What to Buy: Rhino Resource Partners LP (NYSE: RNO)

Why Now: We took a long, hard look at Rhino Resource Partners LP (NYSE: RNO) last month but eventually picked fellow coal producer Natural Resource Partners LP (NYSE: NRP) as the August Big Yield Hunting selection. Up until a week ago, Rhino had outperformed Natural Resource since the Aug. 24 issue was published. But since then, it’s skidded back from a post-second quarter earnings announcement peak of USD15.78 on Sept. 13 to a Sept. 20 close of USD14.93, and become more interesting in the process.

Rhino primarily produces thermal coal, the type used in electricity generation. It also produces metallurgical coal, the type used in steel making. Rhino’s recent slide coincides with a continuation in the decline in the generic front-month coal futures contract traded on the New York Mercantile Exchange to a more than two-year low of USD52.50 from USD59.65 in mid-August, as well as continuing pessimism in global met coal markets.

Rhino sells steam coal primarily to electric utility companies as fuel for steam-powered generators. Customers for its metallurgical coal are primarily steel and coke producers who use coal to produce coke, which is used as a raw material in the manufacturing process.

In addition to operating coal properties, Rhino manages and leases coal properties and collects royalties from those management and leasing activities. It’s also invested in oil and gas mineral rights that began to generate royalty revenues in early 2012.

Rhino’s geographically diverse asset base includes coal reserves in Central Appalachia, Northern Appalachia, the Illinois Basin and the Western Bituminous region. As of Dec. 31, 2011, Rhino controlled an estimated 437 million tons of proven and probable coal reserves, consisting of an estimated 415.6 million tons of steam coal and an estimated 21.4 million tons of metallurgical coal. In addition, it controlled an estimated 417.1 million tons of non-reserve coal deposits.

Rhino Eastern LLC, a joint venture in which the MLP has a 51 percent membership interest and which it manages, controlled an estimated 43.4 million tons of proven and probable coal reserves at the Rhino Eastern mining complex in Central Appalachia, consisting entirely of premium mid-volatile and low-volatile metallurgical coal and an estimated 17.9 million tons of non-reserve coal deposits.

Major customers include independent wholesale power producer GenOn Energy Inc (NYSE: GEN), soon to be merged into NRG Energy (NYSE: NRG) to form the largest US independent power producer. It also serves privately held blast furnace and steel mill operator Indiana Harbor Coke Company LP and energy and utility holding company PPL Corp (NYSE: PPL), which owns and operates most coal-fired power plants in Kentucky, Montana and Pennsylvania.

Rhino debuted on the New York Stock Exchange (NYSE) on Sept. 29, 2010, priced at USD21.50 per share. It closed as high as USD26.94 on the NYSE on Feb. 15, 2011, but has followed coal prices lower since. The stock is currently off its low of USD12.84, which it hit on May 21, 2012.

The board approved and management declared its first distribution on Jan. 24, 2011, USD0.4208 per unit paid Feb. 14, 2011. The payout stepped up to USD0.455 per unit with the May 13, 2011, and Aug. 12, 2011, payments, and was boosted to USD0.48 per unit for the fourth quarter of 2011 and the first two quarters of 2012.

In July management declared a USD0.445 per unit distribution that was paid Aug. 14, as the elimination of the distribution on its subordinated units required a reduction in the quarterly ordinary-unit distribution to its lowest allowable level.

That should set a floor for the distribution at the current USD0.445 per unit per quarter. And not coincidentally, we’re at a multiyear low for coal prices. At these levels Rhino Resource Partners, with its nearly 12 percent yield, is ripe for Big Yield Hunting. Buy under USD16.

The Story

Like last month’s “Lump of Coal,” this month’s Big Yield Hunting prey will benefit from the US Court of Appeals for the District of Columbia’s recent decision striking down Obama Administration Environmental Protection Agency rules on cross-state air pollution. The court reinstated Bush administration rules allowing considerably more time for reducing emissions of sulfur dioxide and nitrogen oxide gases that cause acid rain.

