USEG is speculative but ready to pop

Disclaimer: this is not the typical profitable company that attracts value investors. If you are looking for long-term quality businesses to hold forever, this is not for you. If you are into low float stocks with a turnaround potential, please continue to read.

U.S. Energy Corp. (USEG) is an independent energy company focused on the acquisition and development of oil and natural gas properties. A speculative play that has very low float with only 1.35M shares. 41.4% of the outstanding shares is held by the largest insider who paid $8.7/share in 2017. The stock was closed last Friday at $5.89. In addition, CEO holds 5%, and another trader, Guy Gentile, accumulated 9.79% in May 2020. 

The math is simple - the number of shares is already low to start with, and almost 60% is held by insiders who are not going to sell when they make a profit. Any small change in the sentiment or positive catalysts will pull the trigger.

Stats

• share price: $5.89
• average cost of the largest insider: $8.7
• 1.35M shares outstanding after 1:10 reverse split in Jan 2020
• only 540K shares (around 40%) are available to trade on the market
• zero debt

Average cost of the largest insider

The largest insider, APEG II LP, didn't acquired its holdings through the open market; it takes a little effort digging into the historical filings. This is what I've found in the 13D form filed on 3/27/2019:

"The Shares beneficially owned by APEG II LP were the result of an exchange of loans held by APEG II LP and made to the Issuer, and these loans were financed with working capital through a creditor relationship whereby APEG II LP held $6,000,000 in principal amount of loans under the Credit Agreement dated as of July 30, 2010, as amended (the “Credit Facility”), as set forth in Item 6, comprising the entire principal balance outstanding under the Credit Facility (the “Balance”). APEG II LP then exchanged $5,063,380 of the Balance for 5,819,270 Shares on the terms and conditions set forth in the Exchange Agreement entered into on September 28, 2017, by and among the Issuer, Energy One LLC, and APEG II LP, as set forth in Item 6."

USEG had 1:10 reverse split in January 2020. The actual number of shares held by the APEG is now 581,727, which was exchanged from its debt balance $5,063,380 in 2017. It gives you $8.7/share.

Charts

1-year chart

5-year chart

10-year chart

The stock has formed a long quiet base since 2016 - it is unfavored and depressed. The price volatility has increased noticeably in the past week; I interpret this as an indicator that the liquidity is drying up. Think shares as a standardized commodity that can be traded on the market freely in real time. For anyone who knows economics 101, the price of the shares is determined by the basic law of demand and supply. When the supply is low (low float + insiders' shares not for sale), a small change in demand can push up the price easily. All it needs is a shift in the sentiment or a positive catalyst. More often than not, price can move higher without any significant news, especially when there are no more sellers left on the market. As small investors chase after price changes, an upward price movement can even become a catalyst itself.

The volume spike in the past week reveals an increasing interest in this stock. Many hands are exchanged to move the price up and down in big ways. All it needs is to wait for all the small sellers to sell out their positions - that's when the supply is close to 0 and a small demand will push up the price.

Fundamentals

As I said in the beginning, this is not a profitable business with an exciting story to tell. The net income has been negative for the past few years while still maintaining somewhat inconsistent free cash flow.

The good thing is that the business is at low risk of going out of business while waiting for the turnaround to take place given that it carries zero debt. At the same time, the largest shareholder, Patrick E. Duke, has been placed as a director on the board with an intention to change the business. This quote is from 13D file his company, APEG, filed:

"APEG II LP (together with its affiliates, “APEG”) continues to believe that the Issuer has the potential to be a strong company, but that substantial changes are needed, given the prolonged underperformance of the Issuer. Despite the past litigation between APEG and the Issuer, which is described further below in this Item 4, APEG hopes to dialogue constructively with the Issuer’s management team and board of directors (the “Board”) regarding opportunities to unlock value at the Issuer, including changes to the Board‘s composition. APEG believes that while it had no intention of making its concerns about the Issuer public, the Issuer‘s management and the Board’s actions have left it with no other alternative. In light of what APEG believes to be clear and continues shareholder value destruction, APEG has determined that it must act for the benefit of all shareholders to protect its investment in the Issuer."

I'll not bet a big position on this one, but I've put down a reasonably small position to wait and see. I like this classic Dhandho situation described by Mohnish Pabrai: Heads I win; Tails I don’t lose much. 

A free hydrogen fuel cell business within HY

Hyster-Yale Materials Handling (HY) is not a typical micro cap per se but is under-followed and unfavored by the market; yet it is one of my biggest positions so far. I noticed HY in 2018 when the insiders had some intense buying on the open market. The company has been going through a series of transformations since 2017, and the insiders have been increasing their positions in the past few years. This has aroused my interest to further investigate the reasons behind their move. I've been building up my position gradually with the insiders since last year. 

