Description

Business Description: public utility (monopoly) providing gen., trans. & distrib. of elec. in W. TX & southern NM

Investment Thesis - I believe EE is a long because:
1) at current prices, the business is free: hidden assets (15.8% of Palo Verde (nuclear) and 7.0% of Four Corners (coal) are alone worth $14.34/shr
2) active & aggressive stock buyback program
3) protected franchise(rate pass-through mechanisms in TX and NM) until 05
4) Served areas are growing rapidly (both economic and population growth)

Basically a way to play a utility LBO:
EE is one of very few utilities not paying a dividend (thereby preventing “traditional” utility funds from investing), though significant equity buybacks and debt paydown make implied yield higher than a typical utility. When EE emerged from bankruptcy 4 years ago, the balance sheet was highly leveraged; today the leverage ratio remains in excess of 50%. The company has devoted much of its free cash flow to debt paydown, until reaching investment grade last fall. More specifically, EE was prevented from buying back stock as a result of its bond covenants and, instead, retired $241mm of debt, or 25% of debt outstanding, thus dramatically improving its credit rating. A year ago, the company announced a 6m share buyback and then spent over $40mm completing it – that’s an effective equity yield of 5%. Another 6m share program was announced and 3.6m shares have already been repurchased. For an equity holder, the risk of the debt is minimal compared to its benefits: with a guaranteed monopoly until 2005 in TX and re-reg passed in NM, EE will easily generate enough free cash to repay all its debt (and repurchase tons of equity). The debt has agency benefits in terms of keeping the management focused (not to say they’re not shareholder value-conscious already). As a long-term holder, no dividend and substantial share repurchases have significant tax benefits, though management annually reviews its dividend policy.

3 ways EE can make its shareholders money
In the near term, the value-opportunity rests in the company’s aggressive share repurchase program, possible because of EE’s substantial cash flow/earning power. By my calculation, in a best-case scenario, EE could generate $1bn in unlevered FCF over the next 5 years. In an absolute worst-case scenario, the number drops to $500mm. Surplus funds should generate an additional $45mm to $70mm in interest income, assuming a 5% return on cash. In either case, we can assume $305mm in interest payments and $175mm in mandatory debt paydowns. That leaves $315mm to $590mm in cash available to repurchase shares – which is exactly what EE intends to do. Depending on the price at which shares are repurchased, EE can plausibly buyback 33% of its outstanding shares. Ongoing repurchases will put a floor on the stock in the short term, and in the longer term, result in a levered recap.

In the medium term, substantial value could be created by a sale of stakes in Palo Verde and Four Corners. Just last year Pinnacle West offered EIX $250m for its 15.8% stake in Palo Verde and $300m for its 48% stake in Four Corners. As FERC requires public auction bidding, the $300 was then topped by another bidder. Nuclear assets have nearly tripled since that deal was signed. So, EE’s stake is worth about $773m, or $14/shr. Obviously, EE would only sell with a long-term power contract – similar to the sale of Nine Miles to CEG. It helps that Northern Power PLC and Duke Energy have announced they are exploring possibilities for building power plants in El Paso, TX and Deming, NM. In the meantime, EE is benefiting from these plants’ selling into CA.

The ultimate catalyst EE’s share price is the potential for a takeover – though a takeover is NOT necessary to unlock EE’s intrinsic value. Management is hardly new to the takeover game: most come from Western Resources which itself was a turnaround-cum-takeover story. It is difficult to gauge what a strategic takeover price might be. Warren Buffet paid 2x book value for Mid-American (effectively an LBO.) and that seems to be the private market multiple. In the middle of 2003 (the year the CEO’s contract expires), 2x tangible book value would amount to $16/share – excluding Four Corners and Palo Verde, so at least double today’s price.

Catalyst

1) short term: active & aggressive stock buyback program
2) medium term: sale of nuclear/coal assets
3) long term: sale of company, or
expiration of franchise protection (elimination of rate caps drive earning power to $1.60/shr)