What’s NACCO’s Margin of Safety?
After reading my write-up, a member asked me about the margin of safety in NACCO (NC):
“…why would someone put half of their portfolio weight in a stock like this where there is customer concentration risk plus a real risk that one of the customers may close shop? Agree that its FCF yield is 10% or so but does it deserve that kind of weight?”
I don’t want to exaggerate the safety of this stock. I didn’t write it up for a newsletter. This isn’t a recommendation for anyone else to buy it. I put 50% into it knowing I would have future control over decisions to sell that 50%. I don’t think I’d recommend this stock to anyone else because the headlines will all be negative and that is very tough for people to hold through.
Having said that, let me take you through how I might have seen the potential margin of safety when I bought the stock at under $33 a share on October 2nd. The way I framed it, the margin of safety in NACCO was a lot higher than what I can get in other stocks. That’s despite the customer concentration and the possibility those concentrated customers are coal power plants about to be shut down.
When I bought the stock, I believed it was then trading at something like a 10% to 15% free cash flow yield. I also believed that the company’s balance sheet will be essentially unleveraged pretty soon (taking into account build up of cash during this year, the expected $35 million cash dividend from Hamilton Beach just before the spin, etc.). The parent company has liabilities but these are not immediately payable in full. Meanwhile, the unconsolidated mines pay cash dividends immediately each year. So, what I’m saying here is that I don’t believe the parent company is more leveraged, more short of cash relative to potential liabilities, etc. than an average stock.
So, the balance sheet is like an average stock.
But, a normal, unleveraged stock usually trades at about a 5% free cash flow yield.
So, NACCO’s free cash flow yield is 5% to 10% higher than an average stock while the balance sheet is similar.
Now, if it is true that when NACCO loses a big contract this means it mostly loses an equal percentage proportion of both revenues and expenses (this is an exaggeration – but I don’t think it’s a huge exaggeration because the mines really are administered very independently and are non-recourse to NACCO), you can kind of think about your margin of safety and the value in this stock as follows…
NACCO has a free cash flow yield no lower than 10% to 15%.
A normal stock has a free cash flow yield no higher than 5%.
5% is 0.50 to 0.67 times less than 10% to 15%. Therefore, NACCO would decline to a normal valuation after it has lost about 50% to 65% of its earnings. Let’s say this is basically after it has lost something like its biggest or even two biggest contracts.
So, your margin of safety in NACCO stock is that it’s priced like it has already lost its two biggest contracts. However, it hasn’t lost its two biggest contracts.
Logically, even if we assume that it is probable that NACCO will lose its 2 biggest contracts and that loss will happen reasonably soon…
The probability that NACCO will lose these contracts is less than 100%.
The likely time till NACCO loses these contracts is greater than tomorrow.
A normal stock is priced like it is 100% certain that it has a 5% free cash flow yield starting this second.
To get NACCO to have that same yield/discounted cash flow situation, you’d need to know it was close to 100% certain they’d lose their 1-2 biggest customers pretty close to right now.
Three things seem true to me about NAACO:
- Till some contracts are cancelled, I’m getting no less than a 10% to 15% cash return on my purchase price ($32.50)
- The probability that the coal power plants NAACO serves will be shut down can’t literally be 100%
- The time till the coal power plants NACCO serves shut down can’t literally be one day
The way I look at it is this:
Investors who pass on buying NACCO probably believe there is a real chance that the coal power plants NACCO serves may be shut down sometime in the near future. I too believe there is a real chance that the coal power plants NACCO serves may be shut down sometime in the near future.
Most investors, seeing this possibility, don’t want to own the stock while it seems probable to them that power plants which are customers of NACCO will be shut down and NACCO’s earnings will drop a lot.
I, seeing that NACCO is offering a 5% to 10% cash yield advantage over other stocks till some plants do shut down, am happy to hold the stock while these negative headlines hit.
In other words, I’m taking higher cash flow now and risking that I will have to endure bad headlines and lower cash flow in the future. I’m doing this not because I believe my 10% to 15% free cash flow yield is secure, but because I think a free cash flow yield greater than 5% is secure because I am starting with a 10% to 15% free cash flow yield that can afford to be eroded some and still leave me with a 5% yield.
A normal stock can’t have its free cash flow yield eroded at all and stay safe. NACCO can.
I don’t have any precise guesses about probabilities of coal plant shutdowns, when they will happen, etc.
But, let’s model two possible futures for NACCO.
Let’s say free cash flow per share is in the $3 to $5 range with the contracts they have now. The stock price is $33 (close to where I bought it). And then let’s say that some important contracts will be lost resulting in a loss of 50% of the company’s earnings in 3-5 years from now.
Well, $3 a year in free cash flow times 3 years is $9 of cash build up per share.
And: $5 a year in free cash flow times 5 years is $25 of cash build up per share.
And then, a 50% reduction in cash earning power is $3 * 0.5 = $1.50 a share or $5 * 0.50 = $2.50 a share.