And as we also noted last month, according to the Energy Information Administration (EIA) coal will be the major source of electricity generation in the US until 2035, even under worst-case assumptions accounting for 36 percent of the US electricity generation from 2010 to 2035, a higher share than any other fuel used to generate power. Rhino also sells output to steelmakers, and it’s diversifying its asset base to include liquid hydrocarbons and oilfield services.

The stock has stalled out a bit after enjoying solid rally in the aftermath of its second-quarter earnings announcement, but at these levels it’s yielding 12 percent. There are risks here, but there’s more than halfway decent compensation for that risk, too.

David: I want to kick off today’s issue with another look at our July pick, CSR Ltd (ASX: CSR, OTC: CSRLF).

CSR has rallied hard since mid-July on the Australian Securities Exchange (ASX). The stock hit a low of AUD1.17 on the local exchange on Jul. 17, 2012. We recommended it on Jul. 20, at AUD1.21, or about USD1.25 including currency effects.

The stock closed at AUD1.62 Thursday, Sept. 21 in Sydney, or about USD1.71 including the impact of the US dollar-Australian dollar exchange rate. The total return in US dollar terms is 33.65 percent.

I’m thinking we might want to book our gain–we did advise Big Yield Hunters to sell half of their positions in CSR in the August issue, noting then that more stimulus measures by the US Federal Reserve and by Chinese policymakers would have a positive impact on the Australian dollar as well as the economy Down Under.

We’ve seen those things happen, in addition to more European Central Bank (ECB) bond buying and a favorable decision from the German Constitutional Court on the European Stability Mechanism, and we did “see USD1.56, at least.”

Roger: You mentioned last month that CSR doesn’t announce fiscal 2013 first-half results until November.

David: Nov. 14, to be specific. It typically declares its interim dividend at the same time it reports numbers for the first six months of its fiscal year. Bloomberg, by the way, forecasts an interim dividend of AUD0.15 per share. That would be a 150 percent increase from the AUD0.06 per share it paid in December 2011 for its fiscal 2012 interim distribution.

Roger: And we’ve also seen the possible positive catalysts line up pretty much exactly as US investors who own CSR could have hoped: more stimulus in the US and Europe, the announcement of significant new spending in China.

I know we’re sitting on a gain of more than 33 percent. And I think it’s very important for readers to realize that Big Yield Hunting is a special service. We’re not just trying to lock down a big yield. In fact, any company yielding 10 percent or more is facing a challenge.

We’re betting they’re going to overcome it and that the market is pricing in too much risk to the dividend. And if we’re right, we’re going to get a much bigger return than that 10 percent yield. In fact, the best-case is we get that gain long before we collect any actual dividends.

That’s the case with this one, and we have recommended readers cut their positions in half. But it looks to me like this we may want to stick around this one just a bit longer. Do you agree?

David: As I look back on how we framed the advice last month–particularly the part about seeing “at least USD1.56” and the way the news has flowed the past month I’m inclined to.

Anyone who hasn’t done so already should sell half of their position in CSR. We’ll keep a close eye on this one so we can protect our gain.

Roger: So, I know you want to talk coal again this month. Before we do that, I want to briefly touch on the other “Open Positions” we still have.

Natural Resources Partners LP (NYSE: NRP) is actually working out very nicely. Despite those headwinds for coal, we’re up about 4 percent, and that’s before getting paid any distributions. And it has done better than Rhino so far.

As far as the oil and gas picks go, we have seen some improvement in PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF), which has naturally been following oil prices. That’s one I’ve recommended to more conservative people in our Canadian Edge advisory, and it’s back up to about a double for Big Yield Hunting folks who bought it initially.

I’m inclined to close it out for this service, as after its gain the yield really doesn’t match the objectives of this service. I do like its rising production profile, but it’s really more of a growth-and-income play now.

