Downward Guidance Revision

The company cited unfavorable energy price movements (i.e. #6 fuel oil vis-à-vis natural gas) and decreased Mid-Atlantic plant availability as the main reasons behind the lowered guidance. The process of adding environmental controls to the Mid-Atlantic coal plants will lower plant availability, as will the Virginia Air Board run-time restrictions on the Potomac River units.

Several factors should lead to EBITDA growth in 2009-2010.

1. Higher natural gas prices based on the forward curve ($7.53 in ‘08 vs. $8.29 and 8.41 in ’09-’10)
2. Plant availability increases once the environmental capital expenditures are finished in 2009
3. Heat rate expansion due to limited supply additions
4. SO2 and NOx permit sales as the environmental controls result in excess credits
5. Potential use of lower cost coal post scrubber installation and Morgantown barge unloader
6. Potomac River resolution

Strategic Alternatives

On the 3Q conference call, there was limited discussion on the terminated strategic alternatives process. We do not know if offers were made for the entire company or for specific regions. One caller suggested management wanted a 10x multiple implying a high $40s/low $50s share price depending on the EBITDA assumption. It is unclear why a buyer would want to pay a premium on $6.4 BN of cash.

Per various power news services, several companies were rumored to have engaged in discussions with Mirant. British private equity firm Terra Firma was said to be working with a strategic player. Additionally, French utility Suez (subsidiary Suez-Tractebal has assets in the US market) and US PowerGen (Madison Dearborn entity with plants in New York City and Boston), among others, were cited as being interested in all or a portion of the company’s assets.

Company Overview:

Pro forma for the divestitures, Mirant’s remaining generation of 10,301 MW is located in the Mid-Atlantic (5,256 MW), Northeast (2,698 MW) and California (2,347 MW) regions. Mirant’s zones within these regions have among the lowest reserve margins in the country. The Pepco Zone, Southeastern Massachusetts and New York Zones F-K have estimated reserve margins of 11%, 19% and 15% for 2007. By 2010, Mirant expects these margins to fall to 6%, 15% and 11% as demand continues to grow and limited generation is built. Despite the industry’s desire to maintain 15% of peak reserves, the political environment and not-in-my-backyard (NIMBY) attitude towards coal or even natural gas plants should lead to continued tightness in Mirant’s regions, even considering optimistic projections for additional transmission capacity from resource rich regions.  

On a capacity basis, coal, gas, oil and dual fuel units (oil/natural gas) represent 31%, 22%, 10% and 37%, respectively. Based on MWhs generated, coal is the dominant fuel at 76% followed by gas and oil at 16% and 8%. Lastly, by dispatch type, 32%, 48% and 20% are baseload units, intermediate units and peaking units.

Per the company’s 4Q 2006 presentation here is a breakdown by region:

Mid-Atlantic                                         New York                               New England                        California

Capacity by Fuel Type:

Coal        56%                                        Coal        21%                        Oil           43%                        Gas         93%                       

Dual        38%                                        Dual        77%                        Dual        43%                        Oil           7%

Oil           6%                                          Other      2%                          Gas         14%                                                                       

Generation by Fuel Type:

Coal        93%                                        Coal        79%                        Oil           56%                        Gas         97%

Gas         5%                                          Gas         16%                        Gas         44%                        Oil           3%

Oil           2%                                          Oil           3%

                                                                Other      2%

Demand typically grows in the 2% range annually, yet the difficulty and cost of adding new generation should limit supply additions. Moreover, the increasing construction and permitting costs require higher energy and capacity prices to justify new builds, which benefits Mirant’s existing fleet. According to Dynegy’s 2Q earnings presentation, costs and time to development (siting, permitting, engineering & construction) are as follows:

Gas simple cycle                                   $500-$800/kW (3-6 years)

Gas combined cycle                             $800-$1,100/kW (4-6 years)

Pulverized super critical coal              $2,400-$2,800/kW (7-10 years)

IGCC & IGCC with CO2 capture        $3,100-$4,100/kW (8-10 years)

Nuclear                                                  $3,800-$4,900/kW (10-15 years)

Given these factors and claims from other generators that power and capacity prices still do not justify greenfield expansions, additional demand will most likely be satisfied by brownfield expansions. These expansions are cheaper due to easier siting and permitting and the availability of basic infrastructure, including transmission. According to the company’s 3Q presentation, brownfield development opportunities of 2,500-3,000 MW, 4,000-5,000 MW and 1,000-1,500 MW exist at the California, Mid-Atlantic and Northeast sites. Mirant’s ability to add new units or repower existing units is a source of value discussed later.

Capital Structure

Considering the cash position and improved EBITDA, Mirant’s debt ratios are very reasonable. Assuming the existing cash is deployed for share buybacks and environmental spending, the company is levered under 3.5x.

Mirant Americas Generation              $1,700 MM

Mirant North America                         $1,406

Capital Leases                                      $34         

Total                                                        $3,140 MM

Environmental (NPV)                           $1,019

Cash Estimate (12/31)                          ($6,228)

NOLs*                                                   ($1,158) 

Equity Mkt Cap + Warrants               $10,939

Enterprise Value                                   $7,712 MM

* The L6 election for tax purposes means that change of ownership limitations are no longer a concern. The Pepco settlement increased the NOL balance and the environmental expenditures should receive accelerated depreciation (over five years) further increasing the tax shield.

