|Shares Out. (in M):||30||P/E||0||0|
|Market Cap (in $M):||186||P/FCF||0||0|
|Net Debt (in $M):||170||EBIT||0||0|
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I am recommending a long position for HNRG on the basis of the following catalysts. A. More dollars in netbacks per ton sold and B. An increase in projected tons sold.
Tallguy did a nice write up where he laid out the business pretty well. I am building on that. I recommend you read that write up too.
An increase in projected tons sold.
In the latest K, HNRG management projects that they will sell 6.8 million tons in 2018 and 7.0 tons in 2019. But in the latest call management said the following “Looking to next year, as we've said before, we think that it's going to come down to buying season. But we think because of the Princeton Loop, we're talking to more customers than we have in the past. And so we think our potential for more sales is greater in 2019 than it is in 2018. The back half of the year, if you look at this, we're going to be shipping -- contractually, we're scheduled to ship at a 7.6 million ton pace -- excuse me, 7.8 million ton pace. And if we make additional sales, that's going to push us potentially to be running at a pace up over 8 million tons.”
Yes, selling 8 million tons is a big plus, assuming that pricing doesn’t get weaker but we shall address that later, as the company made on a gross basis about $10 a ton after maintenance capex. Last year they sold about 6.5 million tons which gets you a number of about $65 million in pro forma operating margin. But during the down turn Carlisle, one of the mines had to be idled and to keep the mine alive, HNRG had to spend around $5 million year. So the simple calculation goes like this. 1.5 million additional tons sold at a $10 margin a ton, gets one an additional $15 million, but since they now are back mining Carlisle, that $5 million drain will disappear too. So that gets us to $20 million additional cash flow.
An increase in netbacks.
If you listened to the conference calls of different ILB coal companies you get two messages. A. The export coal market out of the ILB is really healthy and B. The coal that is siphoned off into the export markets is supporting the domestic ILB market as less supply is available domestically. C. Also domestic inventories have come down significantly. Let me address this, but first some numbers.
Let’s say that netbacks can increase by $5 a ton. Then than means $40 million more in pretax cash flow. If it is $10 more a ton then it is $80 million more in pretax cash flow. On August 3rd, 2018 HNRG had 30,176,990 million shares outstanding times $6.16 that gets me a market cap of $185.9 million. And an enterprise value of $356.3 million. In 2017 HNRG had operating cash minus capex of $32.9 million. Add to that number the $20 million from the added tons and $40 million from a potential added $5 in netbacks, assume a 21% tax rate and you get some great numbers. This would result in a run rate free cash of $80.3 million. If we assume a 7 multiple on that one we get an EV of $562.1 million and a market cap of $391.7 million. If we get $10 in additional netbacks then the numbers get even crazier. Currently management says it sees about $2 in additional netbacks at this time. And keep in mind that coal companies sell a lot of coal months and years ahead, so any price increase works its way slowly into the financial statements.
So now that that is behind me, the two big companies in the ILB are Foresight and Alliance. In 2016 they exported about 3.27 million tons of steam coal out of the ILB. This year they are on track to do more than 18.5 million tons. (Total expected 2018 tons of export out of the ILB is about 20 million tons a year I read.) The ILB on the high end seems to be producing 120 million tons a year. So compared to 2016, in 2018 we will see at least 15 million tons additionally drained from the domestic market to exports. The way it looks now is that more coal will be exported, but I believe we are pretty close to the maximum exports out of the ILB. ARLP says they want to increase production by 2 million tons for export and FELP seems to have capacity for 11 million tons, meaning they can drain another 2 million tons out of the market. Now some new production is coming online in the ILB too. As mentioned ARLP will do 2 million tons more and HNRG is increasing production by 1.5 million tons it seems, not a huge growth rate compared to total production. I am sure there are some other mines that are expanding capacity again. FELP overall has been more disciplined when it comes to expanding capacity. They have confirmed that they could add another 5 million tons and that would require an investment of over $100 million. But FELP management wants to first see better pricing and it does still have to fix the retained percentage and MQD issue too. So, we have drained a significant amount of supply out of the ILB in the last two years through exports and that is expected to continue. Also we also had supply reductions over that period in the ILB.
The next question is … “will exports continue”? It looks to me that way.
