Description

Hallador Energy (HNRG)

Company Background

Hallador produces thermal coal in the Illinois Basin (ILB) from three mines: Oaktown, Carlisle, and Ace in the Hole. ILB coal is advantaged over other basins due to its high BTU content and lower transportation costs. ILB coal does contain higher levels of sulfur, but utilities purchasing ILB coal have been retrofitted with scrubbers allowing continued consumption of ILB coal. Despite ILB's advantages, the basin is still at the mercy of the natural gas markets which wrecked coal demand in 2015 and 2016 due to two consecutive warmer winters. These weather conditions led to excessive natural gas supply and the subsequent depression in natural gas prices. As natural gas prices fell, coal burning utilities reduced their overall burn in favor of natural gas generation. This drop in demand along with financial stress from debt burdened coal companies led to a painful two year period for coal producers throughout the United States.

Hallador Mines

Carlisle is Hallador’s legacy mine. Carlisle experienced cost creep in late 2014 and 2015 as the coal seams mined began to deliver diminishing returns and roofing support became costly. In 2015, Hallador idled Carlisle but spends ~$5 million per year to keep the mine “hot”. Management believes they can bring Carlisle back online should demand and contracts warrant it.

Oaktown and Prosperity were acquired in a debt financed transaction in 2014 from Vectren. Prosperity was idled upon completion of the acquisition. Oaktown is currently the only mine with meaningful production.

Ace in the Hole is a surface mine that produces a nominal amount of coal to mix with production from Oaktown and Carlisle to reduce the sulfur content to meet customer specifications.

Why is HNRG an opportunity?

Hallador has set itself up to be a low-cost producer of ILB coal by successfully driving down their operating costs. The market has yet to realize this value because it questions Hallador’s ability to keep production levels high enough to consistently repeat their low-cost performance. Q2’17 earnings only increased the level of doubt amongst market participants as operating costs increased quarter over quarter due to fixed cost deleveraging and earnings were affected by the re-upping of executive stock compensation. This has created a buying opportunity ahead of what we expect to be normalized coal market coming in 2018/2019 which would provide incremental demand for Hallador to increase production and consistently achieve low-cost production.

Cash Costs

Cash costs are the key success driver for any commodity producer. For our analysis, we define cash costs as operating costs + maintenance capex (~$3.50 per ton) + SG&A (~$1.65 per ton).

Oaktown Cost

Oaktown is a low-cost mine; however, like most mining operations, the cash flow generated by the facility is dependent on fixed cost absorption, mining efficiency, and geological conditions (i.e., coal seams, and roof support). Oaktown increased production by 18% to 1.92 million tons in Q1 2017 compared to 1.64 million tons in Q4 2016 and lowered cost per ton by 13% resulting in $23 operating cost per ton (~$30 cash costs). However, these production levels came with another cost: a rather large inventory build. While the low operating cost is impressive, Q1 levels of production are not sustainable without increased demand for coal.

Hallador reported Q2 2017 production of 1.65 million tons, down 14% from the prior quarter. As expected, production costs at Oaktown increased to $26 per ton due to lower fixed cost absorption from fewer tons produced. This higher cost production came with another increase in inventory as rail issues in Q2 resulted in an inventory build.

Source: MSHA

Why did the market not believe these costs were possible at Oaktown?

In Q3 2015 Hallador idled Carlisle and moved all production to Oaktown.  This event occurred less than one year after Oaktown’s acquisition. Hallador spent $14.5 million in growth capex over 2015 and 2016 to ready Oaktown for increased production and to become the main mine. Perceived risk of failure was high given the short time frame of ownership of the asset and risk of the expansion of Oaktown failing. Additionally, relying on a single mine can be dangerous, as any operational issues can wreak financial havoc on the company and equity holders. The operational risk associated with a single mine is mitigated but not eliminated at Oaktown. Oaktown has two separate entry points which would allow mining to continue if an issue developed on one side of the mine/portal. Should an event happen to impair Oaktown, production can shift to Carlisle to fulfill contracts (admittedly, at a lower return for Hallador).

Carlisle Cost

Carlisle is another story. The mine was idled in 2015 and has yet to produce any coal since then. As of Q2’17, it has a net book value of $113 million (21% of total assets). Management has taken steps to get the mine economical again by sealing off problem areas. Since Carlisle’s closure in 2015, the Company sealed 79% of the mine with the most recent sealing occurring in Q1 2017.

