Description

The bet is that HNRG is viewed as a coal mine (which has windfall profits that are ending) when in actuality the biggest driver of its future economics is its recently purchased coal power plant (which has windfall profits that I believe are likely continuing). I believe the opportunity exists because HNRG is generally underfollowed and the company has laid out the economics of the plant qualitatively on earnings calls but not in a way that is concise and clean yet.

Piecing together company commentary with various industry experts and sources increases my confidence that the power windfall could be monetized by the company for several years which is enough to cover most or all of the EV.

Background

HNRG has historically been a coal miner based in the ILB. They have a series of small mines all local to each other in Indiana.

In mid-2021 they purchased the rights to an interconnect at the Merom power plant, a coal plant 20 miles from their mines. (An interconnect is an intangible asset that affords you the right to plug a certain amount of capacity into the power grid at a given location.) As part of the ESG wave of 2020/2021, many coal plants were retired and HNRG was fearful of demand for their coal going away. The interconnect purchase was intended at the time to give them the ability to develop a solar farm at Merom coal plant’s location when the Hoosier Energy co-op that owned it closed it down in May 2023. HNRG, the coal miner, would eventually become HNRG, the coal miner and solar power producer.

Based on conversations with HNRG: in early 2022 when the power market got tight, MISO encouraged Hoosier to scrap its plans to retire Merom in mid-2023. But Hoosier had already sold its interconnect to HNRG. So Hoosier no longer had the right to deliver power to the grid after mid-2023. Therefore, even if they produced power, they could not sell it past this date. So they tried to sell the plant. But the only logical buyer was HNRG - no one else could deliver power for the same reason. HNRG bought it for zero and assumed $7mm of reclamation costs. The transaction closed in late-2022.

The plant is 40 years old but has been very well maintained (according to HNRG) and HNRG suggests it can run for 15 more years, though they are depreciating it over 10.

What is HNRG Now?

HNRG is now a coal mine that can produce 7.5mm tons of coal a year. 3mm of that coal can be delivered to its Merom power plant which can then produce 6.5mm MWh of power annually. The other 4.5mm tons of coal can be sold into the market.

I’ve attempted to value the company’s coal mine and power plant using its currently locked in forward sales and current market prices for the unsold portion. (Basically, how much of the EV is covered by locked in contracts and/or liquid forward markets?)

Coal Mine Economics

Below is the remaining 2023 and 2024 mine economics. They have locked in all tonnage for 2023 and 2.8mm tons for 2024. After 2025, I assume they sell at spot. As of early May, the ILB price curve was relatively flat and in the $60-70 range for several years into the future. As shown below, I use low $50s pricing and cost inflation from the current <$40/ton. Under these assumptions, the coal mine does not produce much normalized unlevered free cash flow (EBITDA-CapEx). Historical EBITDA/ton is in the $6-14/ton range.

Coal Power Plant Economics

MISO-based power plants have two revenue sources. They sell power/electricity and they sell capacity. Capacity is the price charged to be available and ready to produce power for the grid. It is a way for wholesale power plants like HNRG’s to cover future fixed costs (read: help us lock in some revenue so we can pay for the people required to operate the plant – this will bring down the peak cost of power via smoothing).

On the cost side, there are variable costs which include fuel (coal) and other (scrubber stone, etc) as well as fixed costs (including operations and maintenance expense and maintenance capex, etc).

HNRG has sold power ($34/MWh for 1.6mm MWh annually) and capacity ($191/MW-day for 300 MW annually) to Hoosier until the end of 2025. Fixed costs are likely about 65mm based on 1Q23 call commentary. The company has said variable costs other than coal are in the $5-11/MWh range (3Q22, 1Q23 call). On a call back, management tightened that to the middle of the range. Therefore we can build a model and sensitize on realized pricing for power and capacity.

Power Prices

The Indiana Hub Day Ahead Around The Clock power curve is very liquid several years out and is as follows:

The importance of a tight capacity market to the bet

The capacity market is less transparent and less liquid than the power market. I have spoken to several power traders and they have corroborated what HNRG has said: the capacity market in MISO Zone 6 (Indiana) is tight and is likely to remain tight.

