Geoff Gannon October 18, 2017

Does NACCO (NC) Have Any Peers?

A Focused Compounding member who analyzed and bought NACCO himself read my write-up on NC and was curious if I did a “peer analysis” for NACCO:

“Did you consider looking at any potential peers with your analysis? I was quite simplistic with my approach. Omnicom splits cash out year in year out. Its current EV to free cash flow is around 10x whereas I looked at NACCO and thought its EV to free cash flow was around 5x (NOTE: At the much lower spin-off price he bought at) and appeared very undervalued as it should at least be 7 to 10x even though Omnicom is a higher quality business. My hurdle for any new position is Omnicom.”

 

I tried to keep it simple. Really, I asked myself 3 questions early one:

 

  1. After the spin-off, will the balance sheet be pretty close to net no debt/no cash (you did something similar seeing there would be the $35 million dividend but then there’s the asset retirement obligation and the pension).

 

  1. Would NACCO produce its earnings mostly in the form of free cash flow?

 

  1. Would “earning power” be 10% or higher as a percent of my purchase price.

 

In the end, the decision is really just whether you would buy a stock or wouldn’t buy a stock. To me it didn’t matter if the stock’s earnings would be $3.25 a share or $6.50 a share if I was buying at $32.50. What mattered was how certain I was of the $3.25 number. Once I think I have a 10% yield, I don’t spend a lot of time wondering if I have a 13% yield, 15% yield, or 20% yield. So, I didn’t spend time worrying about this. If the stock was pretty much unleveraged, the earnings pretty much came in the form of free cash flow, and the earnings yield was greater than 10%, that would be enough.

 

As far as growth, it’s difficult to value that. The company has a goal of growing earnings from unconsolidated mines by 50% within the next 5 years or so. However, they had the same goal about 5 years ago. Because the Kemper project was cancelled, they won’t achieve this. However, they will achieve growth of say 15% or so over last year due to newer mines producing closer to the tons they were eventually expected to produce.

 

I don’t know what they’ll use free cash flow on. I know that the two businesses I like are the unconsolidated contracted coal production and the lime rock draglines. But, neither of those businesses absorbs capital. So, they will grow through signing new deals in that area but they shrink through losing existing customers. I couldn’t judge one way or the other on this.

 

I feel they have no peer. Omnicom (OMC) is not a good peer, because OMC is permanently durable in my view. I think advertising agencies will be around in 2047 and even 2067. It’s very possible lignite coal will not be mined for use in power plants by 2047.

 

However, you can’t really compare NACCO to something like a trust, because the contracts are long-dated and the mines can last longer than the contracts. It’s really the life of the power plants that matters.

 

You could, I suppose compare NACCO to some other companies tied to coal. However, I am not sure this is that informative.

 

In terms of valuing a stream of cash flow, junk bonds yield 5.5% right now. The yield peaked at around 22% during the financial crisis. The prior peak had been 12% to 13% in the 2002 recession.

 

https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY

 

However, this is not that useful in comparing due to the re-investment risk (the bonds may not last as long as NACCO will) and taxes (NACCO may pay a 23% tax rate and then if it pays dividends there are taxes on that, but if it buys back stock that defers taxes which are then taxed at capital gains, etc.). More importantly, bond yields are nominal – not indexed to inflation. The free cash flow yield on NACCO is real.

 

It would make sense to compare NACCO to the free cash flow yield on something as troubled as coal.

 

However, coal miners have commodity price risk and are therefore not a good comparison.

 

NACCO stock is at $37.40 right now. If you read the write-up I did before (and based on the work you did yourself) you’d come to conclusion that a free cash flow “coupon” of $4 to $5 a share is about what NC will average. This may be conservative (actual free cash flow had been closer to the $5 to $7 range in some recent years – though that was with almost no cap-ex for the consolidated mine). Let’s use a price of $37.40 on the stock and a FCF coupon of $4 to $5 a share.

 

That’s a yield of 10.7% to 13.4%. This yield has two advantages over a junk bond. All the FCF is driven by long-term supply agreements that are cost-plus and indexed to inflation. So, these are “real” yield of like 11% to 13%. The upside is also uncapped. Instead of the FCF coupon being $4 to $5, it can also be $5 to $7. The disadvantage versus a junk bond is you have no contractual protection. There may be years where NACCO doesn’t earn this coupon and in all years it isn’t paid out to you. The free cash flow will be used at the parent company level (“NACCO”) to pay dividends (then it would be paid to you), buy back stock (which is kind of like payment in kind with just giving you additional “junk bonds”), or acquire businesses.

