Ramaco Resources: The True Rare Pair Trade For 2024 (NASDAQ:METC)

Introduction:

I’ve been thinking about writing this for a little while, but truth be told I haven’t had the time. Subsequently, this will be somewhat brief and I encourage the reader to do more due diligence than usual relative to my previous articles. Having said that, I will argue that this is actually a fairly low risk venture I’m suggesting. It’s also unusual since I’m not doing it myself for reasons that I will explain. Now that I’ve fogged up this introduction enough, let’s move on to what I’m proposing.

Details:

I’m sure most of you know what I mean when I use the term a pair trade. You’re long one security and short another security in equal quantity. There are many variations of this arbitrage. It can be used with different companies in the same industry or sector. It can be used with the same company in different parts of the capital structure, but it’s rarer to have the exact same part of the capital structure in the same company. For equity you obviously need to have two separate classes of stock available. Almost always those two stocks are created in order to protect insider’s ability to control the company while still monetizing their personal holdings in the business. These are usually lower volume super voting share classes that trade fairly static but at a discount to the regular common shares. That is not the case with this trade.

I’ve written about Ramaco Resources (NASDAQ:METC) before, and to be fair I didn’t expect to write about it again. The last time was in May of 2021 when I had penned four articles over the course of four years. You’ll find only one other article analyzing the company back then. That’s what I usually like to write about: stocks that most people aren’t focused on except for my occasional foray in with the masses. There’s been 13 articles written by numerous authors since then, so I didn’t think I was needed here anymore.

The company, however, decided to try something novel and issued a rather unique class B share (NASDAQ:METCB), which was distributed to class A shareholders and began trading in June of this year. To quote the prospectus linked to in the previous sentence:

The Class B common stock is a newly authorized and issued series of common stock of the Company that we anticipate will pay a dividend based on the separate economic performance of the CORE Assets.

I.e., it is somewhat like a tracking stock that will follow the economics of a specific group of Ramaco’s assets called CORE which are defined as follows:

The Class B common stock is expected to pay a cash dividend, based on the financial performance of the CORE Assets, which consists of three non-cost bearing revenue streams:

– Coal Infrastructure Assets which will be based on a fee of $5.00 per ton of coal processed in our preparation plants and a fee of $2.50 per ton of loaded coal by the Company’s rail loadout facilities;- Coal Royalty Fees of approximately 3% of Company produced sales revenue on average; and

– Carbon Product Related Assets constituting future income derived, if and when realized, from operations at Ramaco Carbon which include advanced carbon products and potential future critical mineral/rare earth elements production in Ramaco’s operations in Wyoming.

That last tidbit of course created a very big hallabaloo when the Wall Street Journal published this article about the potential of Ramaco’s Rare Earth Elements [REE] mine. Thankfully, this trade I’m suggesting does not require one to have a definitive opinion on whether or not Ramaco will produce any value from REE. I have zero interest in getting into a shouting match with the short sellers now attacking the company. I’m also not a geologist that can weigh in with any authority about the potential success rate of this project. My own two cents on the matter as I’m sure the vast majority of people that have been following this company pre-WSJ article, is that if it works out then great, but REE’s are even more volatile in pricing than Ramaco’s bread and butter business of metallurgical coal. From what I’ve read, I think it comes down to whether or not the National Energy Technology Laboratory [NETL] that did the initial work looking for REE’s there, is correct or not that the minerals can be extracted for less than normal from the surrounding clay. Geologists are mostly arguing against this view. The short sellers are attacking the credibility of the management claiming it’s a pump and dump scheme. Both detractors have incorrectly claimed or neglect to point out that the pie-in-the-sky 37 Billion figure tossed out there by that article was not something actually said by the company. You can even see the CEO say exactly that in this Bloomberg interview from a few weeks ago, which is also fascinating since the article still uses that as the lead despite his comments. Either way, the truth is you don’t have to believe in the REE story for this trade to work, but I do believe that this opportunity exists because of that article so do your due diligence here.

