Coal stocks like NACCO Industries (NC) face a strong secular headwind, namely the transition from fossil fuels to renewable energy sources. This secular trend has greatly accelerated since the onset of the pandemic, early last year.

As a result, NACCO Industries passes under the radar of most investors and has underperformed the broad market by a wide margin over the last two years. During this period, the stock has shed 26% whereas the S&P 500 has rallied 48%.

Nevertheless, NACCO Industries is taking some measures to adjust to the changing energy landscape while its stock is extremely cheap. Therefore, the stock is likely to highly reward those who purchase it around its current price.

Photo by Nikolay Kovalenko on Unsplash

Business Overview

NACCO Industries is a holding company for The North American Coal Corporation, which was founded in 1913. The company supplies coal from surface mines to power generation companies and operates in the states of North Dakota, Texas, Mississippi, Louisiana, and on the Navajo Nation in New Mexico. It has an annual production of 35 million tons and thus it is the largest lignite coal producer in the U.S.

NACCO Industries enjoys great business momentum, primarily thanks to the impressive rally of the price of coal, which has resulted from the strong recovery of global demand for oil and gas from the pandemic this year. The rally of the price of natural gas this year has rendered coal more attractive than it was in recent years and thus it has triggered a rally of the coal price as well.

In the third quarter, NACCO Industries grew its coal deliveries by 6% over the prior year’s quarter. Even better, thanks to the rally of coal prices to an all-time high level, the company grew its revenues 59% and more than tripled its earnings per share, from $1.14 to $3.47. It is thus on track to post earnings per share around $6.50 this year.

Growth Prospects

NACCO Industries has exhibited a volatile performance record due to the high cyclicality of the price of coal. In addition, the stock is out of favor in the investing community due to the secular decline of the use of coal in favor of more environmentally-friendly fuels. However, the company is trying to diversify away from coal and thus it is on track to grow its lithium production in the upcoming years. This is a very promising endeavor, as the global demand for lithium will skyrocket in the upcoming years thanks to its use in electric vehicles, which require 5,000-10,000 times the amount of lithium used in mobile phones.

On the other hand, given the high comparison base formed by the record earnings this year, it is prudent to have conservative expectations for the future growth of NACCO Industries. Overall, it is reasonable to expect the company to incur a 2% average annual decline in its earnings per share over the next five years.

Dividend

Despite the cyclical nature of its business, NACCO Industries has raised its dividend for 36 consecutive years. This is an admirable dividend growth streak for a company in a declining industry. Moreover, the company has an extremely low payout ratio of 12%, which provides a wide margin of safety for the dividend. Furthermore, the coal producer has a rock-solid balance sheet, with essentially no debt. It is thus safe to assume that the company will continue raising its dividend for many more years.

Valuation – Expected Returns

Based on expected earnings per share of $6.50 this year, NACCO Industries is currently trading at a price-to-earnings ratio of 5.2. This valuation level is far lower than the historical 10-year average price-to-earnings ratio of 11.8 of the stock. For the sake of conservatism, we assume a fair price-to-earnings ratio of 9.0 for this stock. If NACCO Industries trades at its fair valuation level in five years, it will enjoy an 11.5% annualized gain over the next five years.

Moreover, the stock is offering a 2.3% dividend yield. Given also the expected 2% annual decrease of earnings per share, we expect the stock to offer an 11.1% total annual return over the next five years. This is certainly an attractive expected return, particularly given the rich valuation of the broad market.

Final Thoughts

The shift from fossil fuels to renewable energy sources has greatly accelerated in the last two years. As a result, the vast majority of investors dismisses coal stocks without performing a due diligence. However, NACCO Industries is exceptionally attractive right now. It is doing its best to transition to the changing energy landscape while it has an extremely cheap valuation level and a rock-solid balance sheet. Overall, the stock is likely to highly reward those who purchase it around its current price.