Hallador Energy (HNRG) is a small company within the basic materials sector that has recently suffered from negative sediment surrounding the industry. Ultimately, as a result, its valuation has been forced into a depressed state, and its common shares continue to trade right around $7. There's no question of whether or not its business model supports a higher valuation. Right now, its market capitalization is just above $200mm, and with an extremely low EV just shy of 6x, HNRG provides an excellent reward opportunity for investors seeking a 6-12 month investment with an adequate level of downside risk protection. In addition, its operating cash flow is adequate and implies the intrinsic value of its operations are substantially higher than the market reveals. Once HNRG's cost structure flattens out and its capital expenditures decrease to its normal level, its overall intrinsic value will augment quite rapidly providing shareholders' with solid value. Patient investors have a lot to gain from HNRG's operations over the next year, and in 2014, the true value of HNRG is highly likely to be priced in. For a good primer, here's an overview of its business model.
HNRG originated as a Colorado corporation in July of 1951 and was formerly known as Kimbark Oil and Gas Company. Roughly 30 years later, Kimbark merged with Hallador Exploration Company in 1985, and formed the company today we now refer to as Hallador Energy. In 2006, HNRG entered a joint venture with Sunrise Coal, which was an LLC at the time. The alliance was highly beneficial and strategic on HNRG's management part because it allowed HNRG to shift the focus of its operations from oil and gas production to coal. This additional segment added to its business proved to be successful, and today, Sunrise Coal stands as a wholly owned subsidiary of HNRG. In addition, HNRG also hold a 45% equity interest in Savor Energy, LP, which operates in Michigan as an oil and gas company. Overall, HNRG's operations cover a vast landscape, and management does a good job at maintaining a diversified set of business segments. Here's a diagram that does a good job illustrating its different business segments.
The overall increase in HNRG's revenue has been quite favorable over the last five years. However, looking at last year's revenue on a stand alone basis is the not the same. In 2012, it's clear that its revenue growth has slowed in comparison to previous years. As it tapered off mid way through 2012, there was a slight increase in the latter part of Q3 in 2012 that pushed the year end revenue total to about $141.32mm, which you will see is slightly less than its current trailing to maturity revenue figure shown below.
HNRG Revenue TTM data by YCharts
So far this year, HNRG has generated a total of 78.4mm in revenue in just Q1 and Q2, which only requires them to need $63.6mm in the last two quarters to generate the total amount in 2012. Going forward, I anticipate HNRG's total revenue for 2013 to be higher than 2012, but to effectively evaluate its aggregate earnings growth, it's essential we take a look at its operating and free cash flow. Its operating cash flow will allow us to determine the quality of its earnings, while the variation in its free cash flow from operating cash flow will allow us to see how effectively HNRG is able to add value to the firm for its shareholders'. Then later on you will see how its free cash flow is used to derive the intrinsic value of HNRG's operations.
Just as we saw with HNRG's revenue, the cash flow generated through its operations fell quite a bit in 2012. For the purpose of this analysis, it's important to focus on the trend over time as opposed to the $36.30mm figure, which is simply the trailing to maturity average. In 2011, you will see its operating cash flow was $61mm, and in the following year, it declined by about 40% to $37mm. Additionally, over its total capital expenditures declined over this same period from $35mm to $19mm, respectively.
HNRG Cash from Operations TTM data by YCharts
Overall, HNRG's earnings are not poor, and its operations are fully capable of generating real earnings. However, what is important to know is that the YoY increase in its capital expenditures created the substantial downfall in its fair valuation. To compute its intrinsic value you need to calculate its free cash flow, which is done by subtracting its capital expenditures from operating cash flow. So it's now understandable, why we saw the decline in its price, but 2013 is a different story.
Based on the first two quarters of 2013, its capital expenditures are right on track to come out lower than the year before. In Q1 and Q2 its capital expenditures were $9mm and $15mm, respectively. By the end of 2013, I expect its total capital expenditures to come out right around $26mm. Given it generated $19mm in cash flow from its operations in the first two quarters this year, HNRG is right on track to generate a higher level than the year before. Going forward, I see the greatest potential in 2014. By then, its cost structure should be fully stabilized and it should sustain a level of operating cash flow around what we saw in 2011.
Ownership Activity & Liquidity Enhancements
From the standpoint of its balance sheet, HNRG is fairly liquid with a current ratio of about 3.2. For the period ending June 30, 2013, its current assets were $32.434mm, while its current liabilities were only $10.089mm. Given the distinct difference between the two accounts and the fact their deviation remains relatively the same YoY, we can expect this trend to continue. However, it's important to recognize that inventory consistent constitutes about 27%-30% of its current assets. The main inventory item that generally sustains the highest value is HNRG's coal inventory, and for the most recent period, this item represented just over $5mm of its inventory. Furthermore, its quick ratio (which excludes inventory) is quite attractive as well at 2.4. Therefore, I do not foresee any short-term liquidity issues standing in the way of HNRG being able to fund its operations. Also, its current long-term debt to equity ratio is extremely low at 0.07, and given HNRG consistently maintains a low level of total debt on its balance sheet, solvency is also an area that should not concern investors.