Should Carlisle return to production, management would successfully defer reclamation costs into the future and avoid idling costs. After considering the seals in place, management believes they can still produce 2.5 million tons per year; however, we have handicapped it to 2.0 million tons in our analysis. We forecast operating costs of $29 for Carlisle bringing total cash costs for the mine to $34.

The success of bringing Carlisle back online is wholly dependent on incremental demand for ILB coal, whereas Oaktown is operating at a level allowing it to steal share from existing mines. While Carlisle return is a possibility in the future, we do not include this in our base case. We do however include the cost of maintaining the mine in a “hot” idled status.

Comparing Oaktown to Other ILB Producers

ILB production in 2016 was ~100 million tons, down 19% from 2015. Approximately 77% of the production is from public companies (market share as % of production): Alliance (27%), Foresight (20%), Peabody’s Midwestern Division (18%), Armstrong (6%), and Hallador (6%).

The weighted average cost of this group was ~$32.00 in FY 2016, down 9.4% from ~$35.50 in FY 2015. The costs presented in this table are historical and as such may not reflect the expected ongoing costs. Many producers cut back dramatically on maintenance capex during the down turn. We estimate normalized fully loaded costs below. We note Hallador is shown on a consolidated basis with idling costs included in the cost per ton.

We believe Normalized costs for the group look something like this:

Note: Hallador consolidated basis includes idling costs.

Coal Pricing

After costs, the key variable in the valuation is coal pricing. We believe Hallador will be able to realize a coal price of $43 per ton in a normalized coal environment. Hallador’s production mix for 2016 was 80% Indiana and 20% Florida, based off EIA data. Assuming this sale mix holds going forward, a $2.75 Henry Hub price, a $.35 and $1.35 premium paid by Indiana and Florida natural gas generators we see an average price of $43 per ton FOB mine. This pricing assumes a heat rate of 10,000 for coal plants and 7,000 for natural gas plants.

Why $2.75 natural gas prices? Break-even in the Marcellus for producers is ~$2.50. Cabot, arguably the lowest cost producer of natural gas, has a break-even of $2.30 ($.40 F&D, $1.10 production and transportation, $.80 differential). The slide below is from Range Resources July 2017 Company presentation. It lays out Marcellus operator breakevens from RS Energy Group. Additional sell-side research pegs the best break-even for the Marcellus at $2.48 with a basin average around $3.00.

Source: Range Resources July 2017 Company Presentation

Differentials in the Marcellus are created by bottlenecks in transporting the gas out of the region. It’s because of these bottlenecks that Cabot has an Eagle Ford drilling program and is testing two new prospects in Texas despite project level IRR's of 100% in the Marcellus. Constructing additional pipes to take out said bottlenecks and improve differentials will come with only slightly better economics to producers as differentials and the cost of firm transportation, commitments made by producers to pipelines, are correlated. As Rice disclosed in their 2016 10-K:

“In recent years, the cost of new firm transportation projects has risen significantly concurrent with the increasing basis differentials experienced in the Appalachian Basin... As such, our net sales prices may be materially less than NYMEX Henry Hub prices as a result of basis differentials and/or firm transportation costs”

We expect realizations to improve in the Marcellus, but the majority of the economic benefit will reward transporters of natural gas. Additionally, well cost inflation and increasingly limited access to capital markets should reinforce capital discipline among natural gas producers.

What about Renewables and Other Fuels?

There has been much news made about renewables and the impending death of coal. While renewables are valuable to society, so is consistent and reliable power generation provided by fossil fuels. Any transition to renewables will be slow and will rely on fossil fuels to carry the load.

Germany, for example, committed to Energiewende (“Energy Transition”) in 2010 to increase their reliance on renewable energies. Since announcing this transition, renewables have grown at a 10.4% CAGR moving from 17% market share to 29% in 2016. During this period, coal generation was unchanged with a -0.1% CAGR and ~200 bps decline in market share from 42% to 40%.

