Description

At $10, AYE consists of three monopoly businesses and a low cost generating business, all of which may be purchased for 8x forward EBITDA. The company’s earnings potential is currently obscured; new management is not motivated to explain the company’s earnings potential because of a compensation plan which rewards management for a low share price through October 2, 2003.

Why 8x EBITDA Represents Excellent Value

1. The equity market capitalization figures and net enterprise values used in this report are conservative. For instance, the current market capitalization of $1.8 billion assumes that AYE will issue 33 million shares to raise $300 million in the next 12 months; this represents a 26% dilution. The figures used in this report also assume 20% dilution from the conversion of 25 million shares of convertible trust preferred securities which were issued this summer. Finally, the $300 million raised from the convertible trust preferred securities is included in the debt calculation i.e., we double count the convertible trust preferred shares.

2. The 8x EBITDA calculation is predicated on AYE generating $900 million of EBITDA, which is at the lower end of our forecast range of $850 to $1.3 billion EBITDA.

3. AYE’s interest and preferred dividend costs are approximately $410 million, leaving ample room for earnings, taxes, capital expenditures ($304 million for ’04)and the eventual resumption of dividend payments.

4. AYE’s coal and hydro generating plants (75% of AYE’s generating capacity) are the low cost producers in the regions they serve, with an average production cost of $17 per MWH. AYE’s markets are deregulating and are soon to be capacity constrained. As their markets deregulate, electricity prices will be set by the highest cost producer required to meet demand; in this environment, AYE’s earnings from generation (currently $340 - $470 million annual EBITDA) will increase substantially, possibly more than 50%.

5. AYE will get through the current liquidity crisis. The company’s creditors will continue to be flexible because AYE is worth more alive than in bankruptcy. From a regulatory standpoint, AYE, like other electric utilities, is viewed as a public good. We expect the regulatory authorities to continue their forbearance.

Risks
There are at least three risks one should consider before investing in AYE: 1) Liquidity 2) Covenant Violation and 3) Low Equity-to-Capitalization Ratio. Below is a summary of these risks; we argue that the risks are mitigated by the company’s ability to generate annual EBITDA in the range of $850 to $900 million. As of this writing, AYE has net debt of $6.2 billion comprised of $2.4 billion bank debt, $4.4 billion of bonds plus preferred stock and cash of $600 million. (Debt is equal to 7x EBITDA).

1. Liquidity AYE has $640 million of loan maturities in ’04. Due to the nature of the debt instruments, $200 million of this will be easy for the company to pay. This leaves $450 million of bank debt maturities. During the conference call on 9/26/03 (after the release of the company’s 2002 10-K) Paul Evanson, AYE chairman, president and CEO, said that the company will not be able to meet the $450 million obligation using cash from operations. This leaves the company three options:

a. Sell assets. The Mountaineer gas distribution business is the most likely asset to be sold; it is probably worth $150 - $250 million.
b. Refinance the bank debt under more flexible terms.
c. Sell equity in a secondary offering.

While future liquidity is a serious risk to the business, consider that the bank debt was put into place in February of this year as the company was sinking into the current crisis. The bankers have shown flexibility in their enforcement of the covenants presumably because of the company’s earnings potential. For example, the company’s bankers have allowed $72 million of the proceeds from the September ’03 sale of the California Department of Water Resources (CDWR) contract to be held in escrow rather than demanding the cash be used to pay down debt. The banks also allowed the company to use $242 million of the proceeds from the CDWR sale to unwind two unprofitable trading contracts in Nevada; this too was done rather than demand repayment of bank debt. Furthermore, AYE was able to raise $300 million of new money through a private placement of convertible preferred shares this summer, even though it hadn’t issued financial statements in a year.

2. Covenant Violation / Qualified Auditors Opinion AYE filed its 2002 10-K on 9/25/03 and to date has not filed its 10-Qs for the first half of 2003. This is a violation of the company’s loan covenants; as a result, all of the company’s bank debt ($2.4 billion) is, technically speaking, due within one year. As a result, the company’s auditor (PWC) issued a “Going Concern” opinion. While this is not good, note that the banks lent to the company under these conditions. Last week AYE management committed to filing the ’03 10-Qs prior to 12/31/03.

