Description

Summary

Hargreaves Services Plc is a UK based coal merchant whose business has attractive characteristics including a defensive business model, high returns on capital, low capital intensity (capex at ~3% of sales), long runway for growth, and a well aligned management team.

For temporary reasons, the stock de-rated materially and is now available at ~8.2x FY2013 free cash flow and ~6.6x prospective free cash flow, and a TTM EV/EBITDA of 3.7x adjusted for its pre-sold coal inventory.

I believe the stock could produce attractive IRRs of anywhere between 26%-38%, using conservative assumptions, over the next couple of years, with low risk of permanent capital impairment.

History

Hargreaves started out as a coal trucking company with management’s acquisition of the bulk haulage business of RJB Mining Plc (later UK Coal). Throughout the 90s, management acquired another five bulk haulage businesses. The current CEO, Gordon Banham, was brought into the company in 2001, and he began a strategy of growing the company into more value-added businesses in coal handling and marketing, using the haulage business as a platform.

As a result of Banham’s efforts, Hargreaves acquired in 2005 the coke furnace operation of UK Coal, called Monckton Coke Works, for 6.6x operating profit. They have been able to substantially grow the use of this asset and it is today the only independent coke producer in the UK.

The company went public in late 2005 and has paid dividends since the following year, growing them on average 14.6% per year with excellent dividend coverage (6x covered by earnings in 2012).

Segments

Today, Hargreaves operates in four segments that are interconnected as they often serve to feed each other. The original segment, Transport, is now the UK’s largest bulk delivery fleet with trucks, barges and liquid tankers. The fleet is modern and electronically controlled to minimize accidents and empty miles (as an example, Hargreaves began trucking coal to power stations and now trucks ash on the way back, which is sold to building material manufacturers). Monthly indexing of fuel prices is in place to minimize cost fluctuations.

This segment was 7% of the company’s operating profit in 2012 and produced a pre-tax return on net assets of 26%.

The Industrial Services segment began with the acquisition of Norec in 2006 and AJS Contract in 2008. This segment currently has ~800 personnel and specialist equipment providing support services at 18 power station clients and ports, chemical and rail sites. Hargreaves has shifted to supporting steel companies as well (since coke is used for steel fabrication), and has already signed up with all major steel plants in the UK.

This segment was 5% of operating profit in 2012 with pre-tax return on net assets of 53%.

The two largest segments are Production and Energy & Commodities. Production is comprised primarily of surface mining assets and Monckton Coke Works. It produced 31% of the company’s operating profits in 2012 and returned 17% pre-tax on net assets.

Finally, Energy & Commodities is the segment in which Hargreaves operates two key port facilities in the UK (Immingham and Newport), and sources and markets coal, coke, ash and aggregates. It’s important to note that Hargreaves isn’t a commodity speculator and attempts to always enter into back-to-back contracts where it does not take commodity price risk. As it builds coal inventory on its balance sheet during the first half of its fiscal year, it also pre-sells that inventory to avoid commodity price exposure.

About 70% of this segment’s operating profits come from specialty coals (and the balance comes from the much less profitable power station coals). In the context of the entire company, Energy & Commodities produced 57% of operating profits in 2012 and 38% pre-tax return on net assets.

Growth

Hargreaves is expanding geographically into Europe and Asia, where both power station and specialty coal use is expected to grow. In Europe, coal markets are about 20x the size of those in the UK. In Asia, Hargreaves has begun industrial support services at China Power & Light and with another customer in Hong Kong. Typically it engages a customer through one of its segments and through that relationship takes on more responsibility (for example, it may eventually start hauling and sourcing coal for China Power & Light through its Transport and Energy & Commodities segments). The company believes its unique business model (there are no comps for the entire business) is exportable to new geographies.

If you look at Hargreaves’s results since the IPO, there is essentially no recession visible. Diluted EPS, which closely tracks free cash flow, grew from 9p in 2005 to 106p in 2012.

For what it’s worth, the US Energy Information Agency expects developed country coal usage to decline slightly by 2035 but emerging country coal usage to continue growing substantially, both as a result of power generation and urbanization (steel manufacture, etc). I am not a believer in forecasts but I also don’t believe coal will disappear anytime soon.

Management

Hargreaves has good management tenure and insider ownership, with CEO Gordon Banham owning 9.4% of the company and, with other insiders, a total of 10.2% of the company. His father worked in the coal business and died early, leaving Gordon to fend for himself. In a 2008 interview he claimed to only make acquisitions at 7x earnings or less, or at NAV, and that is indeed what he has done at Hargreaves. I was able to track data for 8 out of 10 acquisitions since 2005, done at an average pre-tax multiple of 6.1x.

Temporary Problems

In 2012, Hargreaves suffered from a “perfect storm” which materially de-rated its stock and brought it down to bargain territory. The first event happened in late May, when Hargreaves announced that its deep pit mine Maltby was having geological issues (ingress of water & hydrocarbons), leading it eventually to mothball the mine (the stock declined 27% that day).

Maltby had been acquired in 2007 at an attractive multiple of 4.9x pre-tax profits and management initially expected to operate it for 8 years through 2015.

Further work led the management team to expect recoveries of coal from this mine through at least 2025, setting this acquisition to be a home run. Unfortunately, nature intervened, and the mothballing was concluded in March 2013.

