Black Hills: Buy This Small-Cap Utility For Its Large Gas Potential

| About: Black Hills (BKH)

Founded in 1941, Black Hills Corp (NYSE:BKH) is a small-cap diversified utility company headquartered in Rapid City, SD. Operating in two groups, Utilities and Non-Regulated Energy, the company is focused on electric generation and distribution, natural gas distribution, and natural gas exploration and production. Black Hills Corp is mainly overlooked by retail utility investors, but its recent sale of oil properties and positive Investors Day Presentations has increase interest from Wall Street brokerage firms.

The regulated utilities groups services 202,000 electric customers in South Dakota, Wyoming, Colorado, and Montana along with 528,800 natural gas customers in Colorado, Nebraska, Iowa, and Kansas. In addition, the firm owns 865 MW of electric generation, 8,500 miles of electric transmission and distribution lines, and 625 miles of intrastate gas pipelines. Black Hills sells electric power to other utilities as a merchant power producer and operates a coal mine in Wyoming.

The regulated utilities operate under subsidiaries: Colorado Gas, Kansas Gas, Nebraska Gas, Iowa Gas, Black Hills Power, Cheyenne Light, and Colorado Electric. Combined, these subsidiaries should generate about 77% of anticipated 2013 EBITDA and about 90% of earnings. EBITDA is forecast as follows: Regulated Utilities 77%, E&P 6%, Merchant Power 12%, and Coal 5%.

It is the other 23% of EBITDA that has investors goosed up. Black Hills operates a natural gas E&P business with sizeable holdings in the Powder River Basin along with the San Juan and Picance Basins of the Mancos shale gas play. In Aug, the company announced the sale of an 85% interest in its Bakkan and Three Forks shale oil assets in the Williston Basin (73 wells and 28,000 net-leased acres). The sale brought in $243 million and represents only about 15% of total oil and gas reserves. While the sale represents the bulk of the company's oil reserves and about half the oil production, the price was on the high side of value estimates. Production is expected to decline by about 6% in 2013 to 12.2 MMcfe because of the sale and the company will have total proved reserves of 115 to 120 Bcfe remaining, mainly natural gas.

The proceeds of the E&P asset sale have funded the recent buyback of debt due to mature in 2013. This strengthens the balance sheet and may preclude the need to raise equity capital for a $1.2 billion capital expenditure program going out to 2016. Annual interest cost saving from the debt reduction is pegged at about $0.09 a share.

The exposure to potential gas reserves in the San Juan and Picance Basins could have a profound impact on Black Hills' E&P business. The company believes the Mancos shale acreage could support upwards of 460 wells on its 74,000 acres, based on 160 acre spacing. At $3.00 to $4.00 natural gas, when developed these assets could add value of about $12 to $19 a share if ultimately 2.9-3.7 Tcfe of gas is discovered. Neighboring driller Williams has approved an 80-acre spacing regiment, and if Black Hills adopts this footprint, reserves could potentially double.

The coal and merchant power business should both see a turnaround over time. The depressed coal market conditions should improve with an uptick in competitive natural gas pricing. Merchant power pricing should also improve slightly with an uptick in general economic conditions. While the majority of power purchase agreements are long-term in nature, higher demand would improve efficiencies.

Black Hills is planning on spending about $1.2 billion over the next four years on capital improvements and generating capacity expansions, with about $315 million earmarked for E&P cap ex. The majority of the balance is budgeted for regulated capacity expansion and will add to rate-based assets. With the normally friendly regulatory environment, acceptable ROE should continue to drive regulated earnings higher.

Much like its eastern brethren National Fuel Gas (NYSE:NFG), Black Hills has the potential to expand its E&P business as the catalyst for much higher share prices. National Fuel Gas is a regulated natural gas utility that has large acreage in the Marcellus shale and operates an E&P subsidiary, Seneca Resources. NFG's share price rose from about $45 to $75 when in late-2010 investors were hopeful of joint ventures with foreign partners to develop the shale gas assets, only to slide back to a current price of about $53 when their hopes were dashed. If test wells prove up the Mancos assets, investor interest should drive BKH share prices higher. However, it could take into late 2013 and early 2014 to build the pipeline infrastructure and to complete a series of test well. Development is not slated until 2015.

One aspect of the Bakken sale was the investment structure whereby Black Hills owned a non-operator interest and did not have control over timing or cost of development. In addition, the operator was actively seeking a buyer of their interest as well. The Mancos assets are operated by Black Hills and they have control over cap ex budgets and development timetables.

Earnings per share have been struggling to break $2.00 since 2008 when the company recorded a loss of $-1.08. This year's consensus eps is for $1.99, next year is $2.25 and upwards of $2.55 in 2014. The current dividend of $`1.48 a share and a current price of $36 generates a 4.1% yield, or about average for the industry. The dividend has a 5-yr growth rate of 2.4%, supported by the regulated utility business.

At a current price of $36, and expected 2013 utility earnings of $2.00, share prices are trading at about 18x regulated earnings, giving current valuation a premium to the average regulated electric utility. However, when evaluated as a sum of the parts, the regulated business should be worth about $33, the coal and merchant power business around $13 and the E&P business approximately $3, for a sum of the parts valuation of about $49. Discounting by 10% would give a reasonable share price target of $45 for a potential capital gain of 25%.

For more information, the latest Investors Day Presentation here (regulated) and here (E&P, coal).

The 2nd quarter earnings call transcript is here (next earnings announcement due Nov 8).

Based on growth of underlying regulated rate-based assets, a strengthening of Black Hills local economies, a turnaround in coal and natural gas prices, along with modest growth in the E&P business, long-term investors should be rewarded with an 7% to 8% annual share price appreciation and a 4.1% yield, for a total stock return of about 12% annually.

Author's Note: Please review important disclaimer in author's profile.

Disclosure: I am long NFG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.