Business Description

EnergySolutions is the only pure play provider of nuclear services to government and commercial entities.  The market is undervaluing its one-of-kind radioactive waste disposal site and the international opportunities for a company with ES's unique nuclear expertise.  In addition, a new accounting treatment for its Zion License Stewardship project is obscuring the true profitability of a lucrative new business model for the D&D of nuclear plants - there is a large and growing market for this service and ES is the only company capable of doing it.  Finally, concerns over government budgets in the US and the UK have depressed the stock price of this wide moat business to extremely attractive levels (ES was actually pitched at the recent Value Investing Congress in New York).

Per the 10K, their nuclear services include "engineering, in-plant support services, spent nuclear fuel management, decontamination and decommissioning ("D&D"), operation of nuclear reactors, logistics, transportation, processing and low-level radioactive waste ("LLRW") disposal."  LLRW represents 98% of the volume of radioactive waste with the remaining 2% being highly radioactive spent fuel.  These various activities are reported in two groups Government (Federal) and Global Commercial (Commercial, LP&D, and International):

*figures distorted by Zion ARO accounting*

"""Operating Income for Global Commercial group (Commercial, LP&D, and International) reported in aggregate

We believe there is a misunderstanding of fundamental characteristics and an under-appreciation of several developments in every one of ES business lines which we will discuss below.  Greater details on the specific activities within each segment can be found in the 10K.

ES services are performed under 3 main types of contracts:

• Cost-reimbursable (79% of 2010 Rev) is mostly government work in Federal Services and International

• Unit-Price (17% of 2010 Rev) is for the LP&D segment where ES is paid a contracted amount for every unit of work performed

• Fixed-Price (4% of 2010 Rev) includes commercial D&D projects

So although much of ES's work is awarded by long term contracts - much of the contract risk is minimized with 96% of revenues derived from cost-reimbursable or unit-price contracts.

Federal Services - Government Group

Federal Services work is awarded by either Tier 1  or Tier 2 contracts on projects that are primarily management and operation (M&O) and/or decontamination and decommissioning (D&D) services on DOE and DOD sites:

• Tier 1: federal project outsourced to a prime contract team where ES is either a JV owner or an integrated team subcontractor

• Tier 2: act as a subcontractor to a Tier 1 contractor on project-driven opportunities

Some background: ES IPO'd in December 2007 by PE firm that had levered up company and combined multiple nuclear services operators into one and the previous Chairman and CEO Steve Creamer was overly aggressive in trying to become a major Tier 1 player - bidding against many of the largest E&C companies for Tier 1 government contracts.  Failure to fully meet these and other lofty ambitions, its high debt load, the credit crisis/subsequent recession, and public dispute between Creamer and Utah politicians brought ES from $23 IPO to ~$6 in February 2010 when Creamer was forced to resign and was replaced by Steven Rogel as Chairman and Val Christensen as CEO.  New management has commented that ES was "arrogant" out of its IPO and intends to make a strategic shift in focusing more on Tier 2 opportunities by partnering with the larger E&C players through JVs.

While Tier 1 contracts awards may have a broader scope of work and a higher proportion of revenues, sometimes including incentive fees and fee sharing agreements , the bidding process is extremely competitive and time-consuming.  Pursuing these contracts has resulted in a very lumpy business with higher corporate SG&A and long sales cycles of several years with relatively high uncertainty.  A greater focus on Tier 2 awards (sales cycles of 6 months or less) should help level out the business.  This strategy allows ES to focus on the highly customized solutions that it does best and should also provide ES with more resources to target a greater number of associated higher margin LP&D opportunities.  Federal services work is relatively low margin (see breakdown above) - much of the higher margin work is in the transportation, processing and disposal of the project site's LLRW.  The revenues and profits related to these waste volumes are reported in the LP&D segment.

International - Global Commercial Group

This segment's revenues are predominantly from the Magnox contract with the UK Nuclear Decommissioning Authority (NDA).  Under the contract, ES is responsible for the operations and decommissioning of 10 nuclear sites in the UK - the ninth site was shut down this year leaving only 1 site operational with the rest in various stages of decommissioning.  ES also provides waste management and technology services to customers in the U.K., Italy, Germany, Spain, and recently won 2 new China contracts.  ES will face short term headwinds as UK austerity measures will pressure margins in their Magnox contract but there were many very positive developments in 2011 that have seemingly gone unnoticed:

• In March 2011, ES was awarded an extension of the Magnox contract into 2015.   This was a significant achievement as revenues are highly concentrated with the NDA (57.6%, 60.1%, and 64.8% of International revenue in 2010, 2009 and 2008)