The second event which further de-rated the stock was the announcement in December 2012 that Hargreaves’s Belgian subsidiary – set up to help it expand in Europe – was the victim of fraud perpetrated by a managing director and former customers. Even though this contributed ~5% to operating profits, the stock fell 24%.

KPMG was hired to perform an urgent forensic investigation and concluded the fraud was confined only to this subsidiary.

Both the Maltby and Belgium issues are now history. As far as deep pit mining, Hargreaves’s management and board issued a statement that the company will now only focus on less risky surface mining.

Equity Re-Rating

In aggregate these issues de-rated Hargreaves stock from 1200p in April 2012 to 600p in December 2012. It has since recovered to 825p, however it still trades substantially below the average P/E multiple of 11-13x it enjoyed since 2008.

Note that the stock traded at 28x, 21x and 26x in 2005, 2006 and 2007, as it was and is a growth company. I believe at least part of the reason for the de-rating was the acquisition of the Maltby deep pit mine in 2007. Perhaps the market was discounting this mining risk (correctly, in hindsight). Now that Hargreaves is focused solely on surface mining and Maltby has been mothballed, there is perhaps an opportunity for a re-rating.

April 2013 Equity Raise

In April 2013 Hargreaves raised £42mm at 775p with institutional investors. The method used, without pre-emptive rights for existing shareholders, avoided the cost and time of creating and issuing a prospectus, since Hargreaves wants to quickly deploy this capital to consolidate its position in surface mining opportunities which became available as the industry faltered.

In late 2012, ATH Resources, the #3 coal producer in the UK, filed for bankruptcy. Hargreaves bought a £12.5mm note (face value) for £5mm, which will allow it to control 7mm tons of reserves (ATH produced £3mm of operating profit in 2011).

In early 2013, Scottish Resources filed for bankruptcy and is currently in liquidation. Following the equity raise, Hargreaves has been named the preferred bidder for Scottish Resources’s assets by the liquidator.

The reason these competitors have struggled is that they were long coal on the revenue side, and coal prices have come down dramatically as cheap coal from the US is exported overseas (due to the boom in natural gas production). They are also long fuel prices on the expense side, and these costs have gone up. They also have substantial debt loads, pension and restoration liabilities.

It’s important to note that in the equity raise announcement, Hargreaves stressed it will structure any surface mine acquisition to mitigate restoration and pension liabilities so that it won’t take on these legacy issues. It is also targeting a 20% return on capital on any acquisition.

Coal in the UK

Deep pit mines in the UK have shrunk from 170 mines in 1979 to 3 mines today. There were 4 deep mines in operation early this year, but UK Coal suffered a dramatic setback as its Daw Mill deep pit mine blew up, destroying £100mm in equipment and stranding 56mm tons of reserves.

Imports have filled the gap, as the UK imported only 3% of coal consumed in 1979 but 70% of coal consumed in 2012. While overall coal consumption has come down from 129mm tons in 1979 to 64mm tons in 2012, it is still used for ~40% of the UK’s electricity production. Coal use in the UK is expected to keep shrinking, but surface mineable coal in the UK would still amount to 45 years of reserves at the current domestic consumption rate (total of 852m tons of surface coal reserves). Furthermore, surface coal can be exported through Hargreaves’s port facilities and turned into coke at its Monckton Coke Works.

The management team is very aware of the coal trends in the UK and does not appear delusional, but rather very scrappy and dynamic as they have grown exceptionally despite lower consumption in the domestic market.

Balance Sheet

Hargreaves has a solid balance sheet with £227mm of committed banking facilities (through Oct 2015), 8.5x EBITDA/interest expense coverage, and net debt to EBITDA of 1.0x pro forma for the April 2013 equity raise. With such low leverage, why raise equity at all, particularly at such a distressed price? I believe it’s because the management team is exceptionally risk averse, and also because it is targeting investments which will generate at least a 20% return, meaning that the equity raise should generate attractive earnings growth.

Valuation and Potential Returns

Hargreaves trades at ~8.2x my conservative estimate of fiscal 2013 EPS of 101p (year ends on May 31^st). Management has indicated strong trading expected for the second half. Note that this EPS number excludes the one-time costs of Maltby and Belgium.

I do not believe there is any structural reason for earnings to decline in the future. The equity raise, if it delivers 20% after tax returns, could raise EPS to ~125p, meaning you can buy the stock today at a forward multiple of 6.6x.

Assuming EPS and dividend growth of 5-15% in the next two years (EPS has grown 22% compounded over the past 3 years and dividends have grown 14.5% compounded over the same period) from the current EPS of 101p, and assuming a re-rating of the stock to 11x (below its median yearly of 11.7x since 2008, which excludes the multiples of ~25x in the years 2005-2007), gets us to a total return of anywhere between 56% and 87% including dividends, or a two year IRR of 26% to 38%.

I believe stock multiples are cyclical as sectors and companies move in and out of favor and I find it unconvincing that Hargreaves will remain quoted at such a low multiple. However if you do not believe in a re-rating, the low entry multiple of 6.6x should give you a long term IRR of ~15% assuming no growth and ~20% assuming 5% yearly growth.

I’d be happy to answer questions in the Q&A.

Catalyst