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Coverage Initiation: Rhino Resource Partners (RNO)
Rhino Resource Partners (RNO) recently made its debut in The Value Line Investment Survey. The coal owner and miner’s initial public offering was held in late 2010. It is important for investors to note that the company is structured as a limited partnership, which allows for favorable tax treatment of distributions but requires unitholders to deal with more complicated tax filing issues (investors should consult a tax advisor regarding the effect of owning limited partnership units). Another important aspect to consider is that, because of its corporate structure, a limited partnership must distribute the majority of its earnings to unitholders (limited partnerships issue limited partner units, not shares), leaving little cash for growth initiatives. As such, secondary offerings are a normal course of business for these entities; Rhino’s first secondary offering of units was held in mid-2011, about six months after its IPO.
As of December 31, 2011, Rhino Resource Partners had four mining operations in Central Appalachia, two in Northern Appalachia, and one in the Western Bituminous region in Utah. Many of these contain “mining complexes,” which are a central location for processing raw coal and loading coal into railroad cars or trucks for shipment to customers. The partnership actively mines most of its properties, with a small number operating under lease agreements to third parties. This increases the partnership’s operating risks, as it must ensure the safety and quality of its operations—not a small matter in a very hazardous business.
Rhino owns most of the equipment utilized in its mining operations. It also operates several subsidiaries which provide auxiliary services for its coal mining operations, such as Rhino Trucking, which serve a broad range of functions from coal hauling to mine-related construction, site and roadway maintenance and post-mining reclamation.
Incidental to its coal mining process at one complex, the partnership also mines limestone, which, when market conditions are favorable, it sells as aggregate to various construction companies and road builders that are located in close proximity to the complex. This is not a material part of the overall business. In addition to coal properties, however, Rhino Resources has recently begun to branch out to other types of properties, specifically land suitable for oil and gas exploration. In conjunction with other companies, the partnership has acquired an interest in a portfolio of oil and gas leases in the Utica Shale, and oil and gas mineral rights in the Cana Woodford region of western Oklahoma. It views this, along with continued expansion in the coal operations, as a growth business.
Coal is primarily consumed by utilities to generate electricity and steel companies to make steel products. It is also used by a variety of industrial users to heat and power foundries, cement plants, paper mills, chemical plants and other manufacturing and processing facilities. In general, coal is characterized by end use as either steam coal (for electric power) or metallurgical coal (often referred to as “met” coal, which is used in the steel making process). Met coal is generally more expensive to produce and commands a higher price. It is also less subject to competition from substitute products, unlike steam coal which competes with natural gas, among others, as a source of heat. In 2011, steam coal accounted for 72% of the total coal sold, with met coal representing the remaining 28%. The price disparity between the two resulted in steam coal accounting for only 61% of coal revenues, with met coal making up 39%.
Recent advances in natural gas and oil drilling methods have resulted in an increase in proven natural gas reserves, and a consequent decrease in the price of that fuel. This, along with the dirty image of coal, has led many utilities to build natural gas-fired plants and close coal-fueled ones, ultimately resulting in generally reduced demand for and weak pricing of steam coal. This dynamic is material and not likely to change in the near term, though overseas markets, which continue to build new coal-fired plants, may eventually provide an outlet for coal sales. Still, the weak industry fundamentals have left the entire coal industry under significant pressure. Met coal, meanwhile, has proven to be relatively resilient.
Part of the risk of running its own mines comes from the mountain of rules and regulations with which Rhino must comply. As noted, coal mining is a dirty and dangerous business, leading to many regulations—ranging from the federal level to both the state and local levels. Not keeping up with new or existing rules could materially impact Rhino’s top and bottom lines. Insurance costs are another material issue, based on the risks associated with its operations. Complicating matters is the view of coal as a significant source of carbon emissions, negating many of the mineral’s advantages, such as its relative abundance and cost effectiveness in The United States. Indeed, many groups target the fuel in their efforts to support the environment.
In addition, Rhino relies on a relatively small number of customers and transportation providers. There is a finite number of electric utilities to which deliveries are economical, making the list of potential customers small. Moreover, coal is primarily delivered via rail. There is an even smaller list of railroads available for hauling its products. That said, the railroads and utilities are reliant on coal producers for revenues, too. Moreover, the partnership generally enters into longer-term contracts to alleviate some of the risks here.
Since Rhino Resource Partners must issue new units to support growth, the state of the capital markets is an important ongoing issue. If the partnership is unable to raise new capital through unit or debt issuance, growth could be difficult to achieve. Of course, any acquisition that does not live up to expectations would render unit issuances dilutive to current unitholders.
Although coal related entities have been under material pressure recently, Rhino Resource Partners pays a handsome distribution. This, coupled with the potential for capital appreciation if coal pricing strengthens, might make it of interest to more aggressive accounts. Subscribers can monitor the company’s ongoing quarterly coverage in The Value Line Investment Survey to keep tabs on the partnership’s progress, while watching for supplemental reports when breaking news hits.
At the time of this articles writing, the author did not have positions in any of the companies mentioned.