Description
Thesis
Aquila, Inc. (ILA) is a regulated electric and gas utility serving customers in the Midwest. ILA’s shares trade at a substantial discount and have for some time. The company’s pending merger with Great Plains Energy Inc. (GXP), however, is likely to unleash ILA’s value. Interestingly, the combined company’s rate base is expected to grow by 60% over the next three years but, by our calculation, they will need to dilute their current equity base by about 10% to support this growth.
Introduction
There are three aspects of ILA which need to be considered in order to understand the value currently being overlooked by the market:
- Balance sheet: $1 billion PP&E, $800 million value of NOLs and immediate interest savings.
- Additional cost savings: $53 million per year.
- Rate base growth: up 62% by 2011, new equity issuance ~ 10%.
First we outline the basic parameters of ILA’s pending asset sale to Black Hills Corp. (BKH) and subsequent merger with GXP. We will offer some comments on GXP then discuss the three elements of value (balance sheet, cost savings, rate base growth).
The following table summarizes ILA’s balance sheet as of 4/1/07 and adds-back our estimate of the value of their Net Operating Losses and savings from lower interest rates as their debt re-sets when they become investment grade and, eventually, as their debt is refinanced at more normal utility company rates.
|
|
(000) |
|
Current assets (sans cash) minus current liabilities (sans debt) |
87,600 |
|
Non-current tangible assets (sans utility PP&E) minus non-current liabilities (sans debt) |
131,300 |
|
Cash, 4/1/07 |
563,400 |
|
Debt, 4/1/07 |
(1,423,000) |
|
Replacement cost of Missouri generating assets |
1,076,928 |
|
Tax assets |
399,000 |
|
Cash to be received from assets being sold to BKH |
940,000 |
|
Immediate value of interest rate savings when ILA becomes investment grade |
391,040 |
|
Additional value of interest rate savings when ILA debt is refinanced @ GXP's rates |
336,960 |
|
Theoretical tangible book value / replacement cost |
2,503,228 |
|
|
|
|
Actual tangible book value, 4/1/07 |
1,201,200 |
|
Actual market capitalization, 7/6/07 |
1,534,232 |
|
Implied appreciation: tangible BV to achieve parity w/ theoretical BV |
108% |
|
Implied appreciation: market cap. to achieve parity w/ theoretical BV |
63% |
Pending asset sale and merger
On February 7, 2007 ILA, GXP and BKH announced an asset sale and subsequent merger as follows:
- ILA will sell its gas distribution businesses and its Colorado electric utility to BKH for $940 million cash.
- ILA will merge its Missouri electric utility business with GXP (GXP is a regulated electric utility serving Missouri and Kansas). For each ILA share, ILA shareholders will receive $1.80 cash plus 0.085 GXP shares.
The asset sale and merger are expected to close during 2008. The following table illustrates the economics of the transaction to ILA shareholders:
Analysis of ILA / GXP merger per ILA share
|
GXP share price, 7/6/07 |
29.18 |
|
Gross ILA share price, 7/6/07 |
4.00 |
|
Cash received per ILA share @ merger |
1.80 |
|
Net ILA share price, pre-tax |
2.20 |
|
|
|
|
GXP shares received / ILA share @ merger |
0.0856 |
|
Implied ILA share price (net of $1.80), before paying capital gains tax |
2.50 |
|
Taxable capital gain (ILA implied share price less ILA share price net of $1.80) |
0.30 |
|
Capital gain tax (assumes 15% rate) |
0.04 |
|
Net ILA share price, after tax |
2.24 |
|
|
|
|
Implied GXP share price (assumes 15% cap gains tax paid upon receipt of $1.80) |
26.22 |
|
Implied GXP market cap. using ILA shares (after paying tax on $1.80) |
3,122,425 |
|
New equity issuance to fund capex through 2010 |
367,580 |
|
Market capitalization using ILA shares after equity issuance |
3,490,005 |
|
|
|
|
GXP discount when purchased using ILA shares, assumes payment of capital gains tax on $1.80 distribution |
11.3% |
The table shows ILA shares are trading at about a 11% discount ($2.24 vs. $2.50) to what the terms of the merger imply. Given that the merger will close sometime in 2008 and that GXP’s shares pay a $1.66 dividend yielding 5.7%, a 6% discount is to be expected since ILA shareholders will forgo about one year’s worth of GXP dividends.
The pending merger between ILA and GXP is highly likely because it benefits all stakeholders. From ILA shareholders’ perspective, it is the catalyst for releasing the value illustrated in the table on page one of this report and explained below. From GXP shareholders’ perspective, the merger is likely to be accretive within a year or so. From the customer and regulators’ perspective, the merger is likely to produce cost savings, some of which will be passed on to customers in the form of lower electricity rates.
