Description

Aquila’s stock price (ILA) has come down from $25 to just under $2 during the utility meltdown in 2002 and have not fundamentally recovered. Aquila was left for dead until 4 months ago when it garnered enough liquidity to complete the final stage of its massive restructuring. ILA offered 40 million shares of common stock and 12 million premium income equity securities (PIES) which are mandatory convertible senior notes to be converted in three years. Many partnerships are buying the converts and shorting the common as a solid way to capture the convert’s 6.75% coupon.

However, I believe the greater opportunity by owing the common. ILA’s shares should trade north of $4 in the next six months or so and over $6 thereafter. Given its active shareholders base and new found financial flexibility, all strategic alternatives are at management’s disposal. I arrive at a downside range of $2.60 to $2.90 based on private deal valuations and worse case cash flow assumptions. This assessment implies a -13% downside with a +97% return – making the risk/reward profile for the common all the more attractive compared to the coupon.

Company & Situation:
Given the reorganization of assets that is taking place, Aquila is not an EPS story. The shares currently trade at a discount multiple to its peers at less than 8x EV/EBITDA with depressed cash flows and a below investment grade credit rating of B-. Confidence in the enterprise however, has been strengthening as ILA’s bonds trade above par (around 105/106) since its equity/debt offering.

Aquila’s core business operation comprises of 10 electric and gas utilities in seven states. The customer base is rural with the largest town being Pueblo, CO; there is a high concentration of commercial and industrial customers – who where some of the hardest hit during the past recession. Management’s neglect of its core operations while focusing on “growth” in unregulated business over the years contributes immensely to Aquila’s current dismal operational performance. The gas business has solid ROE’s at 10.5% but the electric business is performing poorly. As the most important state, (contributing to over 50% of the rate base) Missouri is severely under-earning at 2% to 3% returns despite the fact that it has an “allowed” ROE of 9.5%. Kansas, contributing 14% of the rate base, has 0% return.

Another underpinning problem with Aquila is its corporate structure which is not conducive for companies operating a number of businesses with various credit qualities. Aquila does not have a holding company structure (like most other utilities) whereby subsidiaries can obtain cost of capital based on their own individual risk profiles and circumstances. Raising expansion capital for ILA at the corporate level with blended ROE’s and risk profiles was much easier during the bull market. After the recent melt down in 2002, compounded by the fact that Aquila operated merchant service businesses, foreign utilities in Australia, New Zealand, Canada and the UK while maintaining an unusual core domestic utility operation in several different states and jurisdictions only complicated an inevitable restructuring to come.

Management has cut debt from over $4bn to $2bn and completed the recent equity deal that essentially extends ILA’s debt maturities to the point where it does not become an issue – thereby allowing time for Aquila to prudently sell more assets and properly restructure. This is a longer-term story as evidence by the two I-banks who recently downgraded the stock due on valuation when ILA reached $3.75 on concern that the shares were appreciating too fast. There are several new initiatives that I believe will spur stock price appreciation in the weeks and months to come.

Catalysts:
1.Shareholders making sure all strategic alternatives are viable options: Quiet, but active shareholders have emerged as large equity owners of Aquila and are keeping a watchful eye on management’s decision to generate value, e.g., management continues to be pushed to consider: a) selling the highly profitable gas business and reinvest proceeds in the electricity business or to reduce debt further; b) employing a reverse strategy whereby Aquila sell all poor performing electric assets and focus on gas; or c) merge with a higher credit partner and generate ample savings by refinancing debt to more favorable terms.


2.Improving Missouri operations and increase returns: Aquila has identified cost savings in operations that could contribute 10% to utilities EBIT. ILA has taken steps to ensure improvement in Missouri that the outcomes are yet to be reflected in the stock price but could prove to be potent catalysts despite the fact that the financial benefit are not instantaneous. A) One month or so from now ILA is going to the legislative session to request fuel cost pass through. Missouri is one of three remaining states in the US not to have fuel costs adjustments. (The Missouri commission is also hearing directly from investors); B) 5 months from now, ILA will be filing a case to re-adjust costs. The objective is to update the increased costs the company currently operates under such as higher insurance costs, call center costs, workmen apprentice costs, etc. The company has also filed a $25M case in nearby Kansas for rate relief; C) 6 months from now, a new peaker plant with better returns will come online to help overall Missouri ROE;

3.Steadily upgrade credit rating by reducing net debt further from $2bn to $1.4bn: This is how we get there: a) the PIES converting will drop the debt burden from $2bn to $1.7bn; b) no longer a forced seller, prudently selling non-core assets will conservatively generate $120M; c) increase cash balances – refinancing debt at each incremental upgrade can save 300bpts in borrowing cots while contributing $0.15 in earnings; d) increase cash flows – getting closer to investment grade will allow the company to have a larger revolving credit to help weather significant gas price fluctuations. Initiatives to improve Missouri operations will contribute significantly.

4.Lower gas prices will help cash flows: Abnormally high gas price are causing exaggerated working capital swings. Given Aquila’s limited source of capital, lower gas price would prove an all the more important factor to cash flows. For example, for every $0.95 reduction in gas prices above $5.14/Mwhr, generates and $11 million savings for Aquila in Missouri alone.


Valuation, Downside & Risk Assessments:

In the short to intermediate term, Aquila is worth between $4 and $6 per share through a combination of asset sales, rate relief and overall directional improvements in return on equity. In my fair case assessment, I assume Aquila get less than half of the $140 million in EDBITA required to get to management’s ROE goal of 11%. In the shorter term, I get to a $4 valuation assuming that ILA trades with its peers. The catalysts mentioned above should contribute to this realization. Further to the upside, as a simplified, well run domestic utility company Aquila should attract more traditional investors thereby further increasing the value of the business.

On the downside, assuming no asset sales, no relief, no new debt/equity offerings and gas remain prices flat ILA still would have of $623 million to burn for the next few years. Further analysis reveals that the $2.75 range also assumes that there is zero value to the “other assets” held for sale and a $295M EBITDA in 2005 – a meaningful shortfall from management’s guidance of $325M to $345M.

The risks to my assessment are threefold: a) if Missouri gets worse and ROE’s turn negative. While ROE in this state are close to zero, I consider the commission would not allow such negative returns given that the government is trying to encourage increase in capital spending to strengthen our utilities in light of the recent blackout; b) if the restructuring takes over 3.5 years, thereby forcing Aquila to burn through their liquidity or be forced to raise more debt/equity at unfavorable terms; c) finally, gas prices doubling from here would have a meaningful impact to cash flows. This risk however, is limited because Aquila is partially hedged in 2005.

Catalyst

See write-up for details:
1.All strategic alternatives are viable options
2.Improving Missouri operations and increase returns
3.Steadily upgrade credit rating
4.Lower gas prices will help cash flows