Description

Written up last year at $31.50, I want to explain why Maine & Maritimes (MAM) has upside potential of over 100% and a margin of safety that implies almost no downside.  The intrinsic value of the core business alone is worth 15-60% more than the current stock price.

Regulated Utility

MAM owns a regulated electric utility called Maine Public Service (MPS) which owns transmission and distribution assets in Aroostook County, Maine.  It’s tiny, there’s no growth, and just thinking about the business could be prescribed as a sleep aid.  After getting in trouble in years past (see prior write-up: http://www.valueinvestorsclub.com/Value2/Idea/ViewThread.aspx?id=3066&page=0&msgpage=3552), a new CEO has sold unprofitable subsidiaries, cut unnecessary costs, and MPS is now on autopilot.  Cash flow is booming right now and debt is being rapidly paid down, but reported eps is much lower because of some large, obscure amortization charges that flow through earnings.  These charges are mostly non-cash, and relate to various events from years ago…they will all be expiring in the next 10 years.  As a result, this $73m market cap ($33.7m in debt = $107m EV) company is generating about $20m in annual EBITDA but just $3m in earnings.

What exactly is causing the discrepancy?  In 1986 the Maine legislature forced MAM into a 30 year power supply agreement with a biomass plant called Wheelabrator-Sherman (WS), where MAM ended up had to buy power for 3x the market price.  MAM got out of the deal in 07, but 20 years of buying overpriced juice created a huge stranded cost asset.  This asset, currently $28.5m, is being amortized until 2013 at a rate of about $6m/year, creating most of the large non-cash stranded cost amortization charges.  There are also several others which are smaller, but still manage to add up to about $1.8m/year (~$.63 eps).  There are only 1.7m shares outstanding.  After the stranded costs expire eps will leap dramatically, although MAM will lose the tax deductability from the amortization.

MPS consistently generates about $37m in regulated revenue, and a new unregulated service company (USG) is already on a ~$4m run rate from several wind farms being built.  There will be some lumpiness here, but they’re basically the only electric e&c company in Northern Maine, so if there’s a job to do, they’re usually the best guys in town, and they’re the only ones in the state with wind farm experience.  It’s a nice complementary business with mid-teen margins and little incremental overhead.

Utility Value

You can’t use p/e because GAAP income gets killed by the non-cash stranded cost amortization.  How bad is the distortion?  TTM, reported eps was $1.76 but would’ve been $4.43 excluding the charges (I am only talking about the non-cash stranded amortization charges, not all non-cash charges such as plant depreciation).  2008 eps will probably be around $2.00, but would be more like $5.20 without the same charges.  The GAAP earnings power of this company is being dramatically understated.  Cheap utilities trade for ~13-15x trailing eps, but some as low as 10x.  Let’s just say 10x for normalized eps and the stock’s worth about $52/share.

There is no dividend currently so we’re out of luck on that.  Before things got screwy though, they maintained a payout ratio around 70% on average.  This is high because their assets don’t require much reinvestment (they have the lowest expenses per line mile of any public electric utility) and there aren’t many growth opportunities for them.  Theoretically, they could support a dividend of about $3.64 based on the current normalized eps of $5.20, which if we applied an industry-high yield of 6.5% to, puts fair value at $56/share.

You might be rolling your eyes at my eps and dividend valuation, it’s an obviously tough sell since assumptions must be made.  So let’s look at what’s real: cash.  The same group of utilities trades for 7-9x EV/EBITDA, which if we applied the low end to $20m in EBITDA and $33m in debt, gets us to a value of $61/share.  Even little companies with similar growth such as Central Vermont (CV) are trading at almost 9x while MAM is only at 5x despite having a much lower debt/EBITDA ratio of 1.7x vs average of 4x.  MAM is actually the least levered of comp electric utilities.  And free cash flow?  TTM they reported $3.00/share in FCF, so the stock is trading at 14x trailing FCF, but even this is in some ways being depressed by another $1.00-1.50/share because they’re paying off deferred taxes.  I’d tell you what FCF multiple other electric utilities trade at but none have positive FCF (alas, they do have dividends).  A quick look at their most recent 10Q shows they’ve already done $8.4m in operating cash flow and $4.2m in FCF through the first half of the year…reminder, the market cap is $73m.

