Does the idea of a non-dividend paying microcap electric utility in Northern Maine that trades at 26x 2007 eps get you fired up? Maine & Maritimes' (M&M) true profitability is being masked by esoteric accounting rules and several recently divested unprofitable subsidiaries.  To give you a sense of the accounting distortion, it’s trading at 26x this year’s eps, but just 8x FCF.  For 2008 it’s 21.9x eps and 5.2x FCF.  They don’t pay a dividend currently, but if you’re patient I think they’ll be paying between $4 – 5 per share in 3 years.  There are also several free embedded options which are potential company changers. 

 

History:

 

This is not an exciting company.  M&M is a regulated electric utility operating in Northern Maine and New Brusnwick, Canada.  Their assets consist of 400 miles of transmission lines, 1,700 miles of distribution lines, and 36,000 customer accounts within their 3,600 square mile coverage area.  Despite being a plain-vanilla utility in a go-nowhere region, M&M has been through an awful lot over the last few years.  In 2000, the federal electric markets were deregulated having two effects on the company.  First, M&M was forced to divest its power generating assets as the regulators believed it would result in a better competitive market for power generation and thus cheaper rates.  Second, the (now former) CEO, Nick Bayne decided to diversify the company by creating a holding company structure and purchasing several unregulated non-core businesses.

 

It was a disaster.  He bought companies in construction, engineering, consulting, real estate and software.  He was either profoundly stupid or really unlucky, because not one of these companies ever turned a profit, just burned cash and forced M&M to take on more debt.  To support the added businesses he brought in a slew of six-figure execs to help manage everything.  Normally this might not sound too awful, but with only 1.7m shares outstanding, one guy making $100k takes $.06 (pre-tax) out of eps.  It got so bad that the $.38 quarterly dividend in 2004 was cut to $.25 in 2005 and finally suspended in 2006.

 

Apparently it took the suspension of the dividend to prompt any real action against Mr. Bayne.  Some current employees have told me that he was woefully incompetent and almost universally disliked within the company.  In 2006 he was finally shown the door.  Promoted to CEO was Brent Boyles, who had been running the utility quite profitably throughout this ordeal.  Brent is about the exact opposite of Mr. Bayne.  He’s a longtime utility exec with a great reputation.  The guy’s also Brigadier General in the Maine Army National Guard and just returned from Afghanistan earlier this year.  Anyway, Brent wasted no time selling the subsidiaries, cutting costs, paying down debt, and pursuing some relevant growth opportunities.  I’ll get more into the details below.

 

Revenue:

 

Megawatt hours (MWh) usage growth has been understandably slow, averaging about 1.4% annually since 2002.  Residential and large commercial customers comprise 64% of usage, but residential customers make up 44% of revenue.  Rates are broken down by transmission (federally regulated) and distribution (state regulated).  The state regulator usually approves a modest rate increase (2 – 4%) every few years.  FERC transmission rate approvals occur less frequently.  For modeling, I assume .6% usage increases, flat rates through 2009, then a 4% rate increase in 2010.  For now there isn’t a whole lot to this side of the business.

 

Expenses:

 

This is where it starts to get interesting.  About 41% of revenue is consumed by operating and maintenance (O&M) costs for things like line servicing and general corporate expenses.  One of Mr. Bayne’s first priorities was cutting this down to more reasonable levels.  These costs are declining sequentially and yoy due to reorganizations, layoffs, trimming healthcare benefits and cutting back on the defined benefit plan.  In all, management expects to save $1m annually from the cost cuts.  2006 also saw a number of one-time charges from management changes totaling around $550k.  Last year, total O&M was $15.2 million, but after you strip out the one-time stuff and recurring cuts, a normalized ongoing O&M expense level looks like ~$14m.  So EBIT/share should increase anywhere from $.60 - .90 from these simple changes.

 

The bulk of additional costs are from DD&A and stranded cost recovery.  Stranded cost is an obscure accounting device for utilities that can significantly affect their profitability and reported financials.  The basic idea is that under regulation, states often force utilities to build transmission infrastructure or enter into uneconomic supply agreements in order to support a new power plant or some other initiative.  But when markets later deregulate, it’s common for these projects to be rendered uneconomic.  The utility is therefore left with a “stranded” asset that has little or no value.  Regulators will then decide if the utility can recover the costs through rates, which would allow the company to book the stranded cost as an asset and then amortize it as the cost is recovered.  This next part is important.

