Nacco Industries is a strong pre-earnings setup

The chart is testing a breakout, while management has telegraphed operating improvements across the board

Dear Reader,

Recently I listened to a podcast with small cap specialist

Nat Stewart

from a few years ago. A major theme of Nat’s is seizing the opportunity on information that simply isn’t priced in, in contrast with a more speculative approach.

Occasionally such opportunities pop up in small caps: perhaps a material asset sale has been couched away in SEC filings, game-changing contracts have been signed, or an underlying commodity price exposure has moved substantially. I believe that Nacco Industries represents a few such dynamics, all rolled-up into one. I have traded this stock several times and own a 4%+ position going into earnings. Like many small caps, it is fairly illiquid and trades with a wide spread — so be careful if you do decide to buy.

Nacco is a player in a few resource sub-sectors

I’m going to try to keep this background short to 1) avoid screwing up technical details, as a generalist and 2) get to the part that really matters: the earnings setup.

Contract thermal coal mining: Nacco provides thermal coal / lignite for power plants under long-term contracts. These contracts are generally indexed to volumes, with adjustments that reflect a basket of relevant hydrocarbon prices — namely diesel. Notably, a boiler went down in 2023, impairing this segment until it was repaired recently — furthermore, the company received $13.6mm of business interruption insurance income in the most recent quarter. Finally, they gave a temporary price concession to one of their customers that expired in June, 2024.

Mitigation resources: Provides “stream and wetland mitigation solutions as well as comprehensive reclamation and restoration construction services”. I’m no expert in exactly what all that entails. What I can tell you is that management used to hype up growth in this segment, and some shareholders have criticized them for underdelivering. Management has since backed off on that hype but write in the latest quarterly report that they expect the segment to “achieve profitability in 2025” based off “current expectations for new projects”.

Mining: Nacco offers mining services for limestone and phosphate. I am particularly interested in the limestone, obviously. Management has made some optimistic commentary regarding a late-2023 amendment to limestone mining contracts, and has guided to next quarter showing a sequential improvement.

Mineral rights: Management invests some of the cash flow from the operating businesses into oil & gas mineral rights — primarily natty in the Appalachia and Gulf Coast, with some oil in the Permian. It’s questionable what’s going on here. On one hand, management claims that they have a track record of making terrific long-term investments, and that could very well be right — the stock has done pretty well long-term for a resource company; on the other hand, I can see why shareholders are skeptical of employing a whole team to make these deals. The most relevant recent development here is that natty prices have been on the rise.

Lithium: In 2019, Nacco secured an agreement to “design, construct, operate, and maintain” Thacker Pass — the largest known lithium deposit in the United States — owned by LAC 0.00%↑ . The market was pretty excited about this at the time, leading to a blowoff top of over $60/share before the events of 2020 put a fork in it. Note that Nacco is incentivized on volumes, will be receiving milestone payments, and will be receiving reimbursement over 7 years for upfront equipment capex of $50mm. Since then, GM 0.00%↑ invested $650mm to become LAC’s largest shareholder and secure exclusive rights to the first phase of production, condition on a $2.3bb DOE loan. Some last-minute protests / legal motions created a further delay, but the courts have now cleared the way. In short, Thacker Pass is now funded to the hilt and likely to plow forward regardless of project-level profitability. Nacco is therefore a compelling play on lithium as it is exposed to volumes — and will be receiving reimbursement/milestone cash flow — as the massively-funded project is officially underway as of 4 days ago, according to MSN. In the latest quarterly filling, Nacco expects Phase 1 production to begin 2027.

Nacco screens poorly due to VIE accounting

Before we get into the earnings setup, I would like to point out that all but one of Nacco’s coal contracts are unconsolidated due to VIE accounting, therefore showing up below the operating line as affiliate income.

Strong balance sheet + working capital unwind

Nacco has minimal net debt, with a working capital position of 56% of its current market cap.

Governance is a legitimate concern

With the Rankin family owning over 20% of outstanding shares, it’s prudent to consider this opportunity as having all the associated risks of a family-controlled business. Executives + the board clipped nearly $8.9mm in total comp for FY2023, and yeah, that’s pretty hard to stomach as it represents 3.8% of market cap.

Operational updates are much more likely to be positive than negative

What really matters here? The same thing that always matters — beating expectations.

We are coming out of a series of disappointments:

• Thacker Pass delays

• Rumors of the death of coal + we gave temporary concessions

• Natty prices were in a slump

• Mitigation resources was overhyped

• A lot of cash was spent upfront on equipment for Thacker Pass

The situation has changed / is changing considerably:

• Thacker Pass is bursting at the seams with money, and legal challenges are in the past — reimbursements are on the way and we’ve still maintained a strong balance sheet regardless

• AI has made power plants “hot” again and temporary concessions are over

• The boiler is fixed and we received insurance compensation

• Natty prices have been recovering and we have significant exposure

• Re-negotiated limestone contracts are optimistic

• Mitigation resources is (supposedly) on the verge of profitability

Pretty much everything is looking up. That’s why I want to be long before any quarterly updates.

Here’s a rough sketch of where the numbers might be headed. Please do not rely on these numbers and assume that they are made up. The main point I’m trying to get across here is that as operating updates come in moving forward, things are much more likely to be improving / beating expectations than getting worse:

Coal: Headed back to 2022 EBITDA of $40mm+

Mining incl. lithium: I think there’s a path here to $30mm+ EBITDA by the end of 2027 as Thacker Pass ramps up

Mineral rights: $25mm+ EBITDA, in line with 2021

Corporate overhead / mitigation resources: -$20mm, basically assumes mitigation resources goes nowhere

Sustaining capex/depreciation: Let’s use TTM D&A of ~$25mm.

Adding it up: We’re approaching mid-term profit before taxes of $50mm, call it $40mm after taxes. That’s a <6x multiple, while cash earnings are likely to be substantially higher from Thacker Pass reimbursements. There is upside if the natty bull market has legs, if limestone contract renegotiations beat expectations as management has alluded to, or if Mitigation Resources starts delivering.

Risks:

• 6x is a pretty low multiple for the long-term mining projects and mineral rights, but it could be optimistic for coal

• The mine owners (including lithium) could face business risk, especially in a recession

• Money gets reinvested into unattractive mineral rights deals / bloated management comp

Final thoughts:

A long-term investment in this company could be compelling — in particular, the exposure to limestone mining — but it’s far from a no-brainer until we get a more concrete sense of how limestone operating metrics have improved as well as what long-term Thacker Pass economics could look like.

I reiterate that I am primarily bullish on incremental news (earnings) from this company given the frustrating history of the last few years combined with management’s telegraphed operating improvements.