If the merger does not close, ILA shareholders are not likely to suffer because the value of their company would remain in tact in need of another catalyst. In fact, ILA’s share price fell from $4.67 on February 6 (the day before the merger was announced) and have generally traded below the implied merger price of $4.54 (based on the share prices of ILA and GXP).
Comments on GXP
After the merger, GXP’s management will run the combined company; given this and the fact the acquisition consideration includes GXP shares, an investment in ILA is a de facto investment in GXP. GXP operates in two segments:
- Strategic Energy, an intermediary between electric generators and consumers, operates in 10 states. Strategic Energy produced 57% of GXP’s ’06 revenue and lost $10 million.
- Kansas City Power & Light (KCP&L), a regulated electric utility operating in Missouri and Kansas. KCP&L produced 43% of GXP ’06 revenue and $150 million of net income (all of GXP’s earnings).
We are not favorably impressed with Strategic Energy and are skeptical of the value of intermediation in the electricity markets. Our skepticism is confirmed by Strategic Energy’s low margins and declining returns. Accordingly, we assign no value to this business and hope that it is either returned to profitability or shuttered.
GXP’s Strategic Energy: Pertinent Statistics
|
(000) |
2006 |
2005 |
2004 |
|
Revenue |
1,534,900 |
1,474,000 |
1,372,400 |
|
Net income |
(9,900) |
28,200 |
42,500 |
|
Assets |
459,600 |
441,800 |
407,700 |
|
Capex |
3,900 |
6,600 |
2,600 |
|
SE President's compensation |
1,741 |
1,212 |
745 |
On the other hand, KCP&L is a valuable business and its managers have done a good job running the company. Its debt is investment grade and is expected to remain so after the merger. GXP shares pay an annual dividend of $1.66 and are expected to continue to pay this dividend post merger. KCP&L generates 97% of the electricity it sells and enjoys a low cost fuel position (weighted mean fuel costs of $12.38 per MWH). KCP&L recently was granted a rate increase with a 11.25% target return on equity, a full percentage point more than ILA’s target return (though without fuel escalation provisions, which KCP&L is unlikely to need given their fuel mix – see below).
GXP fuel mix and cost
|
|
Fuel Mix |
|
Fuel cost |
|
Fuel |
'07 est. |
|
$/MWH, '07 est |
|
Coal |
74% |
74% |
$12.80 |
|
Nuclear |
22% |
96% |
$4.50 |
|
Natural gas & oil |
2% |
98% |
$95.80 |
|
Wind |
2% |
100% |
$0.00 |
|
|
weighted mean fuel cost |
$12.38 |
Earlier in the decade, KCP&L went through a comprehensive planning process which included working with all concerned constituents, e.g., customers, regulators, and environmental groups, to develop a mid-term plan to meet electricity demand in a responsible fashion. The result of this process is its Comprehensive Energy Plan. The evidence to date is the plan is a success: KCP&L recently was granted a rate increase with a target return on equity of 11.25% and law suits brought by the Sierra Club and other environmental groups have been dropped.
ILA and GXP’s electric utility businesses are geographically adjacent. The close proximity of ILA and GXP is important for realizing some of the cost savings discussed below. Note that all of ILA’s territory falls within Missouri, as does most of GXP’s. As regulated utilities, both GXP and ILA are dependent on their relationship with the Missouri Public Service Commission (MPSC). GXP’s excellent relationship with the MPSC is likely to benefit ILA shareholders (see section below entitled cost savings).
The following table summarizes the valuation of the combined company (ILA + GXP).
ILA + GXP Valuation pro forma
|
(000 except share price) |
|
|
GXP diluted shares outstanding, post merger with ILA |
119,073 |
|
GXP share price |
29.18 |
|
Market capitalization, 7/6/07 |
3,474,548 |
|
Equity issuance to fund capex 2008 - 2010 |
367,580 |
|
Market capitalization, after equity issuance for capex 2008 - 2010 |
3,842,128 |
|
Cash, pro forma 12/31/06 |
890,121 |
|
Preferred shares, pro forma 12/31/06 |
39,000 |
|
Debt, pro forma 12/31/06 |
2,702,841 |
|
Enterprise value, net 7/6/07 |
5,326,268 |
|
Enterprise value, after equity issuance for capex 2008 - 2010 |
5,693,848 |
|
|
|
|
Dividend, annual per share |
1.66 |
|
Dividend yield |
5.7% |
The combined company is trading at 8.3x 2008 EBITDA and 5.5x 2011 EBITDA, based on what we think are conservative assumptions.