BreitBurn Energy Partners LP (NSDQ: BBEP) really had a wild ride last month, almost entirely because the MLP issued 10 million new common equity units. That money is going to help them buy new properties and develop old ones without taking on a lot of debt, a fact people must have realized immediately, as the stock is now back about where it began the month.

That one’s up about 21 percent from our initial recommendation. But it also still yields pretty close to 10 percent, and I see another dividend increase coming next month.

I’d like to lift the buy target up to USD20 on that expectation.

QR Energy Partners LP (NYSE: QRE) is also still yielding over 10 percent, though it’s up about 5 percent. This one is so well hedged and has been growing distributions as well as output pretty consistently. It still looks like one of those anomalies where people are just pricing in too much risk. Let’s keep the buy target at USD21, which should give everyone plenty of room to get in.

We’ve really gotten a nice bounce out of Superior Plus Corp (TSX: SPB, OTC: SUUIF). In fact, we’ve actually hit positive territory including dividends. That’s well beyond what I expected, considering they cut their dividend in half a few months after we entered the trade. Trouble is now it yields only about 6 percent and I don’t see upside for the dividend soon, given how tough its markets are. Let’s call it even and close out Superior.

I don’t mean to keep this a monologue. But let me just talk about a few more, and then I’d like your view.

Otelco (NYSE: OTT) was obviously a disaster and hopefully everyone has now taken the loss on it as we’ve advised. The problem there was clearly opaque accounting, and I don’t see much improvement in what we’ve seen since. It looks like bankruptcy is a real possibility there.

Telefonica SA (Spain: TEF, NYSE: TEF) has actually come back pretty strongly the past couple months, and we’re only down about 6 percent in it now. I think it’s going a lot higher, and I’m going to stick with it in Utility Forecaster as an aggressive speculation. But I also think we should point out that they’ve suspended their dividend at least until 2013 so they can bring down debt.

The market loved it, and that’s why the stock has come back. But it’s hard to have a Big Yield Hunting stock that has no yield. I think we should consider this one closed too, though again I think it will make a lot of money for those who are patient and aggressive and don’t need the dividend.

On the other hand, I think we should stick to France Telecom SA (France: FTE, NYSE: FTE), which is still paying a big yield, though management now says it will tie future payouts to cash flow rather than set a specific number.

I should also point out that we’re pretty far down in this one, about 26 percent at last count. But the bear case seems to be for a complete meltdown, and I’m just not seeing it with this company’s strengths.

Capital Products Partners LP (NSDQ: CPLP) is actually back in the green, thanks to just holding that dividend. But they’re also still making acquisitions, which I don’t think anyone is giving them credit for now. They’re also paying off debt.

This one looks like a victim of the bearish consensus for all things tankers, even though you have the CEO saying there’s clear visibility for the dividend going forward. I think we stick with it.

Data Group Inc (TSX: DGI, OTC: DGPIF) is still off a little more than 9 percent and has been pretty volatile. But it looks like they’re sticking to their business plan and covering the dividend with cash flow.

I don’t know when they lose that “old economy” stigma. But that yield of 16 percent covers a multitude of sins, and they are holding it. I think we stick with it, but again with the caveat that these are high-stakes companies and no one should overload on any one of them.

That leaves the two Australians: OneSteel Ltd, which I guess we should point out changed its name to Arrium Ltd (ASX: ARI, OTC: ARRMF), and TABCORP Holdings Ltd (ASX: TAH, OTC: TABCF). We did recommend cashing out half the position in Arrium–a good thing too, as it’s come all the way back and is about 20 percent below our initial entry. TABCORP has returned about 4 percent since we recommended it in May, all on the dividends.

I’m assuming you want to stick with TaBCORP, and I agree with you. But I would like your view on OneSteel/Arrium. After their drop, they’re back yielding about 10 percent again.