Now that we understand HNRG is fairly liquid as a company, it's also important we look at the liquidly of its stock price. Overall, HNRG's ownership break down is fairly diversified. Nearly 27% of its common shares outstanding are held by institutions, while only about 6% are held by insiders. From brief glance, it may seem to be the case that the rest of its common shares are scattered amongst retail investors, however that is not the reality. Since May of 2011, HNRG has distributed 6 million more common shares to its limited and general partners. According to a recently filed 13-D, there was a transaction dated on August 13, 2013 stating an additional distribution to one of its general partners Yorktown Energy Partners VI. The document reveals Yorktown Energy Partners now effectively holds 34% of HNRG's total common shares outstanding. Another document reveals the distribution of shares from Yorktown Energy Partners to one of its limited partners, which is beneficial for investors because it further disperses its shares in the market place. While this transaction is not pertinent to HNRG's operational performance, it does however aid in enhancing the liquidity and float in the market place.
HNRG currently trades at a P/E of around 8x, and over time, it's variation is insignificant. For this industry, firms typically trade at P/E of what I consider to be below average. In this industry, it appears the market value of a firm coincides with its intrinsic value at a P/E of about 12x. In particular, you will see below HNRG's P/E is considerably lower than 12x, which makes it very easy to understand that its share price is undervalued by traders in the market.
HNRG PE Ratio TTM data by YCharts
In addition to the P/E ratio, the enterprise value (EV) multiple reveals a story that highly similar. For those unfamiliar with the EV multiple, it's simply enterprise value, and then divided by earnings before interest taxes depreciation amortization ((EBITDA)). Focusing on the industry in which these firms operate, the average EV multiple appears to be about 10.25x, and going back even further, historical data produces an average that's relatively the same. Looking at the graph below, you will see HNRG reveals a multiple of 5.9x, which is unusually low. HNRG's business easily commands an EV multiple of 9x, at a minimum.
HNRG EV / EBITDA TTM data by YCharts
To provide investors with a better sense of what HNRG's is actually worth and what it will potentially be worth in the next couple of years, I used a variation of the corporate valuation to place derive the intrinsic value of its operations. The model takes into account directly and indirectly several of the financial statement items I discussed earlier including its operating cash flow, capital expenditures, free cash flow, as well as long-term debt outstanding. Additionally, to incorporate HNRG's capital structure into the equation, I used its weighted average cost of capital (WACC) as the risk-adjusted discount rate. Last, the final assumption included in the model was a perpetual growth rate, which you will see has been altered for the two different projections.
The final output of the model revealed an intrinsic share price estimate for its current value, the end of 2013, and for the end of 2014. As you will see, HNRG's clearly undervalued. Based on the projected value of its operations, the current implied share price suggests HNRG's trading at a discount of about 22% to its fair value. Even though the next estimate for the end of 2013, is only forecasting about three months ahead, you will notice it's significantly higher than its current value. This is primarily because the current estimate incorporates financial statement items that are accounted for using a figure that's on a trailing to maturity basis. Therefore, the estimate tends to be a little skewed due to fluctuations in capital expenditures from quarter over quarter.
In the short-run (next three months), I feel the probability of HNRG trading at its intrinsic value is slim. But as HNRG's capital expenditures level out and its operating cash flow continues to grow, 2014 has the potential to be an entirely different story. And as you will see above, the implied share price for 2014 is far more enticing than the previous two estimates. For 2014, the intrinsic share price estimate implies an upside of over 150% from its current market price. This reflects a conservative level of free cash flow growth, reduced capital expenditures, and a lower perpetual growth rate. As mentioned earlier, it's important to remember HNRG's capital expenditures so far this year were significantly higher, which is the primary reason the intrinsic value of its operations one year forward is so much greater. While you may think these valuation estimates appear to be a bit stretched, they are actually not. The conservative nature of these estimates assume a minimal amount of free cash flow to be generated in the latter part of 2013, and for 2014, the projected level of earnings growth remains mediocre. With that being said, it's safe to conclude that these estimates are extremely conservative.
It's important to understand that the implied share price estimates above are solely based on the intrinsic value of HNRG's operations, which in other words, is the true value of what the company is actually worth. And while these estimates are normally pretty accurate, it's common to see it take a while before intrinsic value becomes priced in the market, which is something investors need to take into account. For a fair comparison, it's good to take these estimates with a grain of salt and look at what analysts on the street are anticipating as well. Three of the analysts who have consistently converted the stock including BB&T Capital Markets, Bean Murray Carret & Co, and Cowen Securities LLC, have a median price target of $10.50, which implies a return of about 48%. As you can see, the implied share price the valuation model produced for 2014 is clearly beyond what analysts are expecting within the next year. But on the other hand, the current estimate is just a little shy of analysts' estimates, and this is a price that could easily become a reality in the next six months to a year. Overall, the fingers are all pointing in pretty much the same direction. Without a doubt, HNRG is undervalued, and analysts have also taken this into consideration.
Right now, HNRG's suppressed valuation presents an attractive entry point for investors looking for a solid six month investment. The reward opportunity is high, and as it continues to trade at a deep discount to intrinsic value, the downside risk remains limited. Analysts have profiled this company as a solid play as well, and remain optimistic in terms of the upside potential to be achieved. While its operations were negatively impacted in 2012, its performance on the upslope now and has made a quicker recovery than its share price reflects. Overall, HNRG is a value play with substantial upside potential. And while it may be 4 to 6 months from now before its positive performance becomes actively priced in, the discount its shares are currently selling for in the market is one offer hard to pass up.
Sources: TD Ameritrade, YCharts, Google Finance, Yahoo Finance, and FinViz, sec.gov, and HNRG's Company Website.