Natural Resources Partner (NRP)

Houston, TX-based Natural Resource Partners, L.P. (NRP) is a master limited partnership engaged mainly in owning and managing coal properties in the Appalachian region, the Illinois basin, and the Powder River basin. The partnership generates the majority of its revenues by leasing coal reserves to mine operators under long-term contracts, which grant the lessee the right to mine coal in exchange for royalty payments. More recently, the company has acquired coal processing and infrastructure assets as well as an aggregates business as a means of diversifying its operations. Like its coal royalty properties, NRP owns but does not operate these assets, thus reducing its risk substantially. As of December 31st, 2007, the partnership controlled approximately 2.1 billion tons of proved and probable reserves. Approximately 59% of its reserves are classified as low-sulfur, and in 2007, 71% of total revenues came from coal mined on Appalachian properties.

The partnership's status as a coal-royalty MLP reduces its exposure to the inherent risks involved in coal mining: worker accidents, land reclamation, etc. Also, it is sheltered from the capital-intensive nature of direct mining and thus, has very little operating expenses and working capital.

Aside from recently acquired properties, the partnership's remaining portfolio of coal royalty assets continues to perform well. Further, we continue to expect distribution growth going forward. Investors in the partnership are likely to receive a safe and growing yield and are well positioned to benefit from any additional acquisitions, lessee production gains, and long-term coal price increases.

INVESTMENT THESIS

Our positive investment sentiment toward Natural Resource Partners is based on:

The company's low risk operating profile

Its leverage to Appalachian Basin coal prices

The recent pullback across the energy space

Natural Resource Partners differs from most other MLPs in that it has essentially no direct involvement with the operations of its assets. It collects royalties from the coal properties and infrastructure assets which it owns based on a fixed price or a percentage of sales, whichever is higher. This allows the partnership to avoid large expenses and liabilities involved in the capital intensive coal mining business. By not having to set aside great deals of capital for capital expenditures or legacy liabilities, which all underground mining operators face, NRP can generate large amounts of distributable cash flow. An additional catalyst that will drive the partnership's unit price in the near term is the ramp up of its acquisitions made in 2007. Discussed in further detail below, NRP has no operating risk in that it leases its coal properties and infrastructure or subcontracts it out to third parties. Locking in contracts that guarantee minimum payments also help the company consistently generate cash even in the event that a producing coal property or properties experience problems. For businesses like NRP the way to add value is by increasing reserves as this represents future minable coal and thus future cash streams. With its Cline Group acquisition in early '07 the company locked in the ability to purchase up to 3 billion tons of additional reserves. This represents long term value for the partnership as it can easily acquire additional reserves with less of a transaction cost.

The combination of increasing global demand and decreasing available supply has created the perfect storm for increased prices and a shift in demand to the U.S. for reliable coal supply. As such, international buyers have been looking to the U.S., especially in the Appalachian region for both steam and metallurgical coal. Due to the proximity to the Atlantic, the Appalachian region is the obvious first choice for foreign buyers. In May of 2007 spot prices in northern and central Appalachia traded around $45 per ton. Currently spot prices from these basins trade around $140 per ton. Additionally, prices for seaborne metallurgical coal, which made up close to 24% of NRP's annual lessee coal production in 2007, now trade above $200. Natural Resource Partners will significantly benefit from being heavily levered to this operating region. In Q2 '08, coal produced from its Appalachian properties represented 78% of production and 86% of its royalty revenues. Amplifying the effect of higher prices on revenues and margins will be the near 9% increase in coal production via the acquisitions of coal properties made in 2007. On the metallurgical side NRP looks to increase its production of this premium coal more than 20% over 2007 to 16 MM in 2008. At a time when metallurgical prices are selling well into the triple digits this will provide NRP with more than enough distributable cash flow to maintain its ongoing consecutive quarterly distribution increases through 2009.

The table below shows the financial flexibility and liquidity that NRP has to distribute cash to unit holders and take on other growth objectives. Residual cash flow represents the amount of cash above what is necessary to satisfy its continual distribution increases. Cash flow at the beginning of the year further shows the margin of safety that NRP has to continue on its path of increasing distributions while maintaining ample liquidity. Based on our 2009 estimates we believe that NRP could increase its distributions through 2009 by 27% or $0.14 per unit from its most recent distribution declaration of $0.515 per unit before needing to tap the equity markets. This assumes no large acquisitions occur in 2009.

TABLE 1

Distributable CF Analysis ($MM's except ratios)

2006

2007

2008 E

2009 E

Op. Cash Flow

138.8

168.1

215.4

243.0

- Princ. Repay

-9.4

-9.4

-9.4

-9.4

- Res. For Princ.

-9.6

-13.4

-17.0

-20.0

+ Res. Used For Princ.

9.4

9.4

9.4

9.4

DCF

129.3

154.8

198.4

223.1

Projected Distributions

-92.0

-147.0

-172.6

-199.9

Residual Cash Flow

37.3

7.8

25.8

23.2

Cash on Hand

47.7

66.4

58.7

56.5

Debt/Cap

0.51

0.44

0.39

0.39

Over the past year, Natural Resource Partners has made several strategic and accretive acquisitions that have helped solidify its coal royalty revenue stream while also creating two new platforms for growth and profitability in processing, transports, and aggregates operations. With coal production increasing from both acquisitions and higher prices (producers have more incentive to sell more at favorable prices) NRP's transport and processing segments should do very well. This can be shown by breaking down Q1/Q2 '08 revenue as well as recent guidance increase. Other revenue sources like transports, processing and aggregates increased more than 60% over Q2 '07 and made up 14% of total revenues, whereas these same assets made up only 12% of total revenues Q2 '07.

Due to the recent pullback in crude oil prices, the energy sector has dropped roughly 30% from its early July levels. While this drop in commodity prices may explain the recent weakening of the E&P industry, the pullback seen in other realms of the energy world seem less valid. Natural Resource Partners has no operations relating to the price of oil. While the argument can be made that substitutes for oil (i.e. natural gas, coal, nuclear, wind) trade in the same direction, the coal market has faired much better than the crude market as global fundamentals are very strong and have not deteriorated. As such, the pullback across businesses in the energy sector that don't rely on the price of oil for cash flow should not have been affected to the same extent. NRP has dropped nearly 15% since its early July highs while its outlook has only strengthened. Our $40 price target represents a 15% return to investors and in our opinion more accurately reflects the value of the partnership. The pullback in coal related MLPs like NRP was unjustified and represents a buying opportunity.

NRP's sizeable cash position on its balance sheet and low debt to equity ratio allow the partnership to easily maintain its current distribution levels and gives it flexibility in financing its acquisitions. At a current debt-to-total capitalization ratio of .40, the company has room to increase its leverage while staying within its .50 debt-to-total capitalization comfort zone. With current assets nearly 3x greater than current liabilities and cash on hand of more than $60 MM dollars, NRP has plenty of liquidity. The dilution of equity to the partnership from acquisitions financed with limited partner units in 2007 should not be a factor in 2008 and likely 2009 as industry consolidation as well as high market valuations for reserves have made the coal acquisition market difficult. The most likely scenario for growth will be smaller bolt-on coal acquisitions with a focus on growing its other platforms (i.e. aggregates reserves).

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