Balance Sheet: $1 billion PP&E, $800 million in NOLs & interest savings
ILA will have cash (net of debt) when the asset sale to BKH closes; ILA also has generating assets in Missouri worth at least $1 billion and has net operating losses and tax credits worth about $400 million. In the absence of substantial liabilities, the company’s balance sheet is strong, yet consider the following facts:
- ILA’s long-term debt is not investment grade, nor is it even close to being investment grade (currently rated B2 by Moody’s and B by S&P).
- ILA closed the sale of its Kansas electric utility assets on 4/1/07 for $292 million cash, leaving ILA with net debt of $860 million.
- The planned sale of ILA’s gas distribution business to BKH is for $940 million cash. BKH is credit worthy and has obtained financing commitments for this acquisition.
- ILA has borrowing capacity of $260 million, none drawn as of 3/31/07.
- ILA’s debt currently trades as if it were investment grade.
This set of observations is remarkable in that ILA will have cash net of debt (when it closes the sale to BKH as currently agreed) with substantial un-drawn borrowing capacity yet it’s debt is five notches below investment grade. This is important because ILA’s debt is outrageously expensive, but becomes substantially less expensive when ILA is upgraded to investment grade, (which happens when merged with GXP). The following table summarizes ILA’s long-term debt:
ILA’s Long-term Debt
|
|
|
|
Outstanding |
|
|
|
I rate |
term |
3/31/07 |
% total debt |
|
First mortgage bonds |
9.44% |
amort. through 2021 |
16,900 |
1% |
|
Senior notes |
7.63% |
11/15/09 |
68,500 |
5% |
|
Senior notes |
9.95% |
2/1/11 |
137,300 |
10% |
|
Senior notes |
7.75% |
6/15/11 |
197,000 |
14% |
|
Senior notes |
14.88% |
7/1/12 |
500,000 |
36% |
|
Senior notes |
8.27% |
11/15/21 |
80,900 |
6% |
|
Senior notes |
9.00% |
11/15/21 |
5 |
0% |
|
Senior notes |
8.00% |
3/1/23 |
51,500 |
4% |
|
Senior notes |
7.88% |
3/1/32 |
287,500 |
21% |
|
Medium term notes |
7.19% |
2013 - 2023 |
17,000 |
1% |
|
Mandatorily convertible notes |
6.75% |
9/15/07 |
2,600 |
0% |
|
Convertible subordinated debentures |
6.63% |
7/1/11 |
2,000 |
0% |
|
Other |
5.16% |
2007 - 2028 |
24,800 |
2% |
|
weighted mean interest rate |
10.56% |
total |
1,386,005 |
|
Note that 36% of ILA’s debt ($500 million which represents 20% of the company’s net enterprise value) bears interest at 14.88%. The company’s mean borrowing costs are 10.46%, which is higher than its allowed return on equity (10.25%). For perspective, consider that GXP’s borrowing costs average 5.45%.
Missouri’s Public Service Commission has wisely not burdened Missouri’s consumers with higher electricity costs to compensate for the onerous terms of ILA’s debts. After all, this debt is the legacy of ILA’s international expansion and diworsification into merchant energy and telecom which brought ILA to the brink of collapse earlier in the decade.
Fortunately, several tranches of ILA’s debt reset (11.88% in the case of the $500 million senior notes) when ILA becomes investment grade post GXP merger. This saves $37.6 million per year in interest immediately. To estimate the terminal value of this savings, we assume a 35% tax rate on cash flow and apply a PE of 16 (typical of regulated utilities) to arrive at $390 million. Eventually, all of ILA’s debt with be refinanced at “regulated utility” market prices, e.g., GXP’s debt cost 5.45% (see GXP’s debt summary in appendix), reducing interest costs from $146 million to $76 million. Using the above methodology, this savings is worth $728 million (70 x 0.65 x 16= $728). Regardless of how one counts it, annual savings of $70 million is substantial to a business with a market capitalization of $1.6 billion.
ILA’s balance sheet also includes Missouri-based electrical generating assets which, by our estimate, have a replacement value of at least $1 billion (see table in appendix for details).
Finally, a valuable collection of assets which are not featured on ILA’s balance sheet are yet another legacy of the company’s storied past: tax credits and operating losses, which are estimated to be worth $399 million.