A few quick highlights about HY:

• Market cap $635M with 16.7M shares
• Insiders have increased their position from 18% to 24% in class A shares between 2017 and 2020
• • Insiders paid around $50 on the open market
• $0 market valuation for Nuvera, the undiscovered hydrogen fuel cell division within HY (yes, it's given away for free)
• • 40% of net income from the other core business is offset by the loss from Nuvera
  • P/E is only 10.4 for the core business in lift truck if excluding Nuvera
  • Nuvera is anticipated to breakeven in near to medium term with the tailwind from China's clean energy market
    

HY is known as a full-line lift truck manufacturer that operates its business across the globe. The company has 3 main business divisions, namely, lift truck, Bolzoni and Nuvera, all of which are expected to see some growth in the medium term.

Nuvera - fuel cell business for free

Nuvera is a manufactuer of hydrogen fuel cell systems acquired by HY in late 2014. I was very excited to discover this "hidden asset" within the company, because Nuvera is often ignored by the investment community as the core business in lift truck has taken almost all the attention. However, after years of investments in R&D in hydrogen fuel cells, Nuvera is close to approaching its inflection point to turn breakeven and contribute substantially to the overall business.

No other fuel cell players are profitable; the overall fuel cell industry is experiencing years and years of losses. Unlike all the other fuel cell companies that finance their operations through external fundings via share issuance, Nuvera, however, is fully subsidized from the other profitable core business within HY. This kind of setup provides a sustainable source of funds into the emerging field that is yet to be profitable and prevents a dilution of existing shareholders's interest. The table from their annual presentation shows that over 40% of the net income from the core business is offset by Nuvera's loss.

Not every investment will turn out successful, but I don't believe HY invests so much money year after year on this unprofitable business if this is not going to yield any returns on its investment. Nuvera is among one of the first movers to launch fuel cell productions in China where huge government investment is focused on developing clean energy. Although the break-even target has been delayed due to additional testing and certification required by the local governments in China (breakeven was originally planned in 2H 2019). The production line has been completed in 2019 with shipments expected to ramp up throughout the second half of 2020; the results are expected to improve significantly in the next 3 years.

Because of the investments in the emerging fuel cell market, the company's overall net income is reduced deceivingly on the book. If Nuvera is taken out from the company, HY has $3.64 EPS and is evaluated at a P/E ratio around 10 given the current price of $37.8 (market cap $635M). Not a bad price to pay for a stable mature business with steadily growing revenue AND you get another fuel cell business for free!

To put things into perspective, if you look at the market valuation at other fuel cell players, BLDP, PLUG and FCEL have market cap at $3.85B, $2.76B, and $549M, respectively (none of them are profitable). Nuvera may not be as prominent as the other names, but this promising business with a clear breakeven prospect is still a steal at the valuation of $0. The fact that HY is under-followed by analysts may be the main reason behind the undervaluation. This is a good news for investors like me to obtain a share at a low price, when the market seems to have completely ignored the strategic position the company has built over the years quietly.

Core business that is also improving

The good news doesn't stop at Nuvera - the other two business lines are also expected to improve over time.

The main lift truck business is the foundation of the company. The management team is competent and has a track record of growing its revenue from $1.8B in 2010 to $3.2B in 2019. The current operating profit margin is only 2.8% and their objective is to achieve 7% target over the medium term with stronger industry and market share growth.

Bolzoni is a smaller business line that manufactures attachments and accessories for forklifts. Bolzoni has recently completed a restructuring to relocate its manufacturing from Homewood, IL to Sulligent, AL. The restructuring is expected to improve the operation in the following years and its operating profit is expected to increase this year with the absence of the $2.5M restructuring charges.

What are the risks

COVID-19 pandemic has negatively impacted the demand side of the lift truck business. Lots of uncertainty exists in the company's core lift truck business as bookings have been down due to the lockdown. The company has taken actions to reduce the operating cost such as reducing the base salaries for all the salaried employees. The near-term results from the core business will not look pretty and the recovery time could be slow depending on the market condition. 

The management has been conservative and the debt level has been low with high interest coverage ratio. The risk of going out of business is not my concern.

On the other hand, the outlook of fuel cell business still looks positive as China is stimulating to recover its economy with a focus on the new infrastructure and clean energy adoption. This tailwind has been confirmed by the recent new high of BLDP.  Here is recent news about a new order received by BLDP in China: https://ca.finance.yahoo.com/news/fuel-cell-stock-rallies-17-161313923.html 

Last but not least - chart

HY seems to have hit the support level and is being traded around the historically low market cap. The MA lines are still trending down, which reflects a general pessimistic sentiment on the stock. 

If you are looking for a quick rebound in the near term, this is not the right place to enter. However, if you are willing to build a position and wait a couple of years for the market to discover this company, now is a good time to acquire some shares at current prices.

The smart money is very patient and can wait years for a full fruition to come. If the insiders paid $50/shares, I'm happy to pay less than $40 now especially when the inflection point is around the corner.