Anyway, I believe that the core business’ intrinsic value is between $50-70/share.  At absolute worst, I think we’re about fairly valued right now.

Free Options

MAM and Central Maine Power (CMP) are in a JV for the Maine Power Connection (MPC) project, which is a potential transmission line with a total price tag of $620m (MAM is a 30% partner).  The line is initially needed because Horizon Wind, a very large wind farm developer, is trying to build an eventual 800 MW wind farm in Northern Maine.  While there are a bunch of reasons why this wind farm is a good deal (lots of wind, minimal NIMBY problems, cheaper, etc) the transmission infrastructure is incapable of handling this kind of power, both because the takeaway capacity doesn’t exist, and Northern Maine isn’t even connected to the New England power grid (it’s part of Canada).  Full project description and details can be found at: www.mainepowerconnection.com.  This site also has links to the MPUC and FERC filings that contain additional details and comments.

After several years of jointly studying the project, MAM and CMP released their findings earlier this year, which show the MPC meets several goals.  First and most importantly, the long-run costs are outweighed by the benefits, thus it creates economic benefits to ratepayers in the region.  Their own studies, along with that of Horizon’s, put total long-run cost savings at over $1 billion from switching off natural gas, which is very expensive in the Northeast.  Second, the MPC would help the region satisfy various state-level initiatives for more renewable energy.  While every state in New England would like to build their own wind farms it’s just not realistic given the population density, NIMBY issues, and odds that those opposed are relatively wealthy and connected.

But what really gives credibility to the project is that it’s not just the parties that stand to benefit who are  confirming the viability of the project.  ISO-NE (the administrative body for all New England electric utilities) has conducted their own study, and early results corroborate the benefits described by MAM.  The ISO doesn’t actually decide anything but they make recommendations to the member utilities, and it has been almost unheard of for member utilities to reject ISO’s findings.  A copy of their preliminary findings is at: http://www.iso-ne.com/committees/comm_wkgrps/othr/econ_stdy/mtrls/2008/may222008/index.html - be warned, you will not be able to understand this presentation, but I can try my best to answer questions.  But understand that having the ISO on board gives the project a lot of credibility.

There are basically two major hurdles to overcome.  The first, and largest, is for the other members of ISO-NE to grant the project socialization status, which would all but guarantee the MPC gets built asap (mid 09).  Socialization means that all of New England’s rates would rise in order to pay for it.  While MAM and CMP would spend the money building the line, the state of Maine alone couldn’t afford the rate hike needed to offset the cost.  Socialization of transmission projects is a common occurrence in the Northeast given the smaller state sizes and outdated infrastructure.  Currently, Massachusetts is unsure of what to do about the MPC.  Most socialized projects are reliability projects that are needed to maintain the integrity of the grid, whereas the MPC project is an economic project designed to save rate payers money in the long run.  There’s a well established protocol for granting socialization status to reliability projects, but economic projects are something new, so some members are hesitant.  

Mass is holding the process up for this reason as well as a new energy bill that Governor Deval Patrick signed.  The bill has a lot of provisions which actually help the MPC, and one that hurts it.  The good things are that it calls for much more power to come from alternative sources like wind, and it will even force Mass utilities into long-term supply agreements with alternative power generators, thus helping spur wind/solar/bio development.  A description of the new Mass energy bill is here: http://www.boston.com/news/local/massachusetts/articles/2008/07/03/state_starts_a_green_era/?page=full.  It is an ambitious piece of legislation, and it works much to MAM’s advantage.  The governor has stuck his neck out on being a “green” advocate, and it gives MAM a great deal of leverage over Mass.

The one negative part of the bill is that ideally, Mass wants all this wind/solar/bio generation to be in-state.  Specifically, the Mass governor wants to see the Cape Wind (of Ted Kennedy fame) project get off the ground.  But as any reader in Boston knows, I wouldn’t count on this happening, it’s basically been a running joke for years now.  MAM and the proposed wind farm present an elegant solution, since they can easily build a giant farm mostly free of siting issues, and the politicians can still boast about their “green-ness.”  The Maine governor is enthusiastically supportive of the MPC.