3. Low Equity-to-Capitalization Ratio Under federal regulations, utility holding companies are required to maintain an equity-to-capitalization ratio of 30% or more. AYE’s equity to capitalization is 27% and one of its subsidiaries, Allegheny Supply Co (AE Supply) is 20%. What does this mean? Until AYE boosts its equity to 30% of total capitalization, the company needs to get SEC approval for financing transactions as well as acquisitions and asset sales. This is inconvenient, but not catastrophic.





Background: How a Nice Company Like AYE Wound-up in a Place Like This
AYE is a public utility holding company consisting primarily of three regulated transmission and distribution (T&D) subsidiaries and an unregulated electrical generating subsidiary. The bulk of the company’s 1.75 million customers are in Maryland, West Virginia, Pennsylvania and Ohio. AYE’s management led the company on an ill advised spending spree culminating in the purchase of Merrill Lynch’s Energy Trading business purchased for $611 million (3/16/01) and the acquisition of the Midwest Assets: 1.7 GW of gas turbine peeking plants purchased from Enron for $1.16 billion (5/3/01). From this experiment, AYE management learned that:

1. Energy trading is a confidence sensitive business requiring pristine credit, a lot of capital and specialized financial controls.

2. Gas turbine peeking plants in the Midwest are worth considerably less than $678 per KW.

Management lost their jobs and shareholders lost their shirts: AYE’s share price is down 80% from its peak of $51 on May 23, 2001. Over the last 18 months the company has been in such disarray that it never filed a 10-Q for the period ending 9/30/02 and just got around to filing its 2002 10-K on 9/25/03.

At first blush, the company looks terminally ill: it lost $633 million in 2002 on sales of $3 billion and it will lose more money in 2003 due to a short position in gas during the first half of the year. There are bound to be more write-offs. Its auditors gave a Going Concern opinion to the recently issued 2002 10-K and its new Chairman said last week that the company would not generate sufficient funds from operations to pay-down $450 million of bank debt which matures in 2004. Why would anyone want to own this company?

The new management team, led by Paul Evanson, has embarked on a simple strategy of focusing on the company’s core assets (which we will argue are quite valuable). Evanson joined AYE on June 16, 2003 as Chairman of the Board, President and CEO. Prior to joining AYE, Evanson was president of Florida Power & Light, FPL Group’s principal subsidiary. The most difficult part of this strategy has already been executed. In the last 60 days AYE has shed most of its trading book through the following actions:

• AYE sold its California Department of Water Resources contract to a subsidiary of Goldman Sachs for $405 million.

• AYE bought-out its Nevada contracts, the Williams tolling contract ($128 million) and the Black Hills contract ($114 million), which were costing the company money.

AYE exited the proprietary trading business and unwound most of its exposure.
As of this writing, AYE’s forward obligations consist of net purchases of 400,000 MWH through 12/31/03 and net purchases of 1 million MWH per year from 2004 – 2012. To put this in perspective, AYE’s transmission and supply subsidiaries delivered 47 million MWH in 2002.

This begs the question, what are the remaining assets and how much earning power do they have? In the following section, Assets and Valuation, we will list the company’s core assets and offer two valuation methodologies, one based on comparing the value AYE’s assets to the current market value of similar assets held by others, and a second valuation based on AYE’s future earnings potential. In the section entitled Management Compensation, we will speculate why management may be reticent about touting the company’s earning power. In the section entitled Liquidity, we will outline the company’s current liquidity position and its liquidity position in 2004.


Assets and Valuation
We will use two methodologies to value AYE. First we will value AYE’s assets based on the current market values of comparable assets held by other companies. Then we value AYE’s future earnings potential using an analysis of the company’s historical earning power (sans the energy trading business). We will then examine how AYE’s key subsidiaries generate earnings. We begin with an analysis of AYE’s current market value.

