underlying demand for coal. Overall, the stock seems fairly valued right now.

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