But I’m seeing some pretty weak projections going forward. Can they hold that payout? Should we think about getting out?

David: Thanks for letting me get a word in edgewise.

I’m with you on PetroBakken. That’s a nice gain, and the company has its production issues well ironed out, having established some consistency. And I agree that we can still get something out of BreitBurn and QR Energy. The late summer rally also provides a nice exit point for Superior, and if there’s no yield on Telefonica then it certainly shouldn’t occupy space in a “Big Yield Hunting” lineup. France Telecom enjoys all the perquisites of an incumbent telecom, and you’re right, it’s not going to suffer a complete meltdown.

Sooner or later Capital Products will get credit for its growth initiatives, perhaps when the global economy settles into a more normal growth pattern. I like the fact that management has been consistent with the distribution, despite difficult operating conditions.

Data Group is a wonder to me. That yield figure is crazy. It seems to me that “the market” is lumping it with Yellow Media Inc (TSX: YLO, OTC: YLWPF) as an old-school relic. But management’s been pretty tenacious about sticking with the post-conversion dividend rate. And their transition to a 21st-century, data-focused business has been a little more impressive than the market realizes right now.

TABCORP is litigating the issue of the failure of the government of the State of Victoria to live up to commitments made in the Gaming and Betting Act of 1994 that would have provided the company compensation should any future law result in any losses. TABCORP’s claim could be north of AUD600 million dollars, and it’s already accounted for the failure of Victoria to compensate it for the expiration of its gaming licenses in August 2012.

An outright victory would be extremely bullish, a likely settlement for something less than is claimed would be good for the share price as well. The company continues to post solid results, even in the face of softening Australian consumer sentiment. Let’s hang on to this one.

Arrium, on the other hand, provides a great shoulda-coulda-woulda moment. In hindsight, the market’s reaction to the announcement of its plan to shift emphasis from steelmaking to iron ore production was overwhelmingly positive. We got in at about USD0.76 in mid-February and by early May the stock hit USD1.40. That’s basically a double, and that should have been enough.

We did advise Big Yield Hunters to book half the gain. But we should have closed it out. Now it’s being priced like all other mid-tier iron ore producers, and that’s not a good thing in the present environment.

Let’s close that one out now.

Just to recap:

We’re advising Big Yield Hunters to book a gain by selling half of their positions in CSR.

We’re sticking with Natural Resource Partners, QR Energy, Superior Plus, France Telecom, Capital Products, Data Group and TABCORP. And we’re boosting our buy-under target for BreitBurn to USD21.

We’re also advising them to sell, or “close out,” their positions in PetroBakken, Telefonica and Arrium.

Roger: OK. I’m on board with that. Now let’s get on to this month’s pick. I like your idea about doing something else with coal. It’s about as contrary a pick as you’re going to find these days, which I guess explains the high yields. And it’s one that you’ve done a bit of research over the past month.

David: Well, yeah, I have. I liked Rhino Resource Partners LP (NYSE: RNO) last month, when we opted for Natural Resource Partners LP (NYSE: NRP). And I still like it. Let’s call it a high-yielding coal MLP field bet, in two parts, if you will.

Rhino closed at USD14.68 on Aug. 24 and peaked at USD15.84 on Sept. 11. It’s come down hard and fast over the past nine trading days, as coal has hit another near-term low.

A report from Reuters this week noted that US Central Appalachian coal prices had slipped to two-year lows because of milder late-summer weather and a sharp reduction in the use of coal for power generation this year…

Roger: Let me guess: Coal is looking better on a price basis relative to natural gas now.

David: Exactly. This was the point of the Reuters story: that coal was getting more competitive with natural gas in the power generation market. Front-month coal futures traded on the New York Mercantile Exchange (NYMEX) hit USD52.50 per short ton on Thursday, down almost 14 percent from a recent peak of USD60.87 on Jul. 31.

