Hargreaves Services plc: on course but destination uncertain

Disclosure: I own shares of Hargreaves Services.

Results from Hargreaves Services (LON:HSP) earlier this week made interesting reading.

The dividend increase to 30p per share was welcome, as it is backed by cash and covered twice by earnings per share. However, there’s no point in pretending that this payout can be maintained, as profits are falling as the firm’s primary coal market continues its structural decline.

Hargreaves says it is targeting a move to a 40% payout ratio and this is reflected in the latest broker forecasts, which show the payout dropping to 21.9p for the current year, and to 18.5p in 2016/17.

Still a coal firm

I think the biggest takeaway for shareholders is that this is still a coal firm. £33.4m of the group’s underlying operating profit of £40m came from coal production, trading and distribution last year. Operating profit from transport (which is diversifying into waste and biomass) and industrial services (outsourced coal supply chain/facility management in the UK and abroad) only totalled £5.5m.

Hargreaves has completed its simplification programme (at a cost of £12m) and is now focused on shifting its strategy for a future without coal mining. Incidentally, the cost of the simplification programme was originally expected to be around £7m, so this seems to have overrun. However, looking the this week’s accounts suggest that the bulk of the extra cost relates to derivative losses, presumably relating to the falling price of coal.

At the moment, the firm’s strategy appears to focus on onshore wind and housing development, using its land assets in Scotland and England. However, it’s too early to say how successful these ventures will be, especially in the face of proposed changes to the subsidy and tax structure for onshore wind.

Hargreaves recognises this and states that its planning is based on the assumption that the wind-down of coal power in the UK will take longer than expected, due to the need for reliable base load generation. Hargreaves’ view is that supplying coal to power stations and steel works will continue to provide the firm with a viable business until 2020.

I’m not in a position to judge the accuracy of this forecast, although it doesn’t seem unrealistic, given the current lack of investment in new power stations.

Still a buy?

One point I think is worth commenting on is the quality of the Hargreaves market communications. I find them to be unusually candid and open, on the whole, and very easy to understand. One exception is that banking covenants are not specified. Instead, the firm simply states that it is operating “comfortably below our covenant levels”. What does that mean?

If Hargreaves’ prognosis that the coal business will survive in its present form for a few more years is correct, then the firm’s shares look reasonable value.

They currently trade on around 4 times 2014/15 earnings and 8 times forecast 2015/16 and 2016/17 earnings, with a yield dropping from nearly 9% this year to just over 5% in 2016/17.

Cash generation and the balance sheet remain strong and the firm’s management has so far proved willing and able to take effective actions to reduce costs and realise value from unwanted assets.

However, one concern I do have is that the current hedging and fixed price contracts all ended in May. As the company admits, these supported the strong profits from the mining business over the last year. It’s not clear to me how this will impact forecast revenues this year, if coal prices do not pick up in the next few months.

Overall, there’s no denying that this is an uncertain picture. However, it may be worth noting that so far, things have turned out broadly in-line with management guidance. On this basis, I intend to hold unless/until something material emerges to change the picture.

Disclaimer: This article is provided for information only and is not intended as investment advice. Do your own research or seek qualified professional advice before making any trading decisions.