Hallador Energy: Undervalued Energy Player With Catalysts For Growth (NASDAQ:HNRG)

Investment Thesis

Hallador Energy offers a unique value opportunity through its integrated coal and power exposure. The company realized a major financial turnaround in 2022 with net income and operating cash flow soaring. Hallador also fortified its balance sheet and secured highly visible long-term power and coal sales agreements totaling over $600 million. Still, shares trade at just ~5x earnings, presenting steep discounts versus industry peers. My bullish view rests on the much-improved financials, favorable energy industry backdrop, clear growth trajectory, and opportunity for outsized returns from further strategic mergers and acquisitions. As management executes on both organic expansion and potential bargain acquisitions, I see the valuation disconnect closing with shares converging towards sector median multiples.

Company Deep-dive

Hallador Energy operates an integrated business model across the coal and power markets:

Coal Mining Operations:

Hallador currently mines 6-7 million tons of coal annually from its Oaktown underground mines and other surface operations located in Indiana. The company possesses over 75,000 acres of mineral rights in the region.

The Oaktown complex represents one of the largest room-and-pillar mining operations in the U.S. Oaktown consists of two active mines utilizing continuous miner machines to extract high-sulfur thermal coal from the Indiana V seam. The coal feeds into a centralized Oaktown wash plant with 1,800 tons per hour processing capacity.

The company also operates smaller surface mines at its Ace, Freelandville, and Prosperity sites, which produce a mix of high and low-sulfur coal for blending. In total, Hallador sold 6.3 million tons of coal across 14 power plants in 5 states during 2022.

The key advantages of Hallador’s coal operations include:

• Strategic Location Within Primary Illinois Basin (ILB): Hallador’s mines sit centrally within the prolific Illinois Basin region, known for low-cost extraction. The ILB supplies over 1/5th of U.S. coal demand.
• Long-Life Reserve Base: Proven and probable reserves total 66 million tons currently, which support a ~7 million ton annual production rate for nearly a decade before depletion. The strong reserve base comes with little reclamation liability.
• Low-Cost Structure: Hallador’s mines maintain cost-competitive positions, with average 2022 costs of $37/ton. Centralized processing also boosts margins.
• Stable Utility Customer Base: 90% of coal volumes sell to just 5 major utilities under multi-year supply agreements, enabling volume/pricing visibility.

Electric Operations:

Hallador expanded into electricity generation in late 2021 by acquiring the 1 GW Merom Generating Station located in Southwest Indiana.

Strategically, Merom provides fuel diversification and market expansion for Hallador beyond just coal mining:

• Direct Internal Synergy: Merom’s existing turbines and boilers create built-in demand for ~3 million tons per year of Hallador’s coal. This allows captive profits across the vertical value chain.
• Optionality: Having both mining and power operations gives management added flexibility across market environments. The mix of contracted versus market power sales can shift opportunistically based on prices.
• Cost Advantage: Owning its own captive plant allows Hallador to fuel Merom at mine-mouth prices below spot market rates. This ensures a lower-cost input for competitive power production.

Turnaround

Hallador has capitalized on unprecedented energy market conditions over the past two years to transform its financial picture:

• 5-Year highs in coal drove the average contract price up, and total net income swung from a ~$4 million loss to $85 million profit over the LTM.
• The 13% jump in coal production in 2022 paired with the Merom acquisition pushed up operating cash flows
• Debt decreased 50% to $59 million, bringing leverage down to a prudent 0.71x EBITDA as of Q3 2023 per management.

The increasingly diversified revenue mix, combining legacy coal with newer power sales, offers stability. Gross profit margins soared from 20% to 30%. Hallador has grown into a materially stronger business financially.

Growth Outlook

Despite turbulence for coal producers amid decarbonization pressures, Hallador maintains a clear growth roadmap built on contracted sales. The company currently holds over $600 million in locked-in coal and power sales agreements. Over half of 13+ million contracted tons of coal carry set prices averaging $52.60 per ton through 2027, considerably above the company’s production cost in the high $30 range. Hallador also indicated on its Q2 2023 earnings call securing ~27% of the Merom plant’s future power production through 2025 at $34 per MWh. The company additionally signed agreements totaling $366 million to sell 3.3 million MWh across 2026-2028 at $56 per MWh.

With current 2026 power prices far exceeding that contract level, these visible volumes offer strong profit visibility. The 80% uncontracted open exposure does introduce some volatility but allows full upside participation as energy markets potentially tighten further.

Financial Profile Improving

Hallador maintains a flexible financial position, even after funding nearly $50 million in growth and maintenance capex over the past year. Cash from operations easily covers the company’s capital expenditures.

Management targets reaching a net debt-neutral position within the next 6–9 months by Q2, 2024. This could pave the path for shareholder returns, beginning with a potential dividend initiation. The prudently managed balance sheet gives Hallador optionality in capital deployment including organic growth, acquisitions, buybacks or dividends to unlock shareholder value.

Valuation

Despite significantly improving its financial and operating profile, Hallador’s valuation disconnect persists, with shares trading at a ~5x forward earnings multiple. This reflects a discount of ~50% to coal producer comps:

Applying a peer average 10x multiple to Hallador’s would imply a 2x increase in valuation. Over 100% upside exists simply from multiple convergence.

The cheap level fails to account for Hallador’s double-digit cash flow growth in strengthening end markets. While some discount is merited based on the company’s smaller size, I see 50-100% price gains likely driven by peer multiple expansion and EPS growth execution.

Catalysts

• Additional Debt Paydowns Setting Stage for Dividend: Hitting its net debt target could set up Hallador to initiate shareholder dividends.
• Tighter Energy Markets Boosting Forward Contracts: With most future power unpriced, tighter supply driving electricity prices materially higher would flow straight to Hallador’s bottom line.
• Accretive Deals in Consolidating Industry: The recent Merom purchase and balance sheet strength position Hallador well for other value-enhancing acquisitions amid industry consolidation.

Risks

• Customer Concentration: The top several utilities account for a majority of Hallador’s coal revenues currently. Losing one chunky contract poses downside risk.
• Commodity Exposure: Thermal coal and power markets remain volatile. Though somewhat mitigated via long-term contracts, material declines would pressure the income statement.
• Legal/Regulatory: All coal miners face incremental regulatory threats around emissions restrictions and usage declines. However, Hallador’s low valuation already discounts these risks.

Conclusion

Hallador Energy has completely transformed its business over the past 24 months – boosting profitability dramatically, shoring up its balance sheet, and expanding scale/capabilities with the strategic Merom acquisition. The company now operates an efficient integrated coal mining to power generation platform that is uniquely positioned to capitalize on supportive energy market conditions. Despite ticking all the right boxes fundamentally, HNRG stock trades at steep discounts to peer valuations. This presents a compelling risk/reward setup for opportunistic investors comfortable with inherent commodity volatility. I anticipate shares converging towards 10x P/E valuations across the coal comp set, implying at least a 100% upside from current levels, driven by Hallador’s continued execution.