Hargreaves Services plc HSP
July 15, 2014 - 11:52am EST by
flux13
2014 2015
Price: 782.00 EPS $1.30 $1.44
Shares Out. (in M): 33 P/E 6.0x 5.4x
Market Cap (in $M): 262 P/FCF 0.0x 0.0x
Net Debt (in $M): 98 EBIT 60 66
TEV ($): 357 TEV/EBIT 5.9x 5.4x

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  • Coal
  • Mining
  • Commodity exposure
  • Distributor

Description

Please note that all figures are in GBP. 
 
Short Synopsis:
Hargreaves Services (LSE:HSP) seems to be a misunderstood company with ROTCE > 16% and historical growth > 10% p.a. over the last 10 years trading at a PE multiple of 6x last 12 months earnings (which I think are not only sustainable, but may be low). 
Fundamentally, while it has coal mines, which is part of the reason for its low valuation, its core business is a niche distribution business, which is not a commoditized business and which has good business economics. 
 
History and Mgmt:
Hargreaves Services was founded in 1994 with the acquisition of a haulage business from RJB Mining plc. At the time, it was simply 20 trucks focused on coal haulage in the UK. During the 1990’s Hargreaves Services (“HS”) continued growing organically and buying further haulage operations. In 1999, Hargreaves Waste Services was founded and haulage diversified to hauling waste. In 2001, Gordon Banham (“GB”) joined the group as CEO and began a strategy of diversifying into higher value services. 
In 2001, HS started logistics operations (port services) at Immingham and in 2002 at Newport, which remain two of their main port operations today.
In April 2004, the management team, including GB, completed a MBO of the company- Barings English Growth Fund invested £3.5 million in debt and equity and GB invested approximately £1 million of his own money.
On 17 June 2005, Hargreaves completed the acquisition of coke production facility Monckton from UK Coal plc.
In November 2005, HS floated on AIM at a share price of ca. GBp 280.
In 2006, a JV was established with UK Coal in distributing niche coal products – JV was called Coal4Energy.
In 2007, HS acquired the Maltby Collier (Coal Mine), which is having geo-structural issues.
In 2009, HS acquired the 50% of the JV in Coal4Energy that it did not own.
In 2011, HS discovered that its Maltby coal mine had geo-structural issues; subsequently in 2012, HS decided to Mothball and sell the Maltby mine.
In 2012, HS discovered that fraud happened at their Belgian operations, and took a GBP 17.7m write-down related to this development. 
In 2013, HS under GB has announced a plan to acquire further surface mine assets in the UK when possible under distressed conditions/prices
The main management influence comes from Gordon Banham, who built the business to what it is today – a provider of logistics/distribution/production services of coal.
 
Core Business Segements
 
Hargreaves Services has 4 core business, out of which the E&C division accounts for ca. 60% of the EBIT.
 

Business Division                      Revenues %                 EBIT %       Operating Margin

Energy & Commodities                       61%                           57%                      7%

Production                                         17%                            27%                     11%

Transport                                            12%                            9%                       5%

Industrial Services                             10%                             7%                        5%

Going more into detail about Energy & Commodities, Hargreaves is responsbile for a range of services starting from basic distribution/trading of coal (for example for power plant customers) to the mixing and creation of specialty coals, which have much higher gross margins. The key here is that across this specturm of different value-added that Hargreaves Services provide, the higher the value, the higher the potential for value-based pricing and the higher the margins. Although for example trading of coal, gross margins may be only 1.5%, for the extraction and blending and resale of specialty coals, the gross margin could be > 7%.

Because of this, HSP naturally makes most of its money from extracting high value products. One should refer to the company presentations of the company for details, but roughly speaking 1/3 of operating profits in this division come from sales of power station coal and 2/3 from other products, which include specialty coals, such as domestic heating coals, coking coals, low ash coals, and locomotive coals. 

The production division is the division of HSP that owns/operates coal mines and manufacturers coke. It has two mines -Tower and Hatfileld - both surface mines in the UK. it has also been pursuing actively for opportunities to buy additional coal mines when prices are distressed. This is an aspect that has scared a lot of investors, but if one takes a look at the historical track record of the management in doing such acquistions, i would have to say that they have been overall very value creating - the prices they acquired the mines for have been fantastic and they have been able to run them profitably. This division also includes Monkton - a coke works. Overall, this division is a commodity business, but one which Hargreaves seems to be a good operator in a space (UK coal space) where there are few remaining good operators. 

The Transport division is one that is the largest bulk materials hauling business in the UK. It includes transportation via trucks and a fleet of barges. This is a decent business.

The last division is Industrial services. In this division, Hargreaves Services provides management and other technical indsutrial services primarily for the power and steel sectors. For example they help manage certain processes for utility customers like Scottish Power and EDF. 