Nuclear has been the loser in Germany, shrinking at a -8.1% CAGR over the past three years. While the decision to leave nuclear was driven by German political forces, we expect Nuclear to be a loser in the United States for economic reasons, ceding portions of its 20% market share over time. Nuclear is highly challenged by renewables (even more so than coal) as nuclear is designed to run 24/7 with a single digit number of starts and stop occurring during the year. Startup times at nuclear plants typically run between 13 to 24 hours and can last up to multiple days depending on the conditions of the plant. Without capacity factors (i.e., utilization rates) north of 80% and limited cycling (i.e., starts and stops), nuclear becomes unprofitable. Bloomberg New Energy Finance estimated in June 2017 that 34 of 61 nuclear power plants in the United States are losing money.

All plants will need to be more agile in responding to grid demands as the curve of electricity demand will shift with the introduction of solar and wind. Solar produces most electricity during the day (shocking), and wind generates the most electricity at night. Without energy storage, which has substantial hurdles to commerciality in our opinion, the grid will need fossil fuel generators which can quickly react to changes in renewable generation.

Coal, while not as agile as natural gas OCGT (open cycle gas turbine – typically peaker plants) or CCGT (combined cycle gas turbines – typically intermediate and baseload plants), is more flexible and better suited to compete than nuclear in a renewable powered grid. Coal plants in the United States reflect the characteristics of hard coal-fired power plants outlined below.

Another lesson from Germany’s transition is the effect on the price of electricity. According to the IEA, in 2015, German electricity cost for industrial consumers was 17.9 cents per kWh and 39.5 cents per kWh for residential consumers. In the United States, industrial and residential electricity costs 7 and 12.5 cents per kWh.

The Department of Health and Human Services (HHS) published stats for 2011 energy burdens by fuel type. While different households have differing levels of energy consumption and type of fuel (electricity, natural gas, heating oil, etc.…) we can draw some usefulness from the those who heat their homes with electricity. The median energy burden in 2011 was 4% of median income for all households and a median of 8.3% for low-income households. Should the United States reach parity with German electricity prices, the American energy burden would be around 10% of median income nationwide and 20.8% for low-income households. This is would be a hard pill for consumers to swallow.

While the coal market will be challenged by competing fuels (namely natural gas and solar/wind) in the future, coal powered generation will be around for decades to come.

Coal Plant Retirements

The largest risk to Hallador, and any coal producer in today’s market, is the pace of coal plant closures. The trend is leading toward more coal plant closures driven by cheap natural gas and old age. Plants which have survived are younger, more efficient, and are equipped with pollution control systems than their retired peers. Until recently, announced coal plant retirements consisted of units which were not being dispatched (utilized), resulting in lower capacity factor (i.e., low levels of demand).

Unfortunately, Vectren, one of Hallador’s largest customers, announced plans to retire two of their coal plants, A B Brown and F B Culley, by 2024. These plants purchased ~1.5 million tons from Hallador in 2016. Despite being seven years away, these planned retirements do create a visible path to the end of these tons and a cloud over the stock. Vectren also announced it would be backing out of its joint venture with Alcoa in the Warrick coal plant; however, we do not know plans for the site.

With over seven years of runway, this provides Hallador’s management team ample time to take advantage of items within their control (e.g., costs and operations) to win new business from higher cost producers like Peabody, Armstrong, and private producers. It is worth mentioning here that Armstrong defaulted on their debt and have hired an advisor. Management announced test shipments to new customers on their Q2’17 conference call which, if successful in converting into contracts, will act as a catalyst for a re-rating.

The best driver to slow down retirements for coal producers would be for the United States to experience cold winters, increasing the volatility in natural gas prices and demonstrating the value of fuel diversity.

Leverage

Back to Hallador. The Company has a substantial amount of debt on their balance sheet from their acquisition of Oaktown and Prosperity. Management has made it abundantly clear in the past that they want to avoid debt; however, they utilized their revolver in the past year to acquire coal contracts and reserves from competitors. Recently, management has made comments surrounding the strength of their balance sheet, indicating an increased comfort with debt. Should there be a sizable M&A transaction, it would require equity which, at current prices, is not attractive in our view.

As of Q2 2017, Hallador has a net leverage ratio (Net Debt to TTM (Operating Income + DD&A + Impairments)) of 3.1x with interest coverage (Operating Income + partial adjustment for stock comp /Interest Expense) of 2.4x. Q2 Interest coverage was affected by a re-upping of stock comp for the CEO and CFO inflating stock compensation by $3.8 million over the previous quarterly run rate of ~$700 thousand. Without the downward adjustment of $3.8 million to stock comp, interest coverage would be 1.2x. If our base case plays out, then leverage would be a non-issue come 12/31/2018 due to debt pay downs and increased earnings.