 

You could try to compare NACCO common stock to coal miner bonds. For example, people wrote about Peabody Energy bonds in 2015 due in 2020 and things like that. So, I can see where investors thought there was value and at what yields.

 

Again, I’m not sure that’s helpful. The only similarity between NACCO and Peabody is they are both existentially tied to coal. But, their business models have nothing in common and they don’t share any risks except “coal going away” completely. NACCO’s risk is coal power plants shutting down. Coal prices, capital costs of coal mines, etc. aren’t the risks for NACCO.

 

There is a company I analyzed previously called Babcock & Wilcox Enterprises (BW) that is tied to U.S. coal power plants and whether they shut down. Originally, the company’s cash flow was largely from maintenance on U.S. coal power plant boilers and related equipment. That’s similar to NACCO. BW is in serious financial trouble. But, that’s not purely because it was involved in coal power plant maintenance. Instead, it tried to shift to other kinds of work and ran into the kinds of problems that can bankrupt any engineering firm. I’m not sure the company is comparable and it doesn’t produce free cash flow to value it on. So, BW is a dead end.

 

We know who NACCO’s customers are, but they are more diversified than just coal power plant operators (in the cases where they are publicly traded) and so it’s difficult to value NACCO against companies who are their customers or are similar to their customers. If we went this route, we’d chose companies like Southern Company (SO) and Vistra Energy (VST). Vistra is a utility that is shutting down some “mine-mouth” operations in Texas.

 

But, utilities are the customer taking the other side of risk/reward bet from NACCO in these deals. Utilities are taking the capital risk, not producing any free cash flow, etc. NACCO isn’t taking the capital risk. NACCO is getting the cash dividends. They’re not peers. They’re opposites.

Utilities are really the opposite of NACCO’s business in that they are leveraged, convert little reported earnings into free cash flow, and use up lots of capital. Utilities may need to issue bonds, issue stock, not buy back stock, etc. NACCO doesn’t need to issue stock or bonds and is in a good position to pay a lot in dividends or buy back stock in the years ahead.

 

Utility yields are probably about 4% in terms of their dividends right now. Their reported earnings yield may be closer to 5%. Those are leveraged figures though. Debt/Equity is high at these companies. It’s probably the case that utilities’ FCF yields are about one-third as much as NC right now (that is: NC’s FCF yield is about 3x the FCF yield on of a basket of utilities).

 

What are other people using for peers?

 

In the write-up on NACCO, Clark Street Value uses peers like Vistra:

 

http://clarkstreetvalue.blogspot.com/2017/09/nacco-industries-hamilton-beach-spinoff.html

 

He uses EV/EBITDA. And says reorganized coal miners trade at 4-5 times EBITDA and something like the reorganized Vistra Energy trades at 7-8 times EBITDA.

 

NACCO’s most recent adjusted EBITDA figures were about $33 million on a 3-year average of 2015, 2016, and the last twelve months (June of 2016 to June of 2017). I used that figure since it’s more conservative than taking the $44.4 million in last twelve months of EBITDA.

 

Post spin-off, NACCO is essentially unleveraged at the parent company level (it has long-term liabilities for pensions and mine shutdowns but it also has cash on hand from Hamilton Beach). So, instead of EV we can just do EBITDA per share.

Here we go: $33 million in EBITDA is $4.82 a share and $44.4 million in EBITDA is $6.49 a share (NACCO has about 6.84 million shares outstanding). That gives you two different bands of peer valuations if you’re using 4-5 times (coal miners) or 7-8 times (utilities) of:

 

4-5 times EBITDA appraisal value: $19.28 to $32.45 a share

7-8 times EBITDA appraisal value: $33.74 to $51.92 a share

 

If you look at these figures, I think this is what some special situations type individual investors are looking at. You can read the comments under the post at Clark Street Value, read the forum posts at Corner of Berkshire and Fairfax, read the 3 old write-ups at Value Investors club (written in 2012, 2015, and 2017), etc. and come to a conclusion that the company was very cheap at about $20 a share (where it traded the moment it spun off Hamilton Beach) and fairly valued where I bought it ($32.50 a share) and would be overpriced at anything much over $50 a share.

 

However, I think using EV/EBITDA is extremely misleading here. It goes against all common sense.

What investors care about ultimately is “owner earnings” or free cash flow in the sense of the actual annual build up of cash per share. There’s a huge difference between a company that converts 40% to 60% of EBITDA into free cash flow (like some possible peers we’re using here) and a company that converts 80% to 100% of EBITDA into free cash flow (like NACCO).