That article hit on November 9th, and the stock launched in reaction to that massive figure. Here’s the thing though, it was the class A shares that launched the most. The class B did react but to a much smaller degree. In fact, I sold all of my class A METC shares within a few days, and eventually started buying some exposure back but in the class B shares. Here’s how both classes traded from just the start of November, (METCB is blue):

I started buying the B shares because, as you can see, there have been periods when it actually traded below the price it was trading even before the journal article was released. I believe the primary reasons for all of this is the following: First, the journal article unfortunately did not note the two classes and how the REE exposure is actually connected to the B shares. Instead, they just referenced the A shares as METC and away that stock went. Second, the liquidity of the B’s versus the A’s is significantly less. In fact, even before the article the B’s traded about 1/20th the volume of the A’s, which of course makes perfect sense when you note that’s exactly the ratio of the distribution of B shares to A shares back in June. Hence, anyone wanting to buy Ramaco in size had to go to METC over METCB in order to take a position. Third, with all of this happening at the very end of the calendar year, there is an incentive for large stake holders to hold those A shares where their exposure is up through to the end of the year. Portfolios will get marked, bonuses will get paid, taxes on gains will get deferred for 16 months, then we’ll see what happens when the calendar flips into January of 2024. This happens all of the time. If you don’t believe in window dressing, then you just haven’t been following small cap stocks closely for long enough. Last, as I just mentioned, the distribution of the B’s to A’s was at a 20% ratio. That means there are a lot of investors out there with tiny holdings in the B shares. Those odd lots often get cleaned up at the end of the year by individuals. All of these factors I think puts downward pressure on METCB and upward incentives on METC.

Even a simple trade like this has some layers of complexity when trying to explain it. In this case, I’m arguing that the B shares, which now trade less than the A shares, shouldn’t be that way. Here’s how the relationship looks in its short history:

That spike down below zero in the spread was from the article’s release. We’re now back to the low point of the spread again and I think it’s mostly due to the calendar which creates the opportunity. The bottom line question though is how should these two stock classes trade relative to one another?

Here are some of the key factors in my mind. First, we need to consider what the purpose of the class B share distribution was for. There’s no super voting rights attached to them. It doesn’t change the balance of control equation and of course they were distributed to all shareholders equally. The key phrase to focus on from the previous quotes I noted earlier is to the “three non-cost bearing revenue streams.” Ramaco’s business valuation, as well as fellow metallurgical coal producers, has been extremely low. Coal is still viewed as a four letter word by the market despite the differences and necessity of metallurgical for steel production versus thermal’s use in energy production. METCB’s distribution is an attempt by Ramaco to effectively build a royalty similar share class that would elevate the overall valuation of the combined business. METCB’s cash flows will be significantly more stable than METC’s since pricing variances will only effect a portion of the payouts. If you check out the possible comps on this basis, and assign a similar value to METCB, then you’ll understand the thought process.

In fact, that’s just what I did back in August of 2022 after they had announced the plan to issue the class B stock. I wanted to see how the security could be valued in comparison to royalty trusts. Above there are two columns that show how the group yielded back then, and what they yield right now. Note the number of securities that don’t exist anymore from this group. I’ve highlighted the Median yield figure and Westlake Chemical Partners LP (WLKP)’s, because I believe those to be viable benchmarks to use in METCB’s case. WLKP has a very steady low volatility cashflow that is not subject to commodity pricing. It has not been growing though, and arguably there is 50+% potential growth in production at Ramaco in the next few years based on estimated expansion plans. Hence, one can argue that METCB should yield less than WLKP to factor in the likely future growth. However, the market is a fickle beast and I tend to be conservative. As I just mentioned, note how many of these securities don’t exist anymore after just over 1 year’s time. I’d also be remiss if I didn’t point out that METCB is actually a regular common stock, where most of these are L.P. units that require K-1 filings for tax purposes. A definitive negative to many in the retail income seeking marketplace. Nevertheless, let’s focus on say 8.7% yield as a round figure to use for fair value of something like METCB’s dividends.

Valuation:

I’ll state out flatly that my confidence in my ability to estimate forward pricing is very low due to the abnormally wide spreads we’ve been seeing between U.S. and Australian pricing this year, caused by specific factors effecting the latter country’s production. Having said that the street seems to be pricing significantly lower spot pricing for 2024 than the Australian futures curve suggests. Hence, I’m frankly not comfortable using the street view unless you know with certainty that there’s a global recession in 2024. My numbers are much higher so feel free to ignore, alter etc… however you feel best. Of course, that wouldn’t change the opportunity of the pair trade in my mind, but I show this exercise in part to explain why I’m just long METCB and not shorting METC on the other side. Note above my estimate for the B class dividend is $1.18. That amount yielding 8.7% equals $13.56 suggested fair value for METCB. The stock closed on Friday 12/22/23 at $13.76. The other reason is that I’m holding that security in income accounts now. Some of which I don’t even have the ability to hedge by shorting the class A against it. Overall, METCB trading close to a 10% yield with either a 12 or 11 handle on its price seemed attractive to me. Now let’s looks at the other side of the equation for the overall company.