AYE shares closed at $10 on 10/24/03. If we assume the company raises $300 million of equity at its current valuation (an option the company has discussed) and assume full conversion of the recently issued trust preferred securities, the company’s equity market capitalization comes to $1.8 billion and its net enterprise value is $7.4 billion. This calculation is somewhat conservative because it double counts the recently issued convertible trust preferred securities (once as equity, then again as debt) It also assumes dilution from a possible future equity offering.

Assets
AYE consists of a holding company (Allegheny Energy), three regulated transmission and distribution (T&D) subsidiaries (collectively referred to as Allegheny Power) and an unregulated generating subsidiary, AE Supply.




Valuation: AYE selling at 35% - 44% Discount to Peers
AYE’s three regulated T&D companies, Monongahela, Potomac and West Penn, collectively have 1.75 million customers. AYE also has 8.8 GW of coal and hydro generating assets and 2.21 GW of gas turbine generating plants (for more details on AYE’s generating assets, please see exhibit at the end of this document). Note that AYE’s coal and hydro plants enjoy an average production cost (including fuel) of $17 per MWh, which makes it the low cost provider in its region e.g., they sell most of this production for more than $30 per MWh, we will come back to this point below. Given this set of assets, what are they worth? We use the current enterprise values of CPN, MIRKQ.PK, RRI and TGN as to determine the current comparable enterprise value (per MW) of AYE’s generating assets and CNP, EA, ED and NST to determine the current comparable enterprise value (per customer) of AYE’s transmission and distribution business. The result, using the mean values, AYE is trading at a 35% discount to its peers; using the median values, AYE is trading at a 44% discount to its peers.

The inference we draw from this data is that AYE is trading at a 35% to 45% discount to its peers. At first blush this may sound reasonable because of AYE’s current liquidity crisis. It is our contention that the company will get through this cirisis because it is worth more alive than in bankruptcy. The company’s banks realize this. As previously mentioned, the banks put in place the current financing while the company was deteriorating and they have shown flexibility in their interpretation of the loan covenants. With this in mind, a 35% discount on an enterprise value baisis implies a 75% equity appreciation as the company returns to parity with its peers; a 45% discount imples 100% equity appreciation returns to parity.

In the next section, we will estimate the earnings potential of AYE then we will draw some conclusions about AYE’s implicit value.









Projected EBITDA method #1: EBITDA $850 to $950 million
Starting from 53,000 feet, note that AYE is comprised of a collection of assets most of which it has owned for decades. Also note that the core generating assets currently owned by AE Supply (the unregulated generating subsidiary) were owned by the three regulated subsidiaries until November 1999. In fact, AYE today is comprised of roughly the same assets as it had during the 1990s. AYE’s EBITDA during the years 1996 – 2000 averaged $850 to $900 million. How likely is AYE to contiunue to generate at least $850 – 900 million? Consider that AYE’s three T&D companies are monopoly businesses and its AE Supply subsidiary is the low cost producer in its region. Also, the North American Electircal Reliability Council estimates that demand for electricity in the regions AYE serves is likely to grow by 7% – 10% between now and 2006.

By this metric, one would conclude that AYE is likely to generate EBITDA of $850 - $900 million, suggesting that the company is trading at about 8x forward EBITDA (using our conservative market valuation which assumes further share dilution and double counts the recently issued convertible shares).

To reality-check the $850 - $900 million forward EBITDA projection, lets examine how the company’s primary subsidiaries generate earnings. As described above, AYE’s core subsidiaries are the three T&D companies (Monongahela, Potomac, West Penn) and its unregulated generating subsidiary, AE Supply. We will begin with AE Supply because it is the least understood yet offers the most upside potential.

Projected EBITDA method #2: EBITDA $930 to $1.3 billion
Formed in November 1999, AE Supply was originally going to be AYE’s merchant energy subsidiary comprised of generating assets and an energy trading business. To this end, AYE transferred most of the generating assets from what are now the T&D subsidiaries (Monongahela, Potomac and West Penn) to AE Supply at book value. AYE also executed the ill advised purchase of Merrill Lynch’s energy trading business and the Midwest Assets and embarked on building several merchant generating plants. A public offering of AE Supply was even in the works. While these plans have come to naught, AE Supply still holds a collection of valuable generating assets.