 

Business Economics

Hargreaves Services has a historical growth in revenues of > 15% p.a. since 2008. This can be partly attributed to M&A, but much of it has been organic growth. In terms of the return on capital econiomics, Hargreaves Services has much better returns than many would expect - primiarly because it is not simply a coal mining business. Based on a last year's total tangible capital base (PPE+Inventory+ Accounts Receivable -Aacounts Payables) of ca. GBP 250 million, the return on capital employed after tax is 16%. 


Competition

A key aspect for the investment case in HSP is that its competitive environment is much more favorable than most realize. Foremost, as could be expected, in the bulk segements of coal trading (thermal coal), HSP compets with large competitors like Glencore, Peabody Trading, and Trafigura, which are formidable competitors. However, as much of the profitablity of the company, and what they want to focus on is specialty coals, in those niche markets, they have much fewer competitors.

Taking one specific example of a niche market - domestic heating coals - Hargreaves Services competes with Ferguson (Scottish firm), CPL and 88Resources. Essentially, these are smaller distributors who are regional and besides from Ferguson, which does make good money in Scottland, they are sub-scale. In the heating coal market in the UK for example, Hargreaves ahs a market share of ca. 60%. Moreover, the nature of this business depends as much on dependability and service as it does on price, so its not just a price based commodities business.

 

Risks

Long Term Decline in Coal: One of the key risks that seems obvious with any company dealing in coal is the common knowledge that long term prospects of coal as an energy source is poor in Europe. This is heavily reinforced by regulation: In the UK, three regulations are relevant: (1) LCPD - an EU directive, IED - another EU directive, and the Carbon Price Floor, which is a UK regulation. All three have the impact of increasing costs for operating coal power plants and reducing costs for alternative energy sources. Without this regulation, coal is clearly the cheaper source of energy in the UK compared to the alternatives that are incentivized - biomass including pellets. A potential investor should understand these directives in more detail, but the basic effect is that the UK regulation is even more limited currently than the EU regulation and if this regulation is in full force, then compliance would add very signficant costs to UK coal power plant operators. The result is that a lot of the UK power companies have committed to drastically reduce their coal usage by 2022, with many coal power plants in the UK shutting down between now and 2022. 

Why do i think this risk is overblown? First, I think the company based on its cash flows is priced as if ALL coal in the UK is elminiated by 2022, which not even the regulators who want to reduce coal usage are predicting. More imporatantly, Hargreaves business while certainly affected by thermal coal demand, is not solely based on thermal coal. As discussed, their main profit driver is specialty coal distribution, and while less thermal coal demand means less ability to blend and extract the specialty coals HSP is focused on, it does not eliminate that work. Moreover, the amount of thermal coal that HSP needs to do what is necessary to get to their specialty coal is less than ca. 3 million tons of thermal coal. That is a small fraction of the 40+ million tons of thermal coal still used in the UK today. That means, even the thermal coal usage is reduced by 3/4, a very simple view is that HSP will still be able to do what they do today. (to be very specific there will be some costs on the margins, but the point is that the business is not dead). 

Furthermore, i think the outlook on coal in the UK right now is that the consensus is that it is dead or will be soon. I think this is not necessarily true. I think the chance that regulation changes again to be more positive for coal is very possible - especially with the possible change in government in 2016. First, looking more into detail at the Carbon Price Floor in the UK, penalizing usage of coal to incentivize use of wood pellets (just look at what is happening at the UK energy company Drax, which has converted sevearl of their coal plants to burn this biomass) makes very little sense. The argument is that biomass is sustainable/can be regrown, but fact is also that it involves  transporting wood pellets that processed in the US with ships all the way to the UK to then burn them in their converted coal power plants - which by the way produces even more CO2 for a BTU than coal does. There is signfcant literature on this, but an FT article that mentions the case with Drax is here: http://www.ft.com/intl/cms/s/0/f0661836-cb04-11e3-ba9d-00144feabdc0.html

In any case, as of late, the Carbon Tax Floor, which was incrementally to increase, has been frozen, which is a positive development for coal. Also the pressure on UK energy prices being too high bodes in my opinion significant rationale for relaxing coal legislation. In any case, the point is that the scenario of all coal being eliminated in the UK by 2022 is not 100%. Even if it were, it would affect HSP's business, but would not kill it.  

 

Valuation

I will leave you to do your own valuations. I prefer using a sustainable cash earnings multiple, but have for the sake of a first touch point included its tradtiional valuation based on EV/EBIT and PER below.

              2013Actual  2014Estimated

PER        6.3x             6.0x

EV/EBIT  6.8x             5.9x

 

Conclusion:

Hargreaves Services priced as if it were a coal mine in the UK under a scenario where all UK coal becomes uneconomic in the next few years - thus as if it was a dead business. In reality, HSP is neither a coal mine, but rather primarily a less cyclical distribution business in specialty coals. Nor do i believe that the scenario of all coal being eliminated in the UK by 2022 is realistic. Based on this divergence, I beleive that the intrinsic value of HSP is more than 2x its current price.

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Low valuation. 
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