Coal plants have retired and renewable energy has not been added quickly enough to offset the capacity loss. This is largely because coal plants are reliable sources of future capacity (read: have the ability to run when needed) because fuel is stored on site while wind and solar are not (will it be windy or cloudy that day?). Renewables are good at generating cheap power. But they are not good at knowing they can run on a particular day several years in advance.

This has tightened the capacity market. HNRG contends this will allow them to cover nearly all fixed costs for the next few years with just capacity payments. It is therefore very important to the bet. An industry participant I spoke with believes this is true through at least 2024 and likely beyond. But he also suggested the market is not liquid enough to be able to say for certain beyond 2024. Based on EPS calls, HNRG feels strongly about this point. But it is a big risk to the bet if they are wrong.

It is important to note that HNRG sells most of its capacity in off-market bilateral agreements directly to utilities rather than in the MISO auction. Last month, the MISO auction cleared at $9/MW-day for the fiscal year ending 5/31/24. HNRG contends, on the other hand, that utilities want to buy its capacity around the Hoosier price of $191/MW-day. This is obviously a large delta and it’s a big assumption in the model so I spent a lot of time trying to independently verify HNRG’s claims. Based on the sum total of my various conversations, I feel pretty confident they are representing the short term accurately but less so beyond 2024. As best I can tell, supply/demand specific to the auction was a big cause of the auction clearing so low but a lot of the market traded prior to the auction at significantly higher prices. Notably, it has been suggested to me that bids appear to have remained elevated even after the auction which lends credibility to the idea that the auction is not representative of the bilateral market.

In 2026 and beyond, the model based on spot prices looks like the below:

Note that normalized EBITDA in the above case is 138mm. EBITDA is highly sensitive to capacity and power prices. The plant can lose money if power and capacity prices are too low. See the below sensitivity table.

In my SOTP I use 60mm of normalized EBITDA vs the 138mm above (several illustrative cases highlighted in yellow).

SOTP

In my SOTP I value the coal mine at 1x third party EBITDA after the 2023 and 2024 windfall years. I value the plant at 2.5-3.5x EBITDA (5-6x less 2.5 years) under a similar methodology.

As discussed above, plant EBITDA of 60mm is highly sensitive to market inputs. So I sensitize the SOTP on plant EBITDA below.

Low/mid/high HNRG cases based on sensitizing the 60mm normalized EBITDA in the above SOTP:

Risks

1. Historical Power Prices have hovered around $30. The power curve is above $50 through the end of the decade (see above) and is reasonably liquid. Is this sustainable? Will HNRG lock in power at these prices?

2. Capacity, as discussed above, is a key offset to fixed costs. If capacity is sold for near zero (as has historically happened in most of the MISO auctions), the plant could lose money at low power prices. How tight is the market despite the recent auction clearing at $9/MW-day?

3. The pieces of the SOTP are not independent. It is likely that if power plant economics start to go bad, that the coal mine economics will also go bad. Therefore, there are correlated outcomes. This widens the range of outcomes and creates fatter tails in the distribution of possible futures.

Catalysts

I am hoping that HNRG signs a larger portion of capacity and power forward sales in the near term. Once they do that, I am hoping they disclose more precise information about the economics of the power plant. To the extent they sell multiple years forward at economics that are anywhere close to what I have modeled, I think it can be a catalyst for investor understanding and therefore incremental upside.

Because of the FCF from coal this year, they should be net debt free by early 2024. This should help de-risk the bet and move the whole range of outcomes higher as additional cash flow accretes to the equity.

** The thesis expressed above contains forward-looking statements and is intended for informational purposes consistent with the nature of this forum; it is not a recommendation to buy, sell, hold or otherwise trade the securities of the referenced issuer.  The authors/their affiliates do not hold a position with the issuer such as employment, directorship or consultancy.  The authors/their affiliates currently own a position in the referenced issuer's securities; however, that position may change at any time and without notice.

Catalyst

Announced forward power and capacity sales

Ongoing FCF generation/debt paydown