AE Supply includes 8.8 GW of generating capacity, 75% of which is coal fired steam turbines or hydro generating stations. What makes AE Supply’s generating assets special is that they are low cost producers selling into markets that are in need of generating capacity and which are in the process of deregulating i.e., where the price of electricity will be set by the highest cost producer needed to meet demand. Better yet, we don’t need to wait for deregulation to enjoy the earnings potential of AE Supply’s generating assets. Under agreements which roll-off between now and 2008, AE Supply is obligated to sell power to AYE’s three regulated T&D companies at prices which provide a substantial profit margin. The likely earnings from these agreements, known as Provider of Last Resort contracts (PoLR) over the next five years is $340 to $470 million per year.

And what happens as the PoLR contracts roll-off? AYE sells its power in the PJM, the Regional Transmission Organization for Pennsylvania, New Jersey and Maryland. Note that AE Supply’s average cost to produce power is $17 per MWH. Currently, AYE’s PoLR contracts are below market in the PJM e.g., if they were selling power at market clearing prices instead of under contract, they would make more money. Furthermore, the PJM market is generating capacity constrained and is likely to become more constrained over the next five years. For instance, the MAAC region currently has summer generating capacity margin of 18% which is forcaset to decline to 7% by 2006. A 15% capacity margin is required to maintain reliable power. What does this mean? The regions to which AYE sells electricity will need to build more generating capacity over the next 36 months; more than likely, the new capacity will be supplied by gas fired turbines, which have significantly higher operating costs than AE Supply’s core generating assets. To the extent that electricity generated by gas turbines is required to meet demand in these regions, AE Supply stands to be even more profitable than it is under its current PoLR contracts.

Allegheny Power (the T&D subsidiaries): $590 to $688 EBITDA
Next, let us consider the likely earnings generating capacity of AYE’s three regulated T&D companies. These subsidiarys generated EBITDA, after charges of $593 million (2002) to $879 million (1999). The earnings figures are deteriorating over time; the explanation for this is that the agreements between the T&D subsidiaries and AE Supply are shifting income away from the regulated subsidiaries to AE Supply. Note that 1999 was the high-water mark for T&D earnings; AE Supply was formed in November of that year. There have been no significant adverse rating decisions against the T&D subsidiaries in the recent past and the T&D subsidiaries are on good terms with their regulators.

This data suggests that AYE’s T&D subsidiaries generated EBITDA between $590 and $880 million annually over the last seven years; if we look exclusively at years after AE Supply was formed and fully functional (meaning most of the generating assets had been transferred from the T&D subsidiaries to AE Supply) the range narrows to $590 to $688. Taken together with AE Supply’s likely ability to generate $340 – $470 million from PoLR contract currently in place, it is certainly not a leap to forecast AYE’s consolidated forward EBITDA of $900 million. On the other hand, the above analysis eliminates several one time charges at the T&D facilities, most of which had to do with deregulation in the markets the T&D subsidiaries serve. We have also disregarded the huge trading losses generated by AE Supply under the assumption that management will not re-enter the proprietary trading business. Prudence would suggest that the future may hold more one-time charges, so we conclude that the $900 million consolidated EBITDA number is a reasonable forecast; one can hope to be pleasantly surprised.


Management‘s Reticence about Touting AYE
There are at least three reasons why AYE’s new management has been reserved in touting the company. First, the new team has only been on the job a few months. Secondly, it is reasonable for management to be cautious given the company’s current liquidity issues. A third reason, which is a bit less obvious, is that the new compensation scheme rewards management with more stock units if AYE had a lower stock price on 10/2/0 (the logic behind 10/2/ was that it was five days after the company issued its belated 2002 10-K). The plan is an enhancement to the rest of the management compensation plan, and is based on the difference between AYE stock price on 10/2/03 and 1/2/04. Now that 10/2 is behind us, management has a lot of incentive to tout the company between now and January 2, 2004. For instance, if the stock closes at $10.64 on 1/2/04, Paul Evanson will be awarded an additional $3.15 million worth of stock grants. If the stock closes at $11.64, her will get an additional $4.95 million of stock, if it closes at $12.64, he will get $6.87 million worth of stock and if it closes at $13.64, he will get $8.92 million worth of stock. Mr. Evanson and the rest of top management will be working hard to get the stock price up over the next 80 days. And there are several things in their power which will enhance the value of the company, most notably, simply filing the past due 10-Qs which will return the company to compliance with its loan covenants and remove the qualification on the auditor’s opinion.


