Hargreaves Services interim results review: deep value or value trap?

Disclosure: I own shares of Hargreaves Services.

The markets weren’t impressed with value portfolio holding Hargreaves Services’ interim results on Tuesday, and the shares closed down 17% at just under 200p.

There’s no doubt that despite the apparent balance sheet value here, the shares have so far proved to be a falling knife. Yesterday’s results were a mixed bag in my view.

The rapid decline of the coal business means that earnings are largely irrelevant. The opportunity here lies in the balance sheet. Working capital (i.e. inventories) will continue to unwind and generate cash, while Hargreaves’ property portfolio also has the potential to deliver significant long-term gains.

Offsetting this potential upside is the risk of unexpected losses and costs relating to the winding down of Hargraves’ coal operations. As an example, the firm warned yesterday that the eventual closure of the Tower colliery joint venture could result in a partial default on Tower’s debts to Hargreaves.

Let’s stick with the numbers

Hargreaves’ management have been admirably transparent and objective in their handling of the firm’s changing circumstances, in my view. It’s also worth remembering that chief executive Gordon Banham has a 7.1% shareholding in the business, so his interests should be closely aligned with those of shareholders — although he might be happy to take a longer term view than many investors.,

In this article I’m going to take a fresh look at the balance sheet. How have things changed since my last review? What’s the most appropriate way of valuing Hargreaves?

I reckon this is a situation where Ben Graham’s net-net working capital approach may be appropriate. Although this deep value approach is often dismissed as offering too limited a choice of companies in today’s highly-valued markets, I think it does still have some relevance. (A good modern-day read on this subject is Deep Value Investing by Jeroen Bos.)

For the uninitiated, the net-net working capital is calculated as current assets minus total liabilities.

In other words, this calculates what would be left if you paid off all of a company’s liabilities using relatively liquid current assets, without trying to sell any fixed (non-current) assets. Here’s how this looked for Hargreaves at the end of November 2015:

• Current assets: £193,273,000
• Current liabilities: £71,872,000
• Non-current liabilities: £58,878,000
• Net-net working capital: £62,423,000 (down from £68m @ 31 May 2015)

Interestingly, Hargreaves market cap has now fallen to £62.8m, matching the net-net figure almost exactly.

Hargreaves also has non-current assets of £78.8m. However, these assets will change following the Blackwells acquisition, which completed at the end of January. Hargreaves’ extensive plant fleet would also probably be worth much less than book value in the event of a liquidation sale. I’ve also ignored the £9.5m of intangibles.

In fact, the only non-current assets I’m really interested in are the property assets. According to yesterday’s interims, these comprise 15,500 acres of mixed development land with a current book value of £24m.

Here’s what the firm had to say about its property assets:

Although the development of property is not expected to generate a steady flow of profits and cash in the short term, the Board believes that, with appropriate investment, there is significant opportunity to create value above the current £24m book value over the next 5 years.

Two key sites which offer significant ongoing development value are Blindwells, a 350 acre residential site situated 10 miles east of Edinburgh, and Westfield, a 350 acre industrial development site at Westfield in Fife.

Hargreaves hopes to have concrete news on these developments towards the end of this year, although both would require significant capital expenditure before generating any returns. The firm’s plan is to sell land that doesn’t appear to offer a significant development opportunity in order to generate cash.

I’m guessing that over a period of several years, Hargreaves might be able to add 50% to the current £24m value of the land portfolio. Adding £36m to the current market cap implies that the shares could be worth around 50% more than they are today.

What about Hargreaves’ non-coal businesses?

Hargreaves does have some non-coal business. Industrial Services provides the know-how to run coal mining and power operations in other countries, where the coal industry remains more important. This generated £2.3m of operating profit during the first half, down slightl from £2.6m for the same period last year. This business appears to be sustainable and just about worthwhile.

Hargreaves also has a large bulk transport division. This was historically used to transport coal but has diversified into waste and biofuel. However, profits fell sharply during the first half due to a reduction in business for a major customer. Operating profit fell from £1.3m last year to just £410,000 for the six months to 30 November. However, the road transport business has notoriously high costs and low margins. I think it’s safest to assume that it will cover its costs but do little more.

Finally, there’s the Blackwells civil engineering and earthworks business, which was acquired in January. Blackwells is expected to have generated an operating profit from continuing operations of £2.1m in 2015.

If we combine Blackwells and Industrial Services, we could be looking at full-year operating profits of around £6-7m. This is nothing to write home about, but should help Hargreaves tick over without consuming cash, while work continues to wind down coal operations and make progress with propertydevelopment.

Buy more or sit tight?

I’m not going to sell my existing Hargreaves shares. The question is whether the stock is cheap enough to buy more. Trading at net-net working capital, buying at c.200p means getting Hargreaves’ property and plant thrown in for free.

However, the timescale for the realisation of this potential value to out is uncertain. I’d guess at 3-5 years. Anything could happen during that time, including a property crash. I’d really like a bit more of a discount, so may wait and see if the shares move any lower.

Disclaimer: This article represents the author’s personal opinion only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.