- The new coal plants currently under construction globally are expected to burn about 500 million tons of coal a year, that’s about 70 percent of what the US burn yearly. And that’s only for what is currently under construction. Keep in mind, the ILB total production is only about 120 million tons. But what is even better is that most of that capacity is for high caloric coal. High caloric coal is only a piece of global coal demand. So the true growth rate of demand for ILB like coal is higher than it looks on first sight if compared to global coal demand. And even better, most of these plants are being built with a desulphurization unit attached, which is great for ILB coal. Yes, plants are closing too, mostly in the US. For example 12 GW closed in the first 6 months of 2018 in the US. Most of this was not for ILB coal. Don’t worry though, we still opened 4 more GW in capacity in the first 6 months than we closed globally. And the US closing schedule will slow down markedly after 2018, but the opening schedule will continue. What is also great is that we have not seen much greenfield development of new mines globally. It just isn’t sexy anymore to open new mines. Actually, the bigger problem is that many financial institutions are refusing to finance the startup of new mines or any other mine activity. This will limit supply over time. There have been new mine openings in mainly Indonesia, but that is mostly low caloric value coal.
It seems like we will continue on this path for a while. Coal is just a cheaper solution globally than gas. Many countries need to import LNG which is significantly more expensive than coal. And those countries are often poor, like India. It is hard for a politician to tell someone in India that he needs to accept a higher price for a KWH because some rich guy in the developed world is worried about global warming. When you struggle every day to feed your family, global warming isn’t your first priority. India especially is an attractive market going forward. Electric demand is growing at a 6% clip annually and the country is struggling to produce enough coal. The delta between consumption and production of coal continues to grow by the year, driving increased imports. India’s infrastructure just isn’t setup to handle this amount of growth in coal demand. The US has the best goods rail network in the world and still rail transportation is a constant annoyance. I can only imagine how efficient coal delivery in India is. Many of the plants there run with 7 to 14 days of inventory, which is a crazy thought in itself. It is not that they choose to do this, it is just a desperate need for coal. Growing coal demand by 6% a year is quite a problem infrastructure wise. Also let us not forget that India has 4 times the amount of cooling degree days as the US with 4 times the population. If India goes China’s way, a country with significantly less heating degree days, then soon they will be installing 8 times the amount of air conditioners a year as they do now. And once the AC is installed good luck convincing someone they shouldn’t run it when the heat index is 110 outside. I know Modi keeps saying he wants to reduce coal imports in India to zero, but the size of the problem will make that impossible. Anyway, you get my point and although India is the country that jumps out the most, one can make the same argument for Vietnam and many more developing countries around the world to some degree or other.
Another continent that is of relevance to especially American coal is Europe. As Europe is closer than Asia, especially for east coast and gulf shipped coal, continued use of coal by Europe would be a plus. Since 1990 Europe has cut its hard coal demand by 50%, but they were so nice to cut their hard coal production by 80%. As you notice I made sure I said “hard” coal, a majority part of European coal burning, especially in Germany, is lignite. And the Germans are really embarrassed that they aren’t making much progress on cutting their CO2 output. Let it just be that per BTU lignite puts out 4 times the amount of CO2 than hard coal does. Especially if Germany closes its nuclear plants by 2022 I just do not see a way Germany can make up for shutting down their lignite industry, except by using hard/bituminous coal. Europe just doesn’t have enough gas available. A friend of mine works for one of the large energy concern in Europe as a consultant. Each time I ask him … “but where is all that gas that you talk about that is going to replace nuclear and coal supposed to come from” … I get a blank stare. Anyway, if not for nuclear, Europe isn’t shutting down its coal burning anytime soon. As a side note no Russia is not the answer to Europe’s gas problems. Yes Russia has a lot of gas, but export of oil and gas pays for 50% of the Russian government budget, money the Russian government uses to build its army. It is quite cynical for Europe to assume that the US needs to protect Europe from the Russian army, an army Europe paid for in the first place. There is a reason why congress isn’t too happy with Nord Stream 2.
One last point regarding exports, we should be close to maximum exports this year and maybe be able to export an additional 6 million tons in 2019. But the US export capacity is not unlimited for the next few years. One still has to be able to get the coal from the mine to the coast for loading and one needs the infrastructure to move such massive tonnage. Once the system is at capacity transportation costs do increase.
- But there are other issues than exports that are relevant to HNRG, especially since HNRG total exports equal zero tons until now. One of the issues helping to balance domestic coal demand is that coal inventories at coal plants have come down from 200 million tons at the end of 2015 to 114 million tons. Part of that was the result of closing coal plants bringing their coal inventory down to zero. And part was working plants bringing down inventory tons. Still on a days burn basis we still can go lower. That number has not come down as much as hoped due to capacity utilization reductions. I personally think tons of inventory could potentially go down below 100 million tons before we reach a lower bound. Now if capacity utilization at coal plants increases then we will need to be above 100 million tons. Luckily we had already a pretty hot summer in the US which has encouraged coal demand so one can assume that coal inventory might now be even lower. Actually we have had heat waves all around the world for a long time ending early August which was excellent for coal demand. But back to the domestic market.