• In April 2011, ES received approval for a new disposal site in the UK.  The Lillyhall site, owned by ES partner Waste Recycling Group (WRG), will be the first of its kind and the only facility licensed to receive high volume very low level waste (HV-VLLW) in the UK - this is huge step in their strategy to open disposal sites in Europe where they will be able to export their technology and expertise in LLRW disposal and management

• In 2011, ES also began start up work on the 2 China contracts it won in 2010.  In January 2010, ES won a contract with China Guangdong Nuclear Power to design and supply a liquid waste processing system for two new nuclear reactors with an option to provide another system for two additional reactors at the same site.  Then in August 2010, ES was selected to provide additional waste management systems for up to 8 new reactors under construction by China Power Investment Corp.  ES was selected due to its patented and proprietary technology in liquid waste processing and these contract wins are just the first of many as China moves forward in its extensive nuclear construction initiative

• In June 2011, ES received its requested license from the NRC to import 1,000 tons of German LLRW to be processed and incinerated at its Bear Creek facility and then exported back to Germany for disposal.  ES began test runs in Q3.

• There is also upside optionality for any work as a result of the Japanese Fukushima disaster (partnering with Toshiba) and the heightened awareness over the need for proper nuclear plant decommissioning and waste disposal expertise worldwide.  The most obvious of which is Germany's permanent shutdown of 8 nuclear plants in March 2011, and its announcement in May that the remaining 9 plants would be shut down by 2022

Logistics, Processing, and Disposal (LP&D) - Global Commercial Group

This segment owns and/or operates several strategic and unique assets:

• The Clive disposal facility in Utah handles more then 95% of all commercial LLRW disposal volume in U.S. and is the only facility licensed to receive Class A LLRW and MLLW waste from anywhere in the U.S. 

• The Bear Creek processing facility in Tennessee has the only commercially licensed radioactive metals recycling furnace and the largest LLRW incinerators in the U.S.

• Another facility in Tennessee is the only commercial facility in the world with the ability to produce a variety of products from depleted uranium

• ES operates a facility in Barnwell, S.C. that is licensed to receive all 3 classes of waste (A, B, and C) from South Carolina, New Jersey, and Connecticut

Although the majority of ES's fixed assets and their associated depreciation costs are in this segment, the maintenance capex for these facilities is extremely low.  One of the hallmarks of this superior business is the amount of total capex necessary to maintain their competitive advantage:

$26.6mm in 2008, $24.4mm in 2009, $17mm in 2010, and an estimated 25-35mm in 2011. 

ES provides services for all 104 operating nuclear plant in the US and has "life of plant" contracts with 84 of them.  This means ES is contracted to process and dispose of the plant's waste over the remaining useful life and the waste from the D&D activities when the plant is shut down.  As previously mentioned, the LP&D segment operates primarily on unit-price contracts so profits are tied to the waste volumes that are transported, processed, and disposed of.  Clive currently has Class A LLRW disposal capacity of 95mm cubic feet with a pending licensing amendment to increase capacity to 140mm cubic feet which is enough for another 30 years of operation.  This will be more than enough to satisfy the disposal and decommissioning needs of all 104 operating nuclear plants "with space left over."  There are two other commercial disposal sites in the US, but they are both much smaller than Clive and are restricted from accepting waste from certain states (discussed below).  The Clive facility is also one of the main reasons why ES was able to come up with its new License Stewardship model within the Commercial Services segment.

Commercial Services - Global Commercial Group

• This segment's services are divided into 3 primary activities:
• Commercial Project Delivery with the greatest opportunities in Large Component Removal and Disposition.  As the U.S. commercial nuclear fleet ages, large components will need to either be disposed of in the course of regular maintenance or replaced to extend the life of the plant.  The Commercial Project Delivery group prepares these components for transportation, processing and disposal by the LP&D group
• Liquid Waste Processing has proprietary and patented technologies that were instrumental in winning the 2 China contracts in the International division.  This technology is also playing an important role in the clean up efforts in Japan.
• License Stewardship is a new way to decommission a nuclear plant where the ownership of the license and the asset is transferred to ES who is then able to do it more quickly and cost efficiently.  ES closed their first License Stewardship deal in September 2010 at the Zion Illinois plant with Exelon in September 2010. 