ILA Tax Sheltering Assets
|
|
Projected Benefit to GXP |
|
ILA's Alternative Minimum Tax Credits |
78,000 |
|
Net value of ILA's U.S. NOLs |
360,000 |
|
Other deferred tax assets from ILA |
56,000 |
|
ILA Reserves |
(95,000) |
|
Total tax sheltering assets |
399,000 |
ILA’s net operating losses expire in 2023 – 2025, so there is ample time to make use of them. The merger with GXP is designed to preserve the value of these assets and GXP management estimates that they will be consumed within five years.
Additional cost savings: $53 million per year
The planned merger between ILA and GXP is expected to save the combined company $90 million per year. This is substantial when one considers ILA’s mean EBITDA for the last three years was $148 million. It is also conservative when one considers that GXP’s management is banking on only $37 million of interest rate savings, while, in the medium term (~ 5 years), GXP will be able to refinance most of ILA’s debt resulting in approximately $70 million annual savings.
Other sources of savings are anticipated from supply chain, operations and shared services. These anticipated savings seem reasonable given the geographic proximity of the two businesses and the fact both companies are regulated electric utilities. Finally, GXP management will be running the show after the merger and, unlike ILA’s management, they have historically proven to be solid stewards.
Rate base growth: up 62% by 2011, new equity issuance ~ 10%
ILA and GXP rely on public utility commissions, e.g., the Missouri Public Service Commission (MPSC), to allow them to set electricity prices high enough to earn an acceptable return on capital. The capital that the utility commission considers for this calculation is called rate base and consists of the depreciated property, plant and equipment of the businesses plus allowances for working capital requirements. As a result, there are two ways in which regulated utilities can increase earnings:
- Increase the allowed return on rate base
- Grow the rate base
In the case of ILA and GXP, the MPSC is likely to keep the allowed returns on the equity portion of rate base between 10.5% and 11.5%; we use 11% in our projections. On the other hand, Missouri is currently short on electric generating capacity. According to data published by GXP, Missouri is current short 200 MW of power; this gap is expected to grow 500 MW by 2010 unless additional capacity is built. GXP figures they will need to increase their generating capacity from 4155 to 4700 MWs to stay ahead of demand (utilities generally need at least 12% more generating capacity than peak summer demand to provide reliable service). ILA is in worse shape: during the last several years the company purchased nearly half of the electricity it sold, much of it generated using natural gas as a fuel. As a result, ILA and GXP are implementing capital expansions which are likely to increase their rate bases by 62% by 2011.
ILA + GXP Rate Base Growth
|
|
ILA |
GXP |
Combined |
Cap. Structure |
Target equity |
Implied |
Implied |
|
Year |
Rate base |
Rate base |
Rate base |
Equity / total cap. |
Return |
Earnings |
Appreciation |
|
2007 |
1,068,000 |
2,400,000 |
3,468,000 |
53.0% |
11.00% |
202,184 |
|
|
2008 |
1,224,000 |
2,700,000 |
3,924,000 |
53.0% |
11.00% |
228,769 |
|
|
2009 |
1,339,000 |
2,700,000 |
4,039,000 |
53.0% |
11.00% |
235,474 |
-3% |
|
2010 |
1,841,000 |
3,700,000 |
5,541,000 |
53.0% |
11.00% |
323,040 |
33% |
|
2011 |
1,918,000 |
3,700,000 |
5,618,000 |
53.0% |
11.00% |
327,529 |
35% |
The table shows that the earnings of the combined ILA + GXP are likely to increase by 60% by 2011 driven by the increase in rate base. What is striking about this is that most of the costs of the capital spending projects will be financed with debt and cash flow, requiring little equity issuance (see capital spending exhibit in appendix). The following table summarizes the sources of financing for ILA and GXP’s capital spending plans:
Financing for ILA + GXP Capital Expenditures through 2010
|
Capital Source |
Amount (000) |
|
New debt financing (based on maintaining 53% equity, 47% debt capital structure) |
1,591,420 |
|
ILA tax assets |
399,000 |
|
Cash from ILA's sale to BKH, net of cash distribution to ILA shareholders |
263,000 |
|
Anticipated contribution from rate increases |
370,000 |
|
Internal funds & other |
100,000 |
|
Savings from merger (interest rate, supply chain, operations & shared services) |
295,000 |
|
Estimated new equity issuance (share sale) required |
367,580 |
|
total capital spending through 2010 |
3,386,000 |
Less than $400 million of new equity is likely to issued to fund these projects. The net result is that earnings are likely to increase by 60% supported by a 10% increase of shares outstanding: a very good scenario for shareholders.
Catalyst
Catalysts
1. Merger with GXP / debt upgrades.
2. Rate base growth / execution of ILA/GXP capital expansion plan.