Liquidity and Leverage
AYE’s is in the middle of a liquidity crisis. The genesis of the current situation was the increased debt the company assumed as a result of the purchase of Merrill Lynch’s Energy Trading business (3/16/01, $611million), collateral requirements to support the newly acquired proprietary trading business, losses associated with the newly acquired trading business, the acquisition of the Midwest Assets: 1.7 GW of gas turbines (5/2/01, $1.16 billion) and the construction and later curtailment of construction of several merchant generating plants.

At the same time, the credit rating agencies have been downgrading AYE’s debt, making the debt more expensive and more difficult to issue and obtain. To make matters worse, as the crisis unfolded during 2002, management failed to issue its financial reports in a timely fashion, e.g., they never filed the Q3 ’02 10-Q and only filed the 2002 10-K last week.

Since June 2003, the company has raised $436 million cash plus $102 million currently held in escrow accounts. As of 9/25/03, AYE had $600 million of cash on its balance sheet; this will be used to meet $337 million of debt maturities and other commitments coming due during the fourth quarter of this year. The following table summarizes AYE’s debt maturities for the remainder of the year.

It is little wonder that management expressed confidence during the last conference call (9/25/03) that the company would be able to honor its financial commitments for the duration of the year. During the call, Paul Evanson was less sanguine about 2004, stating that the company will not be able to meet $450 million of its bank debt maturities obligations using cash from operations; one factor for this (discussed above) is that his compensation package actually benefited from a lower stock price on 10/2/03.

Regarding 2004 debt maturities, note that the West Penn medium term notes are funded from the West Penn subsidiary, and the West Penn Transition Bonds are funded by a tariff on electricity sold – neither of these will be difficult for the company to meet. Evanson’s caveat concerned the bank debt facilities (highlighted in yellow) which come due during the second half of ’04. While we take him at his word, we would like to point out the following mitigating circumstances:

1. The bank facilities in question were agreed to on 2/25/03 while AYE was in violation of its covenants, had not filed its Q3 2002 10-Q and had little prospect of meeting the filing deadline to file 2002 10-K. Also at this time, AYE’s trading book was in disarray resulting from its inability to post counterparty collateral, thus the company was short gas at a time of escalating gas prices. The company was bleeding cash from its western book of business (the CDWR contract and the two Nevada contracts, all of which have been disposed). Finally, the management team responsible for the debacle was still in charge of the company.

2. As we have argued above, AYE is capable of generating $900 million of EBITDA (maybe more) once it gets back on an even keel. This is enough to service its debt and generate handsome banking fees for years to come.

3. The banks have continued to show leniency with AYE. For instance, AYE’s banks allowed the company to buy-out the two Nevada contracts (Williams and Black Hills) which together cost $242 million rather than demand repayment on their loans.

Given these facts, we speculate that AYE management will be able to refinance its current bank debt under more favorable terms. The first step in doing this is to get current on its financial reporting, a priority that Evanson and Jeffrey Serkes, AYE’s new CFO, said would be completed by 12/31/03. A second possibility is that the company will sell stock to raise capital; to this end, we have assumed an 18% share dilution in all valuation metrics used in this report; if the company does not proceed with an equity sale, or if there is a significant appreciation in the share price between now and a secondary offering, the shares will be that much more valuable.

Catalyst

1.Due to the structure of the management compensation plans, AYE management has a great deal of motivation to sell the restructuring plan after 10/2/03.
2.The company will be in compliance with its loan covenants when it files its 2003 10-Qs. Management has committed to doing this by year end.
3.Management will refinance AYE’s bank debt and / or raise equity in a secondary offering.
4.AYE’s earning power will become clear and the company will resume paying a dividend.