Zion License Stewardship - Commercial Services - Global Commercial Group

As this is the first transaction of its kind, it is important to understand how accounting affects reported results:

• Initially, ES recorded an increase in its assets from a prepayment for their services in the form of a nuclear decommissioning trust (NDT) fund of $767mm ($801mm of investments less 34mm tax liability) and recorded an offsetting deferred revenue liability ($772mm).  The $5mm difference was recognized as a deferred gain related to the planning of the contract

• ES also assumed a $767mm liability to decommission the plant in the form of an Asset Retirement Obligation (ARO) and in conjunction recorded an equal and offsetting deferred cost asset. 

• These entries made it look like ES increased its balance sheet by  double the amount that it actually did

The ARO liability is an estimate of all costs and labor plus a profit margin component that a hypothetical third party (in this case ES) would earn for performing the D&D work.  The ARO will shrink over time under the proportional performance method as the actual work is performed and the actual costs are incurred.  However, the recognition of profits over time on the project are not explicitly recognized in the income statement.  As is evident from the entries above, the only obvious gain initially is the $5mm for planning purposes, yet ES expects to earn 15-20% on the estimated eventual cost of $1Bn or $150-$200mm.

This profit will be recognized in the form of an ARO settlement gain which flows through the income statement as a reduction in the cost of revenues.  However, ARO GAAP accounting also requires an accretion expense to be recorded in each period to reconcile the difference between the future ARO liability (~$1Bn) and the present ARO liability.  This accretion expense is recorded as an increase to cost of revenues.  Theoretically, over the life of the project the gains from the NDT trust fund will cover total accretion expenses.  But because NDT investments are classified as trading securities, gains and losses are recorded as other income thereby depressing gross and operating margins.  Understanding the true impact of the project is further complicated by the timing of the recognition of ARO settlement gains, accretion expenses, and NDT earnings which are not at all linear so quarter by quarter results from the Zion projects can completely misrepresent the underlying economics. 

This timing mismatch is indeed what has happened thus far in the project so while high accretion costs (est. $30mm in 2011) and low ARO settlement gains make it look like ES is making little or no money and even losing money in certain periods, work at Zion has actually been progressing better than expectations

We may see some proof of this progress soon as the Zion annual review of the remaining ARO liability is currently underway and management will be reporting the results in ES 's annual report.   Any cost estimate adjustments will flow through the quarter's income statement as an adjustment to the cost of revenue.  When estimating the ARO liability, ES must make projections of when various costs will be incurred over time - this is a difficult and inexact exercise that is further complicated by the subsequent adjustments to those cash flows using inflation rates and credit adjusted discount factors to arrive at a PV for the ARO liability.  By far the most costly and difficult estimate is for the removal of spent fuel rods and ES has already locked in all costs associated with that part of the project.  This mitigates much of the uncertainty in the project and management has said that it plans over the next 12-18 months to have a significant percentage of the entire projects costs to be spent, committed to or subcontracted out.

Management has also reaffirmed its former guidance of $150-200mm of profit from the project and there is further upside if ES is able to accelerate the work and come in under budget.  One of the largest fixed costs in the decommissioning is the large on-site workforce and management has specifically mentioned hotel costs.  Due to accounting, margin improvements from lower fixed costs won't show up until the latter years of the project when they reduce the man hours required.  However, an observable benefit to accelerated work is that the sooner that the early stage work is completed, the sooner they can begin to transport waste volumes to the Clive facility.  Note that the 15-20% ARO settlement gain EXCLUDES the profitability of all the waste disposal volumes that would go to Clive and be recognized in the LP&D segment. 

As a part of the Zion deal, ES set aside 7.5mm cubic feet of disposal capacity at Clive.  ES estimates that Zion D&D will produce 4mm cubic feet (mmcf) of LLRW, 2.7 mmcf of fill materials, and 1.3mmcf of recyclables.  The majority of this must be transported, processed and disposed of at Clive.   ES has not provided guidance as to the estimated impact of this is but we can get an idea of the potential profit opportunity by looking at manifests provided by the DOE of historical commercial waste volumes shipped to disposal facilities in the U.S.  In the past 3 years, Clive has received 2.0mmcf in 2008, 1.8mmcf in 2009, and 2.1mmcf in 2010 of commercial LLRW.  The corresponding gross profits in the LP&D segment have been $97mm, $92mm and $99mm.  The split between commercial and DOE generated waste in 2010 was about 45/55. So this translates to roughly $90mm of profit potential from the 4mmcf of LLRW without even accounting for the 4mmcf of other waste.

The Zion project has experienced accelerated work in the first 3 quarters of the year and it is expected to continue to year end.  These indications give Zion the potential to earn almost $300mm over the next 10 years.  Even though it may be too simplistic to annualize that figure, assuming $25-30mm/year provides an idea of the economics of the project as opposed to the existing accounting treatment that completely obscures Zion's profitability.

