2023-07-25 00:31:37 ET
Summary
- Natural Resource Partners L.P. has significantly improved its financial position since 2015, reducing its asset base by half and nearing its goal of retiring all outstanding debt.
- The firm's business model, which involves leasing its mineral rights to operating companies, has allowed it to generate significant free cash flow and support growing distributions to unitholders.
- Despite its strong performance and high FCF yield of 32.86%, NRP is currently trading at a price-earnings multiple of just 4.24, suggesting the market is undervaluing it.
In 2015, Natural Resource Partners L.P. ( NRP ) found itself highly indebted, with an extremely risky capital structure, and unable to raise more funds from external sources. Today, the firm is in sight of its goal of retiring all outstanding debt, it has nearly halved its asset base, and is now an engine of economic value. Nevertheless, the firm is trading at a price-earnings ((PE)) multiple of just 4.24, and has a free cash flow ((FCF)) yield of 32.86%. The market has failed to properly appreciate the qualities that make NRP such a strong candidate to continue to beat the market.
Strong Stock Market Performance
Over the last five years, units in Natural Resource Partners have appreciated by over 83%, compared to nearly 67% for the SPDR S&P 500 ETF Trust ( SPY ), which tracks the S&P 500 ( SPX ). When you factor in the partnership's distributions, total unitholder returns ((TUR)) were nearly 177% compared to nearly 82% for the SPDR S&P 500 ETF Trust.
Source: Morningstar
Distributions are Supported by Free Cash Flow
Given the importance of distributions to the partnership's performance, it seems appropriate to try and see if distributions are supported by FCF. Indeed, this seems to be the case. Since the bear markets of 2015 and 2016, NRP has generated significant FCF, more than doubling its FCF generation since the pandemic crash of 2020. In that time, the firm has generated $1.41 billion of FCF, while making nearly $316 million in distributions. Narrowing our window of analysis shows just how remarkable the firm's FCF generation has been, with the firm earning over $850 million in FCF, or nearly 117% of its market cap or 96% of its enterprise value.
Data Source: Natural Resource Partners L.P. Filings
The partnership "cash flow cushion" is a further sign of the strong position that the firm is in in terms of its liquidity and its ability to grow distributions, with the cash flow cushion rising from -$8.34 million in 2015 to $102.52 million in the trailing twelve months ((TTM)).
NRP's Business Model De-Risks It
As the partnership's 1Q23 10-Q shows, over 80% of its revenue is derived from mineral rights. The firm owns around 13 million acres of mineral interests and other property rights across the country, including 3.5 million acres on which carbon dioxide is sequestered in underground pore spaces. The firm also owns a 49% interest in Sisecam Wyoming, LLC, one for the world's lowest cost producers of soda ash. This interest is responsible for the residual revenue the firm earns.
Source: 1Q23 10-Q
The firm does not conduct any operations, choosing instead to lease its mineral and other rights to operating companies, in exchange for royalties and other fees. Consequently, any operating expenses, capital expenses and other liabilities related to production, are not borne by the partnership. In the case of its soda ash interests, those costs are borne by Sisecam.
Research shows that managers tend to overestimate future FCF , raise too much capital, and overinvest in the business, in pursuit of those initiatives it believes will raise FCF. This tendency is particularly exacerbated during boom times. When those anticipated FCF do not emerge, the now-over-invested firm is forced to shrink its balance sheet until profitability returns to an acceptable level. This happens whether its tech firms overinvesting in one year and being forced to shrink their balance sheets and retrench workers in another, or in more traditional businesses such as thermal coal and soda ash. This creates a boom and bust cycle which Marathon Asset Management calls a "capital cycle" , and which researchers have characterized as the "asset growth effect" . The asset growth effect refers to how, on average, firms with a high asset growth underperform low asset growth firms. This is due to the errors that emerge from managerial overconfidence.
Given that NRP does not need to make any sort of investments in order for it to earn royalties from its mineral interests and a share of profits in Sisecam, management has been able to commit itself to the goal of retiring all outstanding debt, while also shrinking its asset base. NRP's total assets have decreased from $1.67 billion in 2015 to nearly $836 million in the TTM period, almost halving its asset base since the doldrums of 2015. As asset growth is a predictor of future returns, the sustained asset decline helps to explain why the firm has beaten the markets, and why it is likely to continue to do so in the long run. The partnership's outstanding debt has also declined markedly, with long-term debt shrinking from $1.21 billion in 2015 to nearly $134 million in the TTM period. Current debt has declined from nearly $81 million in 2015 to $$39 million in the TTM period.
Data Source: Natural Resource Partners L.P. Filings
Since 2015, NRP has exploited its business model to aggressively rationalize its financial structure in ways that de-risk it and put it in a strong position to continue to beat the market. This was in response to its own encounter with the ill effects of managerial overconfidence, which left it with debt that made up two-thirds of its capital structure, bonds trading at 65 cents per dollar, unable to use external sources to refinance its maturing debt. Unlike other firms who cannot commit to an as-aggressive project to de-lever and de-risk, NR was able to fully exploit the possibilities of its business model.
Creating Economic Value
The asset shrinkage has also involved right-sizing the business from four operating segments to two, and these changes have ensured that the firm now earns a return on its invested capital greater than its cost of capital. Having experienced a return on invested capital ((ROIC)) of -26.3% in 2015, NRP now enjoys a ROIC of nearly 48% in the TTM period.
Source: Author Calculations
Valuation
NRP has a PE ratio of 4.24 compared to 26.26 for the S&P 500. The metals and mining sector has a PE multiple of 32.18, according to Prof. Aswath Damodaran's data . Given the asset light nature of the business, it is not surprising that it enjoys a gross profitability of 0.44, which is higher than the 0.33 threshold that Robert Novy-Marx' research shows marks a stock out as attractive. Finally, with $290 million in FCF in the TTM period, and an enterprise value of nearly $883 million, NRP has a FCF yield of 32.86%, which is far higher than the market's current FCF yield of 2.3%, according to New Constructs . The firm appears to be trading attractively on a relative basis, compared to the market, and its peers, and its profitability is at an attractive level, and its FCF are trading at very attractive levels.
Conclusion
NRP has emerged from the doldrums of 2015, when it was saddled with massive debts, had a highly risky capital structure, and no recourse to refinance, to become a highly deleveraged firm that is in sight of being able to retire all outstanding debt. This has been enabled by the firm's business structure, which NRP has skillfully exploited to shrink its asset base, and maximize its ability to beat the market. NRP's performance is not just about limiting the ability of managerial overconfidence to hurt the business, it is also fueled by the firm's ability to deliver growing distributions to its unitholders, something we have shown is very supportable. NRP is very attractively valued and is a strong bet for the long haul.
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Natural Resource Partners Continues To Impress