- Hallador Energy has generated free cash flow consistently for the past decade.
- The company’s earnings do not accurately reflect its potential for generating cash for investors.
- The stock price has also been punished due to Hallador’s business of mining high sulfur coal.
Hallador Energy (NASDAQ:HNRG) has been in business since 1951. Throughout most of its history it focused on oil and gas exploration and production. In 2006 the company acquired a 60% stake in Sunrise, an Indiana coal mining company. By 2009 Sunrise became a wholly owned subsidiary of Hallador and the company began deriving most of its revenues from coal production. The company sells its high thermal/sulfur coal to power plants for electricity generation. Hallador continues to be involved in gas exploration through its 50% interest in Sunrise Energy, LLC. As the world focuses on decarbonization, the company recently began working on developing renewable energy through a joint venture with Hoosier Energy.
In 2014, Hallador made one of its largest acquisitions by purchasing Vectren Fuels for $296 million. It increased its debt from $16 million to over $300 million. The coal production capacity increased from 3.3 million tons of coal to 10 million tons annually. Since that acquisition investors have been suffering as the chart below shows.
A few quick stats for orientation:
Recent price: $2.99
Market capitalization: $91M
Low float, Insider ownership: 30.7%
Enterprise value: $214M
Dividends: Zero (cut after the pandemic)
The company stopped paying dividends in light of business disruptions caused by the pandemic. Before the pandemic it was a consistent distributor of dividends as the chart below demonstrates.
There are five major coal production basins in the U.S.:
- Central Appalachia (CAPP)
- Northern Appalachia (NAPP)
- Illinois Basin (ILB)
- Powder River Basin (PRB)
- Western Bituminous region (WB)
Coal from each region varies by its sulfur content and heat value which determine its end use. Hallador mines coal exclusively from the Illinois Basin (ILB), an area covering Illinois, Indiana and Kentucky. The U.S. Clean Air Act in the 1990’s stripped the ILB of over 50 million tons of coal demand. ILB coal is high-sulfur which limits its use and is a major source of air pollution. In the mid 2000’s a shortage of low-sulfur coal drove up coal prices which led many power plants to install scrubbers and thus enabled them to buy cheaper high-sulfur coal. The power plants invested millions in these scrubbers and got assurance from the U.S. government that they would be able to recoup their costs. Coal futures contracts allow both power and coal producers to manage risks inherent in their businesses. Hallador has long term contracts to sell much of its coal at set prices to its customers.
There are many types of coal. The main two types are metallurgical coal (or coking coal) used to manufacture steel/iron products and thermal coal used for electricity generation. Metallurgic coal has a higher price than thermal coal and has lower sulfur. Coking coal requires more cleaning rendering ILB’s coal inappropriate.
China is the largest importer, producer and by far the largest consumer of coal. The power generation fueled by coal ultimately affects the global economy. Coal powers Chinese factories that allow it to produce goods that the world, particularly wealthy countries, ultimately consume. In a way when a consumer purchases a Chinese manufactured TV, she is indirectly consuming coal. Following China, India and the U.S. are the next two largest coal consumers. Indonesia and Australia are the world’s top exporters of coal.
Coal use causes ill health and deaths by polluting the air and water. As expected, most of the deaths are in China and India, the two countries with the highest direct usage of thermal coal. Long term, coal is a major contributor to greenhouse gases and climate change. Despite the push for clean energy, coal is responsible for about 19% of the U.S.’s electricity generation. For comparison, natural gas provides more than twice as much fuel for electricity generation than coal. As recently as 2015 coal produced more electricity than natural gas. Nuclear energy surpassed coal in 2020 for the first time. In addition to power generation coal is a primary input in the extraction of iron and production of steel from iron ores.
Hallador has 81.3 million tons of reserves. In 2020 it sold only 5.7 million tons demonstrating that it can supply coal to its customers for years to come. Because of the political environment, many believe that coal power plants will be forced to shut down leaving Hallador’s business in peril. However, recent inflation and spike in energy prices may not make it economically feasible to shut power plants that use coal for fuel. Last winter’s cold spell in Texas led to power outages resulting in many deaths. More recently a summer heat wave in the Pacific Northwest led to hundreds of deaths in Oregon and Washington. These events emphasize the challenges in power generation. The recent rise in natural gas prices shown below will add to the difficulty of power plants switching their fuel from coal to natural gas.