Zion will act as a template for the remaining 11 shut down reactors (plus another 14 in the next 10 years assuming no license extensions) and we believe there is a high probability that ES signs several other similar License Stewardship deals in the next several years.  License Stewardship offers the original plant owner a faster, easier, and a 20-25% cheaper model for complete plant D&D over traditional methods.  The reason ES is able to achieve these advantages is because it is able to skip the slowest and most expensive portion of the prior method.  Normally, the owner would need to hire a contractor to identify and separate all the radioactive and non-radioactive materials to try to save money by separately disposing of them at their respective disposal sites.  In the past, this inevitably led to complications where materials would be mistakenly identified and would end up contaminating others resulting in costly delays and deviations from contract procedures.  The alternative approach is to treat all waste that could possibly have been contaminated as radioactive and skip the separation process which actually ends up saving significant time and money if you own and operate the disposal site as ES does.

The beauty of the problem and its solution is that it effectively makes ES the ONLY company that can perform a large scale project like this because it depends heavily on the combination of their unique technical expertise and their ability and capacity to dispose of waste at Clive.  License stewardship will also act as a catalyst for shut down plant owners to begin long delayed D&D of their plants as many operators have pushed off D&D due to the hassle and cost uncertainties.  Exelon, one of the major operators of nuclear plants, has validated the model by entrusting ES with the Zion project which is the largest commercial decommissioning ever undertaken in the US.  Aside from providing large cost savings and accelerated liability resolution to the operator, the shortened timeframe also benefits ES by accelerating the flow of waste volumes by decades from initial time lines of 20-50 years.  In Zion's case, ES will complete the D&D in 2020, a full 12 years ahead of Exelon's schedule.

Why is ES trading at such a depressed valuation?

We have covered the impact of the obscure accounting treatment on Zion's prospects but there are a variety of additional factors that have led investors to dump ES shares in the past year. 

• Identifying ES with other nuclear power operators that were sold off as a result of the Fukushima disaster
• The disaster actually highlights the need for ES services and the importance of proper nuclear clean up

• US Federal budget cuts and UK austerity measures resulted in lowered 2011 guidance
• Lower government spending and the end of ARRA stimulus funding will indeed pressure Federal results in the near term and the Magnox contract will likely have tougher incentive fee targets going forward as well.  However, much of the drop off in 2011 guidance was also due to contract delays and transitions between lead contractors meaning ES should see a recovery in 2012 even assuming lower gov't budgets.  Lower International revenues from the Magnox contract will be offset with opportunities in China, Germany, and even in the UK with the new Lillyhall disposal site.  Guidance also does not take into account ES's large Tier 2 pipeline for the UK and Canada.  

• LP&D 2011 gross profit guidance was cut by ~$17mm which scared investors who thought of Clive as the "crown jewel" and ES's most stable business due to its life of plant contracts and its monopolistic position. 
• In November, management indicated that ES finally saw commercial waste volumes stabilize in Q3 and expects robust volumes for the remainder of 2011. Investors also need to realize that all those "crown jewel" attributes haven't changed - the drop off was largely due to lower Federal site waste volumes due to the roll off of some gov't contracts as well as the previously mentioned delays and transitions.  In providing guidance, management assumed absolutely zero replacement and no new contract wins which is the prudent thing to do in this environment but completely unrealistic as Clive is still where the vast majority of LLRW will be disposed of and DOE roll-off will likely be offset by increases from the DOD and commercial.  Management revealed that it excluded Clive's ~$65mm pipeline of new opportunities - $11mm of which has been confirmed to have been delayed into 2012.  Guidance also excluded future waste volumes from Zion which as we've mentioned will be a huge boost in future years. 

• The threat of the soon to be operational Andrews, Texas facility owned by WCS/VHI on Clive's margins and customer captivity
• This may be the most over exaggerated concern.  WCS has been touting its new 1,338 acre treatment facility which definitely sounds big and threatening until we start to examine what their actual licensed capacity is along with how much they are actually licensed to receive and who they can receive it from. 
• There will be 2 LLW-disposal sites at Andrews:
• The Compact Waste Facility (CWF) has licensed capacity for 2.31mmcf of Class A, B, and C LLRW waste and was initially allowed to accept waste only from Texas Compact states but gained approval in mid-2011 to accept waste from 36 other states subject to certain restrictions.  To put this in perspective, Clive's commercial disposal volumes in just the 2010 calendar year were nearly equal to the entire capacity of CWF.  Clive also remains the only commercial disposal outlet for MLLW
• The Federal Waste Facility (FWF) is licensed for 26mmcf of Class A, B, and C LLRW and MLLW generated from government sites.  While this is a greater threat to ES than the CWF, ES has always had competition in the federal disposal segment that came from DOE owned and operated waste facilities so an additional 26mmcf of capacity to compete with is rather insignificant