A year ago the price was USD75.28, and a little more than four years ago–before the Great Recession/Great Financial Crisis coal traded above USD130 per short ton.

USD52.50 is roughly equivalent to a natural gas price just above USD2 per million British thermal units. The generic front-month NYMEX natural gas contract closed at USD2.80 on Thursday, down from above USD3 last week and USD3.21 on Jul. 31.

Is it possible that the slide in coal prices could push at least some electric utilities that have been burning cheaper gas to generate power could switch back to coal?

Roger: During his company’s second-quarter earnings call the COO of NRG Energy Inc (NYSE: NRG) suggested that was underway. Since his company is about to be the country’s largest power producer when it completes its purchase of Rhino customer GenOn Energy Inc (NYSE: GEN), that’s worth listening to. In fact, his comments really cut through what’s otherwise a pretty dense fog when it comes to coal’s prospects.

That executive, Mauricio Gutierrez, noted on Aug. 8, “With the gas rally you’re kind of out of the PRB switching area they’re starting to get closer to the eastern coal markets. Particularly in Texas, I would say the combination of that (rising gas prices) and some heat rate recovery, we have seen the reversal of that coal-to-gas switching that we experienced in January.”

He’s basically saying that higher gas prices have made use of western Powder River Basin (PRB) coal more economic, and it’s starting to get closer to costs for eastern companies as well.

Rhino forecast in a mid-June presentation that “increasing gas prices will likely reverse the coal-to-gas switching process and return to 2011 levels, which will allow coal to pick up nearly 90 million tons of demand in 2013, from 2012 levels.”

It also noted that the cutback in supply across the industry should be a tailwind for coal prices in 2013.

David: It think it’s pretty clear–and we worked through the numbers pretty extensively last month–that coal’s role in power generation will continue, for decades. And that holds true no matter who is elected president this time around. Coal is still cheap–and getting cheaper, clearly–and plenty abundant.

At current production rates the US has an estimated 245 years of coal supply remaining. The US relies on coal for approximately 44 percent of its power generation, compared to approximately 23 percent for natural gas. Coal has consistently maintained approximately a 44 percent to 52 percent market share during the past 10 years, principally because of its relatively low cost, reliability and abundance.

It remains the lowest-cost fossil fuel used for base-load electric power generation, less expensive than natural gas or fuel oil.

Roger: Demand for electricity is driven by US economic growth, although it does vary from year to year depending on weather patterns. How is Rhino coping in the current environment?

David: Management noted during its second-quarter conference call that its strategy during this “difficult period in the coal markets” is to maximize cash flow and reduce bank debt.

But it’s also diversifying into other businesses, including liquid hydrocarbons and oil services to provide other sources of income. In July Rhino’s new services company, Razorback, completed construction of its first drill pad in the Utica Shale and has started work on its second.

The MLP suspended distributions on its subordinated units, most of which are held by a single institutional investor, Wexford Capital, which agreed to the move, and reduced its regular distribution to the “the minimum quarterly amount,” USD0.445 per common unit.

Roger: Distribution reductions aren’t ordinarily good things, particularly for an MLP whose payout history is so limited. I guess management and the board concluded that conserving cash by eliminating the subordinated distribution was the smart the thing to do.

What were second-quarter operating numbers like?

David: Let’s start with the fact that the company shut in a majority of its operations at its Central Appalachia locations in eastern Kentucky and West Virginia to decrease inventory, according to management “in response to inventory levels that had grown as we experienced continuing weakness in the coal markers that saw customers delaying a portion of their contracted shipments.”

Rhino resumed operations at a majority of its Central Appalachia locations on Jul. 9, 2012.

Total revenue for the second quarter of USD90 million, including a USD6.9 million lease bonus, was basically flat the second quarter of 2011. Coal revenues were USD72.2 million, down from USD83.8 million in the second quarter of 2011 due to weakness in the met and steam markets.

