Hallador Energy Is Undervalued Due To Extreme Negative Industry Sentiment

| About: Hallador Energy (HNRG)
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Hallador Energy (NASDAQ:HNRG) trades at a low single digit EBITDA multiple despite strong fundamentals. Instead of being the "best house in the worst neighborhood", HNRG is more one of the "most undervalued houses with attractive qualities in a neighborhood at its low point".

Company overview

HNRG (founded in 1951 as Kimbark Oil and Gas) merged with Hallador Exploration in 1989 and became Hallador Energy. In 2006, HNRG entered into a joint venture with Sunrise Coal (now a wholly-owned subsidiary) and shifted from oil and gas to coal.

Sunrise Coal operates the Carlisle Mine in Indiana and produces 3 million tons annually of high-quality (low-chlorine, high BTU) coal from the Illinois Basin, which includes Illinois, Indiana, and western Kentucky. Sunrise Coal has 72.3 million tons of proven reserves and 39.3 million tons of probable reserves. Its customers include Indianapolis Power & Light, Hoosier Energy and Duke Energy (NYSE:DUK). Sunrise is developing a new coal mine (Bulldog) in Illinois, which is expected to begin production in 2014 and produce 3 million tons annually.

HNRG has a 45% equity interest in Savoy Energy (oil and gas production in Michigan) and a 50% interest in Sunrise Energy (oil and gas production in Indiana and coal-bed methane gas production from Sunrise Coal reserves).

Source: Company presentation

Investment thesis

The reports of the demise of the coal industry have been greatly exaggerated and more than discount the current and future challenges including competition from low-priced and greener natural gas, an unfriendly administration, increasing environmental regulations and mild weather. In many cases, the "headline risk" is greater than the actual risk.

Regarding the threat from natural gas, coal is cost competitive to natural gas down to $2.75 and generates electricity at less than one third the cost of other fuels.

Regarding the threat from an unfriendly administration, despite attempts by the Obama administration to shut down all coal plants, this is simply not feasible in the short or long term. Coal will continue to provide a significant portion of America's energy for the foreseeable future, especially as more nuclear plants are retired. Moreover, overseas economies have no problem with coal (especially China) as evident by the fact that coal is the fastest growing fuel worldwide.

Source: Company website

Regarding the threat from environmental regulations, coal continues to get "greener" with new technology at coal-fired power plants producing near-zero emissions. The effect of the retiring of smaller, older and less efficient power plants (due to the high cost of installing scrubbers) is offset by larger, newer and more efficient plants that have already installed (or plan to) scrubbers. Moreover, the Carlisle mine uses the room and pillar, non-subsidence method, which preserves the land above and is one of the safest (minimal injuries in six years of production) and greenest mining methods (e.g. maintains clean water standards).

Regarding the threat from mild weather, obviously the weather will not be mild every year and more favorable weather conditions should drive increased coal sales.

Valuation

As the chart below shows, HNRG trades at a discount to its peer group despite a significantly lower debt load and the highest insider ownership. The former factor alone merits a premium valuation given the capital intensive nature of the coal industry as well as the increased uncertainty regarding future costly environmental regulations. The latter factor shows management and the board have significant "skin in the game".

The union free workforce, no defined benefit pension plans and capped health care claims result in significantly lower compensation costs and drives higher cash flow and bottom line growth.


HNRG is in the right place (Illinois Basin) at the right time with high quality mining assets

Demand for Illinois Basin coal is expected to grow faster than overall U.S. coal demand due to its higher heating content compared to Powder River Basin coal and a lower cost structure than Central Appalachia coal. Increased scrubbing installations (which allow utilities to burn Illinois Basin coal) should lead to additional fuel switching.

Source: Company website

The Carlisle mine produces coal with lower chlorine levels* and higher BTUs compared to a majority of Illinois Basin coal. Moreover, Sunrise can expand its customer base by offering a wide range of coals (e.g. high vs. mid sulfur content) by blending lower sulfur coal from its Ace mine (acquired in November 2012) with higher sulfur coal from the Carlisle mine.

*Chlorine is corrosive to power plants.

HNRG is one of the lowest cost producers

HNRG deserves a premium valuation due to its low cost structure. According to Energy Ventures Analysis, Sunrise Coal has the lowest cash costs of any of the public mining companies in the Illinois Basin. According to the Mine Safety and Health Administration (MSHA), the Carlisle Mine is rated among the highest in efficiency of all underground mines in the Illinois Basin based on tons per man hour.

Sunrise Coal developed the Carlisle mine completely in-house, which resulted in low maintenance costs, less equipment downtime, greater efficiency and overall development costs up to a third less than competitors. The proposed Bulldog mine will use the same approach.

Its mines and reserves are strategically located next to its customers and provides a competitive advantage through lower transportation costs.

There are no old mine properties to reclaim (other than the Howesville mine expected to be completed by the end of 2015), which results in a significantly lower level of capex compared to competitors.

Revenue and cash flow visibility provide return of capital to shareholders

HNRG significantly reduces risk by selling forward production (2.9 million tons at $43.15 per ton for 2014 and 1.2 million tons at $41.40 per ton for 2015). Management expects to continue selling a significant portion of its coal under supply agreements with terms of one year or longer.


Over the last three years HNRG paid $30 million in special dividends.

In April 2013, the board initiated a regular quarterly dividend of $.04 per share. The shift to regular dividends from special dividends should attract a new investor class and highlights the belief of management in its growth prospects.

Risks

Regulatory environment. HNRG is regulated by the (MSHA), the EPA (the Clean Air Act indirectly affects coal mining operations by regulating air emissions of the coal-fired power plants) as well as the states in which it operates. Any proposed rules such as greater emissions reductions for coal fired power plants would reduce the cost advantage coal currently enjoys compared to alternative power sources. Management said in the 2012 10-K that some of its required permits are "becoming increasingly more difficult and expensive to obtain and the application review processes are taking longer to complete and becoming increasingly subject to challenge".

Highly competitive industry. HNRG competes against larger producers in the Illinois Basin.

Conclusion

The target price of $9.32 is conservative given the positive fundamental factors mentioned above and the discount to the average peer group EV/EBITDA multiple.

A tight stop loss should be placed below the recent swing low of $7.56 or ~3.5% below. The time frame is one year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.