We also have about a 26-year record at NACCO to use in estimating normal free cash flow. I’d rather count on my 26-year estimates of FCF rather than trying to do some sort of last twelve months of EBITDA approach.

 

If you assume NACCO – if it pays no dividends, buys back no stock, and makes no acquisitions – would build up $4 to $5 per share a year (about $27 million to $34 million) in free cash you’re going to have to value the company differently from what you’d get using EBITDA.

 

Absent plant shutdowns: by 2022, you’d expect NACCO to have maybe $20 a share in net cash on its balance sheet. Today’s stock price is $37.85. Imagine the stock price grows 10% a year for the next 5 years. That would give you a stock price of $61 a share. A value investor would “back out” $20 in net cash to get a share price of $41 a share in 2022. NACCO will – if it doesn’t lose coal power plant customers to shut downs (a huge if) – still be producing $4.10 a share (or more) in free cash flow. So, the stock could return 10% a year for 5 years and still be priced at an EV/FCF of 10x.

 

It’s difficult to find a peer that would look anything like that. Utilities don’t. Coal miners don’t. In terms of capital light, high free cash flow…

Yes, you can compare NACCO to a stock you mentioned (Omnicom) or a stock I own (BWX Technologies). However, I think that’s even more misleading that using peers like utilities and coal miners.

 

NACCO has a finite and risky future.

 

Omnicom and BWX Technologies have very certain futures. In 2047, it’s likely advertising needs profitability and U.S. Navy needs for nuclear aircraft carriers, attack subs, and ballistic missile subs will be pretty much the same as they are now.

 

Omnicom and BWXT deserve to trade at some of the lowest FCF yields (highest prices-to-free cash flow) of any mature business because their cash flows are predictable decades into the future. Most public companies can’t be counted on to have positive free cash flow 30 years from now. Those two can.

 

NACCO can’t. It’s not going to exist doing this kind of work (mining coal) in 30 years. It’s not clear anyone will be mining coal in the U.S. in 2047.

So, perhaps the right “peer” for NACCO is to reverse this and look at what other kinds of stocks currently have a free cash flow yield similar to NC.

 

If we base our earnings estimates off profit per ton in 2009-2013, you get about $4.75 in my estimate of “reportable” EPS going forward. However, there’s amortization of coal supply agreements that would take you over $5 in cash terms. That’s probably about NC’s normal free cash flow level.

 

The best estimate – not in the sense of most conservative, but simply most honest – would be to expect free cash flow of $5 a share on average. A $5 FCF divided by today’s stock price of $37.85 gives you a free cash flow yield of 13%. Again, this is a real yield in the sense the coupon would rise with inflation.

 

What other public companies have free cash flow yields of about 13%?

Limiting it to public companies most people have heard of, you get a lot of stocks like:

 

* Discovery Communications (DISCA)

* Dick’s Sporting Goods (DKS)

* Kohl’s (KSS)

* Brinker (EAT)

* Gannett (GCI)

* MSG Network (MSGN)

* Office Depot (ODP)

* Pitney Bowes (PBI)

 

I pulled that list off a screen. I didn’t clean-up free cash flow to reflect my estimates of “normal” for those companies. That’s not important. This article isn’t about those companies. It’s just getting a sense of what the market values NACCO like.

 

Right now, the market values NACCO’s shares like it values the shares of newspapers, cable TV channels, retailers, etc. Although we should keep in mind that almost all of those companies have a lot more leverage (they certainly have more leases) than NACCO does at the parent company level. Remember, the mines are non-recourse to NACCO.

 

Many of those companies are seen as being in businesses that will be obsolete soon. So, it’s possible the market may correctly value NACCO (another company in a business that may be obsolete soon) as being a peer of companies in newspapers, cable TV channels, retailers, etc.

 

One difference with NACCO is that it operates under exclusive long-term “cost-plus” supply contracts indexed to inflation. So, it faces no price competition and really no competition at all. These other companies are mostly at risk of being obsoleted by competition from the internet.

 

NACCO’s survival doesn’t depend on withstanding competition. Its survival and whether it can keep generating that high free cash flow yield is based on whether the coal power plants it serves stay open.

 

I thought that was a big difference from the risks faced by the other companies on that “peer” list of high free cash flow yield stock. I like NACCO better than the stocks on that list there. But, it’s possible that others would view those businesses as being NACCO’s peers. And I can’t say they’re wrong.

NACCO faces an existential threat. That’s why – even though I bought the stock myself – I don’t recommend others buy the stock.

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