- Domestically the US coal demand has been challenged by closings. For example in the first 6 months of 2018 12 GW of coal capacity closed. But that pace is about to slow down. A major positive are the new rules just announced replacing the Obama administration’s CPP. Those were onerous regulations that were written to drive coal plants to close. For example the New Source Rule made major capital investments almost impossible. Many of these now allowed investment will allow for an increase in rated capacity and for better efficiency. Also federally mandated retirements of plants will be scrapped which will allow for plants to stay open longer. After all a fully depreciated coal plant produces power cheaper than a new combined cycle gas plant as the new plant needs a return on its investment above its variable cost until it reaches complete depreciation. Actually on an MMBtu basis, coal is still about 25% cheaper than gas on variable cost basis. The story that gas is blowing away coal cost wise is a myth. The problem was just as much onerous regulations that had been loaded upon coal burning utilities. Even if prices of natural gas stay at this level the competitive position of coal just improved. But will prices of natural gas stay at this level? I doubt it. If the productivity growth curve of the directional drillers would have continued improving the way it did the last few years I would have agreed, but the level of progress has stalled. What I find a positive sign is that the last 12 months being a period that saw very fast growth in natural gas production, about 8 to 9 bcf/d, the natural gas storage volumes continue to lag. Now if we wouldn’t have had such a massive increase in production I could have understood that refilling would have lagged, but we should have a glut of gas which should be reflected in pricing. I was expecting natural gas pricing to fall off a cliff this summer, but instead pricing has held up while storage refilling is way behind. If we are going to refill at the pace of 10 bcf/d for the rest of the refilling season then we end up with only about 3,200 bcf. That seems to cut it pretty close to go into winter. Total nat gas inventory would have been close to 600 bcf if we had started with 3,200 bcf of storage in November 2017. It makes sense that Pacific storage lags as nat gas pipeline is currently only at about 60% going into California, but East, Midwest and Mountain should have no difficulty refilling. Actually even South Central should be catching up. And none of those are doing so. Maybe colder weather will help in September and October, but only if CDDs fall off markedly will there be room for enough gas for refilling I feel. And let us not forget that over the next 2 years we will see an additional demand of 10 bcf/d, 6.5 coming from LNG and 3.5 bcf/d from pipeline to Mexico. The US portion is done and now Mexico is building the pipelines and plants to take up that gas. If you see how fast Mexico’s natural gas production is declining, Mexico has to finish those connections. All this also does not take into account that only 55 bcf/d is produced by directional drillers. The rest is in essence run off from conventional plays, these plays cannot compete with unconventional plays. So unconventional gas doesn’t just have to make up the extra 10 bcf/d, but also needs to compensate for the decline curve of the conventional gas. Without further significant productivity growth I do not see how unconventional plays make up the difference at the current gas price. Don’t worry, they can produce enough gas. My point is that they will not be able to produce enough if the price doesn’t increase. Even a $1 increase per MMBtu would make a difference for coal demand.
One more point is that the US combined cycle gas fleet is nearing capacity constraints. For the next few years not enough plants are coming online to change that in a major way. Except if nuclear, which is in secular decline it seems, picks up, there just isn’t the capacity. Yes, I know many peaker plants don’t run at full capacity. Well you can’t have it both ways. Either they are peaker or base load plants, but they can’t fulfill both roles at the same time.
Update on what happened since Tallguy did his VIC write up.
- As I mentioned earlier, HNRG is growing sold tons by a fair amount and has reopened Carlisle which will save $5 million in dead weight costs and the mine will now again drive positive cash flow. The increased volumes help overall, as higher capacity utilizations drive cost efficiencies.
- HNRG is now well on its way to also sell frack sand. The venture is called Hourglass Sands and is located near Colorado Springs. The company is now sending raw sand to a third party wash plant. HNRG management states it has an 800 mile geographic benefit over other sands shipped into the DJ basin. Supposedly that saves $55 per ton. I still have to look into that more. It is not critical to my current coal thesis.
- HNRG recently opened the Princeton Loop, which will allow them to reach out for more customers. In general HNRG has been to some degree captive to its customers, which is also an advantage as most sales travel less than 90 miles. HNRG states that they already gained 2 more customers since opening the new loop. HNRG states they will now have access to the Carolinas and Georgia in a cost effective manner, an area that consumes 25 million tons of coal. This does support the thesis that they should be able to sell 8 million tons going forward, maybe more. Wouldn’t that be awesome.
More tons sold
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