Rhino sold 1.1 million tons of coal during the three months to Jun. 30, 2012, down 7.3 percent from the second quarter of 2011. This shortfall was due to weak demand in the met and steam coal markets as well as delays in customer contracted shipments, which resulted in lower coal revenues.

Adjusted earnings before interest, taxation, depreciation and amortization (EBITDA) were USD25 million, while net income was USD13 million, up from adjusted EBITDA of USD19.4 million and net income of USD9.4 million in the second quarter of 2011. Net income per common unit was USD0.46, up from USD0.37.

Coal sales were 1.1 million tons compared to 1.2 million for the second quarter of 2011.

It’s management’s position that weak steam coal demand was primarily driven by an unseasonably mild winter along with an over-supply of low-priced natural gas, both of which resulted in an increase of coal inventory supplies at electric utilities and fewer tons of steam coal being utilized in electricity generation.

Total cost of operations was USD60.2 million, down from USD67.4 million on lower production, while cost of operations per ton was USD54, a decrease of USD2.07, or 3.7 percent, from a year ago due to a higher mix of lower-cost tons.

Borrowing costs also rose, from USD1.4 million to USD1.9 million, or 43.7 percent, due to higher borrowings on its credit facility.

Cash from operating activities for the first six months of 2012 was USD33.4 million, down from USD34 million a year ago. The MLP paid total distributions of USD27.2 million, based on the prior rate of USD0.48 per unit.

Operating cash flow covered distributions by 1.2 times. And management noted in its mid-June presentation that the “stability of future distributions is supported by current contracted sales.”

According to its 10-Q as of Jun. 30 Rhino had commitments under sales contracts to deliver annually scheduled base quantities of approximately 2.3 million, approximately 3.5 million, approximately 2.4 million, approximately 0.6 million and approximately 0.3 million tons of coal to 19 customers in 2012, nine customers in 2013, six customers in 2014, three customers in 2015 and one customer in 2016, respectively.

Roger: In its second-quarter earnings release management reports that it’s sold 3.5 million tons of steam coal at an average price of USD60.57 per ton for 2013, 2.4 million tons at USD54.94 and 605,000 tons at USD51.77 for 2015.

So we’re basically taking the position that by eliminating the distribution on its subordinated units Rhino will have enough cash to fund operations and maintain its ordinary distribution.

David: Yes. And that the USD0.445 quarterly payout gives aggressive investors who have ample capital set aside for such ventures and who understand the risks attendant to coal right now reason to take them on

Roger: Well said, if a little wordy.

• October 22, 2010: Otelco (NYSE: OTT)–Sold
  
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < 7
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Hold
• October 21, 2011: PetroBakken Energy (TSX: PBN, OTC: PBKEF)–SELL/Close Out
  
• November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD20
• December 16, 2011: Telefonica SA (NYSE: TEF)–SELL/Close Out
• February 16, 2012: Arrium Ltd (ASX: ARI, OTC: ARRMF)–SELL/Close Out
• April 20, 2012: QR Energy LP (NYSE: QRE)–Buy < USD21
• May 17, 2012: Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF, ADR: TACBY)–Buy < USD3.15
• June 22, 2012: Data Group Inc (TSX: DGI, OTC: DGPIF)–Buy < 5
• July 20, 2012: CSR Ltd (ASX: CSR, OTC: CSRLF)–Buy < USD1.35, SELL half of position
• August 24, 2012: Natural Resource Partners LP (NYSE: NRP)–Buy < USD22
• September 21, 2012: Rhino Resource Partners LP (NYSE: RNO)–Buy < USD16

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–SELL
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–SELL (12/16/11)
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–SELL (12/16/11)
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–SELL (12/16/11)
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–SELL (12/16/11)
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–SELL (03/23/12)
• January 23, 2012: Inergy LP (NYSE: NRGY)–SELL (06/22/12)
• March 23, 2012: Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–SELL (06/22/12)