AES Corporation (AES) is a global power company that owns a portfolio of electricity generation and distribution businesses on five continents in 29 countries. Its generation business accounts for approximately 52% of its revenues, while its utilities business comprises the balance.
Though somewhat complicated in its structure and asset diversification, AES is a straight-forward way of investing in worldwide growth in power generation and infrastructure (approximately 85% of revenues are from outside the U.S.). Indeed, with locked-in cash flows in several of its businesses as well as exposure to global expansion, an investment in AES provides an opportunity to capitalize on worldwide economic development (that has always been the "mission" of AES) through a portfolio of international assets and future projects, while also having a margin of safety due to such locked-in or visible cash flow (approximately 70% of its gross margin is attributable to long-term contracts and utilities, which are generally less commodity sensitive). Moreover, despite the fact that the company has $19bn of debt (and hence screens as a very leveraged company), approximately $13.7bn of that debt is non-recourse, on a project by project basis (for example, Lal Pir in Pakistan has $54m of debt, but there is no recourse to the parent co). Given its current valuation (approximately 11.5x 2010 EPS), AES has approximately 30-40% upside from these levels over the next 12-18 months, with a relatively limited downside. (note that the multiples in the above section are somewhat misleading given the structure of the company)
The company's proportional gross margin is broken down as follows:
Latin America Generation: 32%
North America Generation: 26%
Latin America Utilities: 11%
North America Utilities: 11%
Europe Generation: 11%
Asia Generation: 3%
Although the company organizes and discloses its various businesses in several ways, for purposes of this writeup, we have described the business lines by generation, utilities, and wind/other below.
AES' generation business contributes approximately 50% of its revenues and 65% of its gross margin ($1.5bn). The portfolio is comprised of approximately 38,000 MW, consisting of 93 Generation facilities in 26 counties. Performance drivers include plant reliability, fuel costs and fixed-cost management. The key to the company's generation business is its long-term contracts, or PPAs, to wholesale customers. Approximately 60% of revenues from the generation business is from plants that operate under PPAs of five years or longer for more than 75% of the company's capacity. This gives a certain degree of visibility to both the segment and parent company's earnings.
On the portion of revenues that is not subject to long-term PPAs, cash flows are by definition more volatile. At the same time, the company will hedge the majority of its exposure. The company owns generation plants using a wide range of technologies and fuel types including coal, nat gas, hydro and biomass
AES' utilities business consists primarily of 14 companies owned or operated under management agreements, each of which operate in defined service areas. The three largest utility businesses, IPALCO (U.S.), Sul (Brazil) and Eletropaulo (Brazil), contribute over 90% of the gross margin of the segment.
Another potential upside driver is the company's efforts in alternative energy. For example, additions per year (and projected) for AES Wind have been as follows (MW)
Similarly, AES Solar, which was established in 2008 has 32 MW of operations in Spain in a joint venture with Riverstone. As there is more of a movement to alternative energy, AES should continue to benefit.
The company is currently in the midst of a 3,500 MW construction program, the majority of which will be located in Chile (37% of the MW) and Bulgaria (25% of the MW). Most importantly, 96% of the construction program is contracted under long-term ocntracts.
Valuation/Earnings Growth Profile
Current guidance (adjusted EPS) is $1.05-$1.10 in 2009, $1.05-$1.15 in 2010, and $1.20-$1.30 in 2011. Proportional cash flow (i.e., to the holding/parent company) should be approximately $750-$850m, $900m-$1.1bn and $1.1-$1.3bn from 2009-2011, compounding 22% per year. The profit growth sources are relatively visible, as the 3,500 MW construction program should contribute $0.25 EPS and $300-$400m of cash flow by 2011. In fact, such earnings should be more visible and stable in the future, as the percentage of proportional gross margin from long-term contract businesses increases as projects under construction come on-line
Ascribing a historical multiple of approximately 16x forward earnings to 2011's midpoint EPS would get to approximately $19/share. There is also upside from the $1.25 of 2011 projected earnings as well, as the renewables energy and non-contracted portion of the business could provide earnings accretion, and AES may have other potential international opportunities not reflected in its guidance. (For example, there was recently a report that CIC was in talks about purchasing a stake in AES and starting a joint venture whereby CIC would provide money for AES' plans to develop power plants around the world)
Given its diversity in business lines and geography, a sum-of-the-parts approach may be warranted, in which case target valuation approximates $20 (ascribing higher multiples to IPALO, lower to spot generation, etc). That being said, the attractiveness of the valuation is also based on the downside protection from the locked-in cash flows described above.
The management team of AES is deep, experienced, and has (most importantly) been through the ups and downs of two credit cycle meltdowns. Led by Paul Hanrahan, the team is very well-regarded within the industry for its expertise in financing, long-term contracting and international development.
The chief risks to the investment are (1) sovereign risk given the company's international exposure (to Latin America in particular), (2) funding for the growth projects, and (3) commodity exposure (though this can be somewhat hedged). Financial leverage is always an issue, but at the same time, given the structure of the company, this risk is mitigated by the non-recourse nature of the project-level debt.