Leverage would begin to be a concern should coal pricing reach $36 and/or Oaktown volumes fall below the 6 million production level. While spot pricing for ILB is in the mid 30’s, HNRG continues to realize above spot prices for their coal. In Q2’17 HNRG priced incremental tons at ~$40 for 2018. While below our projected price of $43 per ton we believe the market is turning back up and the risk of coal pricing driving issues with leverage is low.  

By deleveraging the Company, Hallador is accreting value to equity holders on a quarterly basis. We expect debt pay downs in our base case of ~$30 million by year end 2018 leading to an additional ~$1.00 per share of appreciation. Our projected net debt balance is ~$180 million at year end 2018.

While the pace of paying down debt has slowed in 2017, the Company has a substantial amount of cash tied up in working capital. In any scenario, $15 to $20 million of working capital will be converted into cash as inventory and other current assets return to normalized levels, allowing management additional capital to allocate between growth capex and/or further pay down debt.

Valuation

Our base case has Hallador reaching max capacity at Oaktown and maintaining Carlisle and Prosperity in a “hot” idle status for $7.25 million per year. With production of 8.3 million tons (8 from Oaktown and .3 from Ace in the Hole), we believe the company should be able to produce EBITDA less maintenance capex of $95 million. Applying a 5x multiple and deducting $180 million in net debt at 12/31/2018 we arrive at a per share valuation of $10. Valuing the company using unlevered free cash flow (estimated to be $61 million in our base case) and a 12% required return, we derive a share price of $12. Taking the average of these two methods leads us to our price target at $11 per share. Over time, additional deleveraging will further accrete value to equity holders.

Should Carlisle return, we see it adding $21 million in EBITDA less maintenance capex and $16 million of free cash flow at 2 million tons of production. This translates into an additional $3 to $4 per share, however, we are not counting on this for our base case.

Status Quo

In our status quo case, we keep production levels relatively flat at 6.5 million tons with 6.2 million tons coming from Oaktown and the remainder attributable to Ace in the Hole. EBITDA less maintenance capex is $60 million with 5x multiple equates to a $4.50 share price.

Note: Hallador has averaged a TTM EBITDA less maintenance capex multiple of ~6.25x since Hallador lapped its acquisitions of Vectren. Hallador has averaged a ~5.25x TTM EBITDA multiple over this same period.

Conclusion

Hallador currently trades for ~$6. Hallador offers investors a potential ~80% return in the base case and ~20% downside should our thesis not materialize.

We believe there are two near-term catalysts to realize this gap in value. First, Hallador announced on their Q2 call they were running test shipments with new power plants. Contracting out additional tons for 2018 or establishing a new relationship with meaningful shipments would give the market what it needs to revalue the stock. Second, utilities coal inventory levels remain elevated over the past 6 months. Inventory levels are normalizing and with an average winter, we would expect coal plants to be short coal.

Source: EIA

Best of luck.

Other Items

• Yorktown Energy Partners a New York based private equity fund has held a substantial stake in HNRG for some time. Yorktown currently owns 18.3% of the common shares outstanding

• CEO Brent Bilsland owns approximately 3.5% of common shares outstanding. Q2 stock compensation will add another ~1% ownership of the company upon vesting.

• Not a main part of our thesis, Alliance could be a potential suitor in consolidating quality coal mining assets including Hallador. While it would be a nice to have, it is not the basis of our investment thesis.

• Hallador maintains two equity method investments in oil and gas firms. They are not material to the business as they are unlikely to be monetized in the near term nor be a driver of earnings.

Risks

• Warm winter weather persists, creating low natural gas prices and increasing financial pressure on coal producers.

• Hallador customers shut down and Hallador is unable to economically place tons elsewhere.

• Oaktown runs into operational difficulties resulting in cost overruns or reduced production.

• Unable to refinance debt upon maturity.

• Regulations bring additional taxes on carbon emissions.

• Carlisle is closed and reclamation/retirement costs consume near term liquidity.

Catalyst

• Win new customers from test shipments announced on Q2 conference call

• Normal winter weather reduced coal inventories at utilities leading to increased coal demand.