China, where 60% of power is generated by coal, has been facing power shortages lately in its effort to limit carbon emissions. It has also limited coal imports from Australia due to political reasons. Coal shortages in China have prompted power plants to cut output, leading to blackouts and decreased factory outputs. Energy prices have surged in Europe as well. Rising energy prices worldwide is a serious threat to the global economy in light of supply chain disruptions. The U.K. is contemplating opening a coal mine in an area where it ceased operating in the 1980’s.
Hallador – the bull case
My bull case for Hallador rests on the fact that despite relatively poor earnings history in the past few years, the company has been generating high free cash flow relative to its valuation. Given the new threat of inflation, supply chain disruptions, and macroeconomic headwinds, the threat of shutting power plants that consume Hallador’s coal is overblown. The company currently is focused on paying down its debt and recently ceased distributing dividends. Hence, investors who are focused on income or growth are not interested, and the market is mispricing Hallador’s stock. Once the company retires its debt, investors will be rewarded.
Below is a table showing some of the company’s key data for the past decade.
Source: Seeking Alpha
As stated earlier, 2014 was an important year for Hallador. It borrowed close to $300 million for its acquisition of Vectren Fuels. I am focusing my analysis on what happened since then. As the table above shows, the company’s EPS has been unimpressive since that acquisition. The sum of EPS is only 28 cents since 2014. Large impairment of assets in 2019 and 2020 account for much of the poor performance. Now let’s look at the actual cash the company has generated. During the same period, it has made $164 million in net debt payments. This can be verified by subtracting its total debt in 2014 by the 2020 amount. In reality the debt repayment is even better because of the recent $10 million PPP loan forgiveness. The loan forgiveness will be accounted for in next quarter’s earnings report.
During the same time frame, it has also returned $25 million to shareholders via dividends. Net debt payments added to distributed dividends come to about $189 million in the past six years. The cash generated averages to about $30 million per year or $1 per share. Meanwhile the stock price today sits at about $3. Hallador investors today can reap $1 for a $3 investment or a 33% return on investment. I know few companies with price to free cash flow ratio of about 3. Currently, the company is focusing on paying down its debt without distributing dividends. Once the debt is paid down, shareholders will be able to finally reap the rewards of the company’s cash generation potential.
The chart below shows Hallador’s historic price to cash flow ratio. We can see that the company’s fortunes soured after its 2014 acquisition. A return to 2014 P/FCF ratios, would imply a 400% price appreciation. With current low interest rates a P/FCF ratio of 10, about the level of Exxon (XOM), seems reasonable. That would imply a stock price of about $10.
Using shareholder equity as another metric, we see again in the table below that Hallador is trading at about a 50% discount.
Source: Seeking alpha
In the case of Hallador, I prefer valuing it by focusing on its cash generating power rather than its book value. The company has a history of asset impairments and will likely have to take further write-downs in the future. Mining is a capital-intensive business and it is not surprising that companies in this sector are forced to take write-downs on assets. On the positive side, the company has no goodwill and its tangible book value is below its book value.
Insiders own 30.7% of the shares, which is also reassuring. Management has treated outside shareholders fairly by distributing dividends for years and has been a good steward of the company in a difficult business environment. They also have been transparent and good communicators by holding quarterly earnings calls.
Hallador is currently an unfavored micro-cap in an unfavored industry. The company has been able to generate ample free cash to pay down the debt that it accumulated in a 2014 acquisition. Given the risks of inflation and the spiking of energy prices worldwide, it is unlikely that Hallador will lose its power generating customers in the near future. Transition to alternative fuels is a capital-intensive proposition for power generators. Hallador has plenty of coal reserves to supply its customers for years to come. It is difficult to predict short term stock price movements, but in the long term once the company pays off its debt, Hallador could re-price to a price to cash flow ratio of 10 which is about 300% greater than its current stock price.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of HNRG either through stock ownership, options, or other derivatives. 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.
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