Initiating Coverage on Hallador Energy (HNRG)
Cheap (as we like it) and well-positioned to benefit from selling power to data centers
Hallador is an Indiana-based energy company that has roots in the E&P sector beginning around 1950, but it’s mostly been known as a coal company over the last two decades. Below we lay out the company’s circuitous path to becoming a power producer and then get to the investment case for HRNG shares – you can skip down to the valuation section if you don’t want to read so much history on the company.
Hallador got into coal in the then-booming Illinois Basin (ILB) in 2006 by buying into Sunrise Coal, LLC and growing through acquisitions. Around 2017, they mined more than 10 Mst per year from a handful of Indiana mines and were the 4th largest miner in the ILB.
We all know how much US coal demand got pummeled during the 2010’s, however. So, management at Hallador had a pretty good instinct a few years ago, diversifying their business away from thermal coal by proposing to repurpose a large power plant (Merom) that was a customer of their mines in Indiana. Now the company is down to operating just one coal mining complex, Oaktown, and running the Merom power plant, as shown in the following image from the company’s latest 10-K.
Hallador’s initial diversification strategy in 2021 was to build a solar farm at the Merom power plant. It wasn’t a perfect strategy, and it was partly driven by some overblown ESG pressures. However, the strategy resulted in Hallador acquiring grid interconnection rights at Merom from its owner, Hoosier Energy. At the time that Hallador purchased the Merom interconnection rights in June 2021, everyone assumed that the coal plant would soon be closed and solar was the future. The plant’s interconnection to the MISO market (the Midwest power market) is valuable, and the idea is that it would allow the solar development to skip the years-long interconnection queues that are slowing down new-build power projects. This whole investment case came before data center energy use exploded and market participants started recognizing how tight power markets really are.
With the boom in power demand, Hallador’s strategy evolved. Just a year after Hallador bought the interconnection rights, MISO supply-demand tightened, and in 2022, MISO requested that the Merom coal plant stay online. Hallador bid on the Merom plant and got it cheap - they owned the grid interconnection, so they were the only logical buyer. Hallador got the plant for basically zero cash consideration by agreeing to assume some future decommissioning costs and environmental liabilities and signed a somewhat below-market power purchase agreement (PPA) with Hoosier to sell back part of Merom’s power output for a few years. The price Hallador put on the deal for Merom was $184.5M, but most of that figure was based on assumed lost revenues from the PPA. As power prices in MISO didn’t rise as much as expected, the lost revenues on the PPA were less than forecast. And Hallador’s total asset retirement obligations (ARO) of $17.1M aren’t too onerous – those ARO include $5.6M planned for decommissioning the Merom plant, so that’s less than $12M in coal reclamation liabilities hanging over Hallador’s head.
Some quick details on the Merom power plant: it’s a 2-unit 1,080 MW coal-fired generating station in Indiana built in 1982. Hallador has said the 40-year-old plant will be fully depreciated in the next 10 years, but could run for another 15, which we believe is a reasonable assumption and represents a pretty good acquisition if we assume that Hallador really paid in the ballpark of $100M.
The chart below shows the PPA with Hoosier – the PPA represents just over 2/3 of the company’s hedged power position shown in gray. The main play around HNRG shares is fairly straightforward: the company is poised to sell more power in MISO at market prices as the hedges roll off and new deals are signed, and MISO power prices are on an upward trajectory. In 2024, the power business has been contributing the majority of revenues and most of the company’s profits, and that’s where HNRG stands to see the most upside to earnings.
While MISO energy prices haven’t risen as fast as Hallador hoped over the last couple years, capacity revenues at Merom are up a lot. Capacity revenues (or the earnings Merom makes just to hang around and be available) are expected to be approximately $65M in 2024 compared with $10M last year and just $1.5M a few years ago.