So, if the scenario I laid out here is true (NACCO earns about $3-$5 a share now but earnings will permanently fall 50% within 3-5 years) this is what a buyer of NACCO stock today should be getting in 2021-2023 for his $33:
* A stock holding between $9 and $25 of net cash in 2021-2023
* A stock earning between $1.50 and $2.50 a share in FCF between 2021-2023
Net cash is often valued at net cash. And stocks often trade at 10-15 times earnings. So, the sum of these parts would be:
* $9 + $15 ($1.50 * 10) = $24 a share
* $25 + $37.50 ($2.50 * 15) = $62.50 a share
So, you see right there that one of the estimates I came up with predicts a loss. If FCF is $3 a share, stays the same for 3 years, then NC loses 50% of its earnings and the stock trades at a P/E of 10 that gives you a loss of $9 on a $33 stock, so 27% of your capital. That would demolish 14% of my total portfolio right there.
And, of course, this isn’t the worst case scenario.
Power plants could close down before 3 years. NACCO could lose more than 50% of its earnings. The market might never value NC at a P/E as high as 10. You can always imagine a lot of bad things that might happen to a stock. And some of them will happen.
On the other hand, some of what I laid out just there was conservative. For example, I believe NACCO’s “owner earnings” are much closer to $5 a share than $3 a share. And, I did a calculation which assumes NACCO’s cash earning power has a 100% chance of dropping 50% within 3-5 years.
Does it?
First of all, NACCO might win contracts as well as lose them. It might win lime rock contracts. It might take the cash flow from its coal operations and buy businesses unrelated to coal mining (it used to own Hyseter-Yale and Hamilton Beach). Also, the contracts are indexed to inflation. We’re acting like inflation is 0% and NACCO can only make money from coal mining contracts it already has. It can’t have new contracts, acquire other businesses, etc. This is a simplifying assumption. But, it’s obviously a conservative one.
Let’s ignore all that and simply ask: will NACCO lose 50% of the coal supply contracts it now has? And, if so, when?
This is a macro call. And I’m not qualified to make it. But, I can tell you why coal power plants have been closing for the last 10 years. Since the financial crisis, electricity demand per person in the U.S. has declined. Meanwhile, natural gas production has increased.
Coal power plants will definitely close down if:
- Natural gas production keeps increasing
- Electricity consumption keeps decreasing
For the last 7-10 years now, the U.S. has needed less and less power and has simultaneously had more and more natural gas to burn. If these trends persist, it makes sense to keep closing power plants (because electricity demand is decreasing) and it makes sense for those closures to be coal power plants (since the alternative fuel, natural gas, keeps getting more abundant).
A bet on the certainty that coal power plants will close relatively soon is a bet on:
- Declines in electricity consumption
- Increases in natural gas production
That’s what has happened for the last 10 years. However, it’s not what happened for the previous 30 years. Natural gas production is up about 4% a year over the last 10 years. That’s probably in part because companies were looking for oil (not necessarily gas) in the U.S. when oil prices were high. Prior to this 10-year boom, U.S. natural gas production grew 0% a year for 30 years.
The need for electricity has been decreasing recently. However, electricity demand had been flatter to up over the 30 years prior to the financial crisis.
So, both increasing natural gas production and decreasing electricity generation needs are 10-year trends rather than 40-year trends.
I can’t predict future natural gas production or future electricity needs in the U.S. However, I can see that the reason coal power plants have shut down has had more to do with low need for new electricity generation and high supply of natural gas rather than other societal factors.
We can try to speculate on macro factors like this.
Like we can ask: what if electric cars become widely used?
Well, that would tend to reverse both those trends. Electric cars would increase demand for electricity and decrease demand for gasoline. Gasoline demand helps drive the demand for finding and developing oil reserves which tends to have a byproduct type influence on natural gas that increases its production.
But, what’s the point of knowing that electric cars would help extend the life of coal power plants? I can’t make predictions about electric cars, oil, natural gas, etc. better than anyone else.
What I’m saying is that it’s all speculative. If instead of trying to answer the question “What do I need to assume to buy NACCO at $32.50 a share?” you ask “What do I need to assume to bet against NACCO at $32.50 a share?” – you come up with a chain of speculative assumptions. When I flipped the question and said: “How will NACCO end up being worth less than $32.50 a share?” I got a series of speculative assumptions that seemed shaky on the probabilities and the timing.
There’s a big difference between a 99% probability that NACCO will lose more than half its earnings in 6 months and a 51% probability that NACCO will lose more than half its earnings in 6 years. The first case can justify NACCO’s then price of $32.50 (when I bought it). The second case doesn’t come close.
So, when I flipped the question and asked: how can NACCO be worth less than $32.50 – I had such a hard time coming up with a justification for that assertion that I bought the stock instead.
Finally, I want to stress something. I have 50% of my portfolio in NACCO. That doesn’t make me an expert on NACCO. Even though you have 0% of your portfolio in NACCO, you can easily know as much as I do and judge the situation as well or better than I have.
Someone recently wrote me an email asking a lot of questions about NACCO. My response was short:
“I don’t plan to write anything more about NACCO. I only wrote it up because I got a lot of emails from members requesting a write-up when they saw I bought the stock.
Anyone who goes through the filings like you did can know as much about NC as I do and come to their own conclusions. I really don’t have anything to add. I was reluctant to write as much as I did.”
Because this was a spin-off with an investor presentation and because NACCO puts out such a detailed 10-K (and has since the early 1990s) and includes exhibit 99 to the 10-K which is the financial statements for the unconsolidated mines – there’s really not much I can tell you that’s a unique take.
Everything you need to form your own opinion is in those filings.
I’m not recommending anyone buy NACCO shares. I am – however – strongly recommending everyone read the investor presentation, the past 10-Ks, and the financial statements for the unconsolidated mines and then come to their own conclusion.