 

In 1986, the Maine legislature forced M&M into a 30 year power purchase agreement with a waste-to-energy plant called Wheelabrator-Sherman (WS).  M&M was forced to pay WS almost 3 times the market rate for electricity in order to make the plant economically viable, with the hope that Maine would become less dependent on rising fossil fuel costs.  In 2002, M&M was able to successfully negotiate that the agreement be terminated early, ending in January 2007, with the stipulation that M&M make annual payments to account for the remaining 10 years.  In order to make whole to WS, M&M was making $12m cash payments through January 2007.  This was an expense that flowed through earnings which M&M is no longer incurring.  This is almost $7 per share in negative cash flow that has simply gone away, and the uneconomic supply agreement which lasted for 20 years that is finally finished.  They also get to recover the cost through rates and amortize the resulting $36m asset over the next 6 years.  M&M has several other stranded cost line items that resulted from things such a nuclear power plant decommissioning costs and studies to build new power plants.

 

In 2006 stranded costs were $11m (30.8% of revenue), and in 2007 they’ll be ~11.3m (31% of revenue).  It doesn’t look like much has changed on the surface, but the point of all this is that the mix of cash vs. non-cash charges in that stranded cost line item has dramatically shifted.  The cash charges for WS got replaced by non-cash amortization charges.  In total, 40% of operating expenses are now non-cash.

 

Options:

 

M&M is so remotely located that they aren’t actually connected to the New England power grid.  Their area of control is New Brunswick, Canada.  What makes this interesting is that there is a significant supply/demand imbalance for power in New England and Maritime Canada.  Canadian MWh rates are almost 1/3^rd of New England’s due to excess capacity and different seasonal usage.  M&M and Central Maine Power (subsidiary of Energy East) are conducting a feasibility study for building a new high transmission line from New Brusnwick, through M&M’s territory, and into the New England power grid, effectively connecting M&M’s service territory with the New England power grid.  The exact economics to M&M aren’t yet known, but it could leave M&M owning a piece of one of the few direct links between the excess power in Canada and the shortages in New England. 

 

In addition to the transmission line opportunity, the Maine Public Utility Commission (MPUC) still won’t allow M&M to own power generating assets, but this is likely to change.  Parts of Northern Maine are great places for wind farms.  A 40MW wind farm at Mars Hill was recently completed within M&M’s territory.  Again, the economics aren’t yet fully known, but with tax credits these farms can operate profitably and generate low teens ROE’s.  Even if they cant own these assets, there are currently plans for another wind farm in their territory, only this one would be 800MW – very large.  M&M would be able to collect other revenue from project work, but the additional wheeling revenue from transmission of the power could be huge.  Unfortunately, the exact economics of this deal aren’t known either (sorry if that seems to be a theme) because it depends on rate adjustments from the MPUC for which there are no precedents.

 

Financials:

 

I try to note the non-cash charges that flow through earnings.  The interest payments might look low given the debt.  This is because they collect interest based on the stranded cost level.

 

	2004	2005	2006	2007	2008	2009	2010	Comment
Revenue	33.73	34.32	35.60	36.28	36.31	36.55	38.17
Expesnes
Utility O&M	14.07	14.35	15.27	14.35	15.12	15.15	15.45	CEO cut $1m annually in 4Q06
Other O&M	1.25	2.02	1.96	1.29	-	-	-	Old businesses (software, construction, etc)
DD&A	2.83	3.15	3.07	3.07	3.12	3.15	3.25
Employee Healthcare	1.60	1.71	1.81	1.72	1.73	1.80	1.88
Total	19.75	21.23	22.11	20.43	19.97	20.10	20.58
Stranded Costs
Waste Management	8.48	8.49	9.15	-	-	-	-	Forced supply agreement terminated in Jan 07 - cash
Maine Yankee	3.27	3.22	2.93	2.78	1.91	-	-	Nuclear plant decommisioning  - cash
Seabrook	1.54	1.54	1.54	1.54	1.54	1.54	1.54	Nuclear plant decommisioning - non-cash
Deferred Fuel	(3.56)	(3.00)	(3.20)	6.15	7.21	9.35	9.68	Amortization of Wheelabrator stranded cost asset
Incentive Refund	-	-	-	0.25	0.25	0.25	0.25	Amortization
CXL Plant	-	-	0.26	0.25	0.24	0.12	-	Amortization
Special Discounts	0.28	0.28	0.28	0.28	0.28	0.28	0.22	Cash charge
Total	10.01	10.53	10.96	11.24	11.43	11.54	11.69
EBIT	3.97	2.56	2.53	4.61	4.91	4.91	5.90
EBITDA	16.81	16.24	16.04	18.68	19.38	19.52	20.76
Other	(0.05)	(0.12)	0.16	(0.15)	(0.11)	0.02	0.02
Interest	0.95	0.94	1.38	1.12	0.64	0.46	0.11
Tax	0.70	0.65	0.52	1.41	1.67	1.75	2.28
Net Income	2.27	0.85	0.79	2.01	2.40	2.64	3.44
EPS	1.41	0.52	0.48	1.21	1.42	1.55	2.01	1.7m shares outstanding
Cash Flow	3.17	2.70	2.32	13.07	14.92	17.05	18.16
CF/Share	1.97	1.65	1.42	7.69	8.78	10.03	10.68
Capex	6.54	4.85	3.53	6.52	4.80	5.00	5.00	Company says should be closer to DD&A
FCF	(3.37)	(2.15)	(1.21)	6.55	10.12	12.05	13.16
FCF/Share	(2.09)	(1.31)	(0.74)	3.86	5.95	7.09	7.74