When comparing the three primary metallurgical coal stocks to one another, I prefer to use EV/EBITDA as the metric for reasons I’ve stated in previous articles. In this case, I’m going to ignore my estimates since theoretically the street is applying the same pricing calculus to each company equally. METC has definitely gotten a bit of a pop from that REE related article relative to (AMR) and (HCC). Roughly, one could argue it’s trading for about a 20% premium. That’s important to remember, because it’s time to look at the potential return of my pair trade.

Potential Return:

The primary assumption of this pair trade is that at a minimum the two classes should trade for the approximate same price. The above chart shows the range of potential return if both traded equally. The range occurs as it depends upon how that gap is nullified. In all likelihood if it works it probably is something in between those two figures. Still, we’re talking about a 23%-29% potential gross return without taking any market directional bet. That’s comparable to this year’s S&P 500 return. Historically, it’s rare for the S&P 500 to follow up 20+% returns back to back. It’s not impossible but since 1957 when the S&P 500 was created it happens at just less than 30% of the time. Most of those came in the late 90’s bubble. Hence, this potential return is likely greater than the market’s return if you measure that by what the cap-weighted S&P 500 provides.

Back when I was working on a Hedged Equity portfolio, I would track every idea we put in the portfolio and measure on a quarterly basis. Some of our best years in term of absolute and relative returns were thanks to pair trades in dual class equities we put on. Now in those cases they were bets that the companies in question were finally open to doing the right thing and eliminating a dual class share type solely used to maintain control of the company. However, the structure of the trade is wonderful since the spread rarely moved significantly and was truly and completely market neutral. Hence, the absolute gross size of the position would be 2-4x our standard individual stock exposure. When they collapsed the share classes, those were positions that paid! These trades do require patience though. While this trade is likely to have more volatility based upon its origin and current trading pattern, it does offer the potential for outsized returns depending upon one’s tolerance for volatility, (which I do not equate as the same as risk despite the popularity of using such measures as such).

Risks:

What if I’m wrong though about these two classes trading equally? We have a very short period of time in terms of market history to judge how likely these two classes will trade relative to one another. There’s a legitimate argument to make that perhaps they shouldn’t trade at the same price in every environment. I’ve already made the case that the B share is designed to have a lot less volatility in terms of its cash flows than the A class. That helps when prices are lower, but that’s clearly a double edged sword that should hurt somewhat when metallurgical prices are high. This is due to the royalty structure portion on pricing for the B class. As stated previously, Coal Royalty Fees of approximately 3% of Company produced sales is how the calculation is made. This business has the ability to put up huge profits when pricing spikes as the cost structure is more fixed than variable at least on a per ton of production basis. For example, METC’s FY ’22 versus ’21, average revenue per ton nearly doubled, but their EBITDA nearly tripled. Sales volume was only up 8% during that period. Theoretically, the class B shareholder would be giving up some leverage to those kinds of price spikes. Shouldn’t that make METC more valuable than METCB over time?

Let’s do a simulation. If you look at my model above for 2024, then double the ARP from $190 to $380, my model will estimate METCB should pay out $1.69 in dividends. At an 8.7% yield, that would imply METCB’s fair value at about $19.40. So what valuation would METC be trading at for the same price in those circumstances? It would be just over 1.06x EV/EBITDA multiple. That seems ludicrously low doesn’t it? Well, historically this group can do that pretty closely. Below is how met peers HCC and AMR traded on that metric in 2022 when that’s essentially what happened to pricing. 1x does look like the absolute low point, but the market certainly didn’t keep the multiple static on the price spike. Instead it heavily discounted it. Welcome to the wonderful world of investing in resource companies. I can see METC getting some extra love over METCB in this scenario, but it seems like there’s enough exposure in royalty fees for METCB to keep up with the class A shares in most environments.

Now I’m going to reveal the big kicker in my mind about this thesis. When they first revealed their intentions around this B share class, the thing that really stuck out to me was that while it is tracking specific assets within the company, it lacks some pretty key drawbacks to what are usually referred to as Tracking Stocks. In most cases, Tracking Stocks shares are very much what I would call ‘Trust Me’ classes. Meaning, the holder didn’t have any legal right to either the assets the class tracked, nor often even the ability to vote as a regular common shareholder. You had to trust that management wouldn’t screw you if there was a change of control. That’s not the case here. METCB is an equal common shareholder to the class A METC. The dividends are different by what they track, but the METCB is an equal owner in every other way.

Here’s the real kicker though:

Following the distribution of the Class B common stock, our Board may, in its sole discretion, elect to exchange all outstanding shares of the Class B common stock into shares of Class A common stock based on an exchange ratio determined by a 20-day trailing volume-weighted average price (“VWAP”) for each class of stock.