*Recall that Clive  has Class A LLRW disposal capacity of 95mm cubic feet with a pending licensing amendment to increase capacity to 140mm cubic feet*

 Valuation

Considering peers trade at ~9x or greater EV/EBITDA, ES is already very cheap on conservative 2011 adj. EBITDA guidance of $140mm (<5.5x EV/EBITDA) which is down from 2010 EBITDA of 158mm.  Still even though "peers" such as VHI, PESI, ECOL, and CLH all have some similarities there are really no good comps for ES.  So instead of applying some industry multiple to EBITDA or GAAP earnings, we'll try to conservatively estimate ES earnings power on a segment by segment basis and then factor in the effects of the current debt-laden capital structure and potential improvements.  We hope this more clearly illustrate the multi-bagger potential at current levels.

 Segment Annual Operating Income

• Government: $15mm or about half of peak earnings in 2008 to account for budget and stimulus cuts in the next few years

• Commercial excluding Zion:  $15mm which is flat to 2009 and 2010(after adjusting for Zion) and assumes no liquid waste and large components growth and no new license stewardship deals

• LP&D excluding Zion: $85mm which factors in an expected recovery from 2011 volumes and is more in line with prior years $85-$90mm range

• International: $35mm, down from $57mm in 2008 and flat to 2010 - assumes growth in China, Germany, and UK will only offset Magnox contract

• Zion: $30mm, simplified run rate on the contract including benefit to LP&D waste volumes but excluding any further ARO gains even though project is progressing ahead of schedule

• Total: $180mm

Less SG&A of $50mm includes 2011 & 2012 cost cuts

Plus D&A of $45mm which has been steady over past several years

Less Capex of $30mm

Pre-tax and interest Earnings Power: $145mm

Interest expense will be almost $75mm in 2011 from $835mm in LT debt including $300mm of senior notes at 10.75% and the remaining amount in a term loan at adj. LIBOR + 4.5%.  Management plans to aggressively pay down debt and expects $40mm of paydown in 2011 with at least that much going forward as well as the possibility of a lump sum repayment upon amending a $200mm LOC that ES was forced to fully cash collateralize for the Zion deal (ES will not take on additional LOCs or further lever the balance sheet in future License Stewardship deals).  CFO William Benz has been working on renegotiating the LOC with Exelon over the past year and when discussing his progress said that he expects to have "very good news" in the next quarter or 2.  Zion's other largest expense is accretion which is a non-cash charge so ES will continue to generate very high FCF.  Even in the low or no growth scenario above, ES can eliminate approximately a third of its outstanding debt in a few years.  Under these assumptions, ES could reach almost $70mm in net income with future double digit growth coming simply from further debt reduction.  This all assumes no further deals from License Stewardship which we're obviously very bullish on.

Risks

• Highly regulated/political business: ES has been doing this for 20+ years so it knows its way around and new CEO has kept up good relations with Utah congressman.

• License amendment for increased capacity at Clive: Obama's comments post-Fukushima confirm government is committed to future viability of nuclear energy and commercial clients are all very public in saying they have no alternatives to dispose of their waste and Clive is critical to their business.  

• Gov't Reliance (US and UK):  Risk is all in the timing as clean ups aren't abandoned, they are simply delayed.  ES Tier 2 strategy should also provide better visibility.  Growth in other segments should also offset concentration with these 2 governments.
• NDT fund: Zion project gets paid out of the NDT fund so ES exposed to any shortfalls.  However, ES positioned the NDT fund much more conservatively when they took it over and was also very fortunate in significantly reducing equity exposure this year right before the market fell apart in August.  They have 80% allocated to fixed income and have a reasonable sub-5% growth expectation.
• Magnox Contract: renewal risk was pushed out to 2015 which gives it several years to diversify the International segment so as to not be so dependent on the NDA in 2015 - plus its unlikely that they will lose the business entirely, they are planning  on a JV rebid where they will have a 60% interest

• Acquisitions:  Management is fully aware that before it can seriously think about acquisitions it must improve the balance sheet.  David Lockwood of ValueAct is on BOD and should keep BOD disciplined if management strays.

• Volatile Fixed Income Capital Markets: We don't anticipate ES needing additional capital or raising debt so the only risk here is in the timing of their LOC renegotiation with Exelon, ie. how soon they will be able to realize the cost savings from an amended LOC