 

The balance sheet has shown nice improvement since Brent took over and the WS deal was terminated at the end of 2006.  I think they’ll continue to pay down debt by $1.7 – 2m per quarter until the total debt is around $20 – 25m, at which time they should start paying a dividend.  It’s possible that they could even start paying out a tiny dividend in late 2008 as a signal that they’re back in business, so to speak.  After the WS stranded cost has been fully amortized in 2012, then the earnings look more like the cash flow currently, although they lose the tax-deductability of the amortization.

 

 

	4Q05	4Q06	1Q07	2Q07
PP&E	64.8	61.1	62.2	61.7
Current Assets	13.6	18.6	13.2	15.1
Stranded Costs	62.4	64.4	62.0	59.8
Other	10.4	4.0	8.6	4.1
Total Assets	151.2	148.1	146.0	140.7
Debt	44.5	44.7	42.1	40.5
Current Liabilities	7.8	10.3	8.1	6.8
Deferred Tax	26.8	26.4	27.3	26.4
Other	24.3	25.2	26.5	24.1
Total Liabilities	103.4	106.6	104.0	97.8
Equity	47.8	41.5	42.0	42.9

 

You don’t have to take my word for most of these projections.  The company has filed their stranded cost and DD&A estimates through 2017 with the MPUC, it’s all publicly available.

 

Valuation:

 

For a utility, I prefer valuation using FCF and dividend yield; M&M looks extremely cheap by each.  I think that in 2010 they’ll be paying $5 per share in dividends because of their historically high payout ratio near 70% .  Applying a modest 6% yield (no other electric utility yields > 5.7%; avg is 3.5%) and discounting back at their 5.2% WACC, I get a fair price of $72 per share for > 100% return.  If you’re more comfortable using FCF since no dividend is currently being paid, it’s trading at 8.1x, 5.2x, and 4.4x 2007 – 2009 FCF, respectively.  These are some extraordinarily attractive multiples.

 

One of the things that adds to the confusion about the value of this company is that it’s somewhat difficult to back into EBITDA.  First, M&M includes income taxes in operating expenses, so their EBIT looks low.  Second, they don’t make it clear which stranded cost charges are amortization and which are cash.  Data providers like Bloomberg and Yahoo apparently only look at depreciation when calculating EBITDA, so other than looking at book value, M&M isn’t going to look great on a screen.  Anyway, if you back into the correct EBITDA, they’re trading at 4.5x EV/EBITDA, which viewed in isolation looks cheap but when compared to comps’ avg multiple of 9x looks even better.  And it trades at 1.24x book value while comps are between 1.5 – 2.2x.

 

To recap, if this is so cheap, why doesn’t any of this show in the trailing numbers?  First, you have the now divested businesses in there making previous years look bad.  Again though, they’re all gone except a little piece of one.  Second, you have the continuing supply agreement with WS and the $12m make-whole payments, both of which are done.  Third, you have the additional expenses which have since been reduced.  Finally, you’ve got the misreported EBITDA numbers.

 

The thing I really love about this story is that the stage is already set – we don’t even need to wait for other catalysts in order for them to put up great results and improve the balance sheet.  The new CEO has already taken over, the subs have mostly been sold, the cost cuts have been made.  Barring some kind of draconian regulatory changes, I think it’s got a terrific risk/reward profile.  I’m a new VIC member; this is my first writeup and it’s the idea that got me admitted.