The second hurdle for MAM will be financing.  This is an unknown to me, but based on conversations with management, I don’t think it will actually be that difficult to raise $186m.  MAM has already been approached by numerous investment banks offering ideas and pledging future assistance.  And if MAM can’t get financing the company would likely just get bought by someone like Northeast Utilities, Energy East, NSTAR or Emera…frankly I’m surprised it hasn’t happened yet.  I’ll get more into this below.

There are two other big opportunities for MAM associated with the MPC.  First, the $620m project has $186m budgeted for substation construction, and there would be additional line connection needed for the wind turbines themselves.  MAM would be a bidder for a lot of this unregulated work, and in fact favored to work on it.  How much work could they possibly get, unfortunately I don’t know.  But the normally reserved management has been unusually excited about this opportunity when I’ve discussed it with them.  The service work could easily cause reported eps to accelerate during construction and help generate cash which they could plow right back into construction.  Second, there is a proposed 3^rd phase of the project which would connect Canada’s power grid to New England’s.  I detailed this a little in my first write-up, but the gist is that Canadian power can be up the 3x less expensive because of excess supply in New Brunswick.  There is almost no transmission between Canada and the US in this area, so MAM is sort of like a bridge.  Law of economics say that opportunities will open up for MAM…right place at the right time, I guess.

Option Value

What’s the value to MAM if the MPC goes through?  There are some obvious financing assumptions you have to make in terms of debt/equity, the price at which they can raise stock, and how creative they can get in terms of pushing down holding company debt to the utility as equity.  But really, I think the valuation is surprisingly simple…I believe this is how most people in the utility industry eyeball it.  The way to look at this is by asking a) what’s the total value of MAM after the MPC is built, and b) how much of the company do they have to sell to get it done.  From the total value perspective, MAM will be generating about $20m in earnings.  $12.1m will be coming from their 13% ROE on the $92m invested in the MPC, while $8m is coming from the utility after the stranded costs expire.  I would say there is little risk to this $20m earnings number.  I am going to say this $20m is worth about 12.5x earnings, for a total value of $250m.  Tackling part b, if we assume that MAM has to raise the same $93m in new equity sometime around 2010-2012, that means they have to sell an additional 38% of the company, which would increase the total share count from 1.7m to 2.7m.  Dividing the $250m by the 2.7m shares outstanding gets you to a $90/share valuation, so we could say that the MPC adds an incremental $20-40/share in value.  The table below shows MAM’s value at different multiples.  Future eps also shows that eps should be able to grow at 25-30% cagr over the next 5 years.

The big risk here is that they price an offering too low and not enough of MPC’s value accrues to existing shareholders.  Management doesn’t own much stock at all, so I wonder how much they would fight to price this deal correctly.  But I take some comfort in the fact that I’ve gotten to know the CFO and think he’s pretty smart about this stuff, and he seems to be aware of the issue.  Of course, the company could just sell now and get it all over with and no one would have to worry about this.  Because the MPC has future phases that offer even more growth, I think an acquiring utility would be willing to pay between 12-14x for MAM’s earnings.  But you can see that even at a very conservative multiple MAM is about 42% undervalued.

The MPC and Horizon Wind projects aren’t layups, but they’ve already got a ton of support from Maine and surrounding states.  I think the odds are pretty good that these projects will go forward and our options will pay off.  If not, I will certainly be disappointed, but the intrinsic value of utility provides a great floor.

Conclusion

We have a business with a going concern value between $50-70/share.  We have what’s probably a binary option with additional value of $20-40/share.  Then we have as yet unquantifiable upside in the form of construction work and future project phases.  So in all, we’re looking at a $43 stock with a quantifiable valuation range of $48-110, and a good probability of the options paying off.  I think this is a classic value investment.  And for whatever this is worth to you, Leucadia National bought 57k shares last quarter…hopefully this helps to further validate the story and help it get discovered.

Catalyst