There’s an exchange provision in the structure setup right from the start. Remember, the purpose of the class B share is to raise the overall valuation of the company. This exchange provision is the eject the CORE option. (I hope any Star Trek fans out there get this joke). If METCB trades materially below METC for an extended period of time, then management can exercise the exchange provision and convert B’s back into A’s. This is both a blessing and a curse for this pair trade. The blessing is that there clearly is incentive and a structure to at least maintain each class to trade at a minimum of neutral to one another. The curse is that if one puts it on with METCB trading at say a 25% discount like now, and then the discount expands and stays there, you could get a loss locked in by management exercising this exchange provision. What you would earn in price you would lose in fewer shares. I don’t expect this to happen anytime soon. They just spent money to lawyers putting this together and distributing to shareholders. Still, it is something to be aware of long term if I’m wrong about the likely trading relationship between the two classes of stock.

Conclusion:

I said at the start that this was going to be shorter than normal, but that didn’t pan out. That just goes to show how even theoretically limited risk investments often still require a lot of thought to explain a thesis satisfactorily. So to summarize, here are key points I think make this an interesting trade for someone who doesn’t expect the market to repeat a return comparable to 2023:

• The B shares started trading at a discount due to the release of the WSJ article about the REE potential at their Wyoming mine. They are now back to the low in terms of spread, and have even traded below where it was pre-release of that article at some points.
• The potential return in a neutral spread of the two classes ranges from 23%-29%, which is comparable to the return of the S&P 500 this year, and based on history would exceed the index’s return in 2024 70% of the time.
• While Class B shares track the CORE assets for determining its dividend, it has the same common shareholder rights as class A shares, and there is an exchange provision that allows management to turn B’s back into A’s.

I’ve mostly avoided the whole debate about the REE potential despite it being the catalyst for this trade’s potential. I should mention though that if one does believe in the REE’s potential here, or if at some point the company begins to generate real cash flows from production and sales, then those cash flows should go to METCB’s dividends. Of course, METC will see profits flow through the income statement as well, but in my simulation for example, the dividend would be increased to a greater extent than what I have modeled. That could lead to METCB trading at a premium to METC if those cash flows turned meaningful. Again, just something to keep in mind while this spread trades negative for the B class right now all due to an article about REE’s which are tracked by its class share.

One more thing to be cognizant of is the cost to borrow METC in this trade. Right now I see sources that suggest over 2.2 million shares available to borrow and a still positive borrowing fee, but that could change and the fee could turn into something that reduces your net potential return.

For a trade that I like so much I’m a bit sad to not have it on anywhere. My exposure here is now more towards income and tax free retirement accounts where shorting stocks is prohibited. My model suggests the street is too low on Ramaco’s 2024 potential in terms of their metallurgical business, so I want to maintain some long exposure which I do through the much cheaper METCB.

One last point to share, I’ve seen short sellers argue the sales (often distributions) from Yorktown on the price spike are indicative of a pump and dump scheme. I.e., why would the largest shareholder be selling on this if it was legitimate? I would just point out that Yorktown did not so much buy their position as they did create the company. They funded it as a private enterprise. Their model is to do these investments privately, and if they succeed, then bring it to the public market and distribute shares to their limited partners piecemeal over a large number of years. If you’ve been involved with one of their companies before, then you know to expect to manage through year end distributions of shares to limited partners that out of nowhere create volume and price swings. Overall I found that argument lacking from the short calls, but it was an easy point to spin in a negative light. That’s a big difference in my mind these days from short selling behavior in the past. I write under a pseudonym because I used to write some short investment reports on here. You can go back and see how I wrote them. I find most short reports these days as more slander than analysis which is sad.

I think there’s a decent chance that when the calendar flips to 2024, this spread between the two classes begins to narrow. It wouldn’t surprise me at all of it was back to neutral in a fairly short period of time. It doesn’t really matter how that gap narrows of course for this trade to work, and it doesn’t matter at all what the market does, which is why I think this is a really good trade for someone with a more negative view on next year’s equity market prospects. It also allows one to employ a more aggressive position sizing if they don’t mind handling the volatility. There’s a lot I like about this idea. I hope you find the discussion useful. Happy Holidays, and wishing you all a healthy and prosperous New Year. –NCSI

Editor’s Note: This article was submitted as part of Seeking Alpha’s Top 2024 Long/Short Pick investment competition, which runs through December 31. With cash prizes, this competition — open to all contributors — is one you don’t want to miss. If you are interested in becoming a contributor and taking part in the competition, click here to find out more and submit your article today!