EBITDA & Cash Flow

Mirant guidance is for EBITDA of $1,000 MM in 2007 and $907 MM in 2008. The decline reflects above-market hedges in 2007 and decreased plant availability offset by increased capacity payments. The guidance assumes limited contribution from California and the Northeast. This guidance seems conservative.

The environmental spending aggregates $1.6 BN (2007-2010), of which $1.2 BN will remain at year-end. To account for the one-time nature of these expenditures, I capitalize the costs and treat them as an offset to Mirant’s current cash balance. Once these capital outlays are complete, maintenance capital spending is expected to be in the $100 MM area. Interest expenses should be <$250 MM, especially when considering interest income. Taxes should be fairly small due to the large NOL.  

Valuation

At current prices, Mirant trades for 8.3x 2008E EBITDA. This compares to 9-10x for comparables. On a FCF basis, the company trades for around 11x after accounting for the share buyback and tax shield.

Selling the California or Northeast portfolio or both would monetize the strategic value of these sites with a limited impact on operating earnings. The age of many of these facilities and position within the dispatch curve results in limited profitability. However, these plants have significant value given their location coupled with the repowering and brownfield opportunities. A repowering to a more efficient unit is typically 2/3rds (or less) the cost of a greenfield plant. As such, I assign $400/kW to Mirant’s California (ex. Potrero) and Northeast plants (ex. Lovett) to capture this discount for $1.8 BN of total value.

Since these regions are notoriously tough to permit, a brownfield opportunity at an existing site is also valuable. Per discussions with industry experts, the ease of permitting, legacy transmission and other basic infrastructure results in $100-200/kW value for these sites. These development opportunities range from 7,500-9,500 MW as shown in Mirant’s 3Q presentation. Using the low-end of this range and $/kW estimate, I calculate $750 MM of value for the brownfield opportunities.

Enterprise value, excluding the value of these assets is roughly $5.2 BN. Using my “merchant” Mid-Atlantic estimates for 2008, 2009 and 2010, I calculate EBITDA multiples of 8.1x, 6.8x and 6.2x, respectively. The 2008 numbers are conservative given the temporarily reduced run times per the addition of environmental controls and the contango natural gas curve.  While I add in an estimate for CO2 costs, the numbers do not capture any benefit from SO2/NOx emission sales.  The relatively minor maintenance capital spending after the installation of the environmental controls results in strong FCF generation. While the asset sale process did not lead to a transaction, this shows the limited value ascribed to the non-Mid-Atlantic assets.    

So, what’s Mirant worth? Replacement cost is in the low $50s (excluding brownfield expansion opportunities). And this price does not capture the scarcity value of Mirant’s Mid-Atlantic coal plants since new coal facilities are virtually impossible to permit in Maryland. On a FCF basis, Mirant should generate close to $2.50 fully taxed ($7 PF NOL value), or around $3.60 considering the NOL. Again, this captures limited value to the non-cash generating assets and plant expansion opportunities. In light of these considerations, high $40s seems like a reasonable value. The share buyback and 9% FCF yield should provide some degree of downside protection.  As reserve margins trend lower, I would expect Mirant’s assets to trade closer to replacement value. Increases in power prices and capacity payments should result as the market factors in replacement cost economics.

Risks

1. Lower natural gas prices as natural gas often sets the price of power in Mirant’s locations.
2. Supply additions or additional transmission from the PJM West. Constellation nuclear plant (~2016).
3. Significant seasonality as the bulk of earnings should fall in the summer months (3Q).
4. Shutdown of Lovett, NY and/or Alexandria, VA plants.
5. Slowdown in demand growth (multi-year recession).
6. Carbon tax. Discussion below.

Assuming a cap and trade program similar to Europe, Mirant is impacted during the hours natural gas sets the price of power. When coal is on the margin, CO2 costs should be passed on to customers in the form of higher power prices. Natural gas plants emit roughly 60% as much CO2 as Mirant’s coal plants (per the company). Therefore, when natural gas sets the price of power, 60% of the cost of carbon credits should be factored into power prices. The cost of the remaining permits will vary based on the percentage auctioned versus distributed to existing players and the cost of offsets or abatement technology. The net result is discussed below considering both state and federal initiatives.   

The Regional Greenhouse Gas Initiative (RGGI) is set to begin in 2009. Maryland intends to auction 100% of the permits, but many issues have not yet been decided. Based on internal RGGI emission credit price estimates ($2-$10/ton), the impact on Mirant is between $7-$37 MM (all amounts pre-tax cost) in the 100% merchant scenario. In the early years (2009-2015) before emission step-downs, the cost is expected to be in the $2-$6/ton range reducing the near-term impact to $7-$22 MM by my estimates. I assume $22 MM. There are certain factors that can cause this number to be higher or lower (i.e. hedges, treatment of out of state capacity, assumptions on carbon content, etc).  

Federal legislation is of greater concern, but implementation is a ways off (2012-2013). Several players estimate a $10/ton carbon emission cap-and-trade price for their models. The impact to Mirant’s bottom line assuming a 100% auction is $37 MM. The suggested worst case scenario assumes a 100% auction and $30/ton cost, or a roughly $112 MM pre-tax hit, although this case is unlikely, especially in the medium term.

The state and federal carbon initiatives are designed to reduce CO2 emissions. However, current carbon sequestration is not yet technologically feasible. With legislative uncertainty and limited new coal development, new power demand will need to be met with other fuels or new transmission lines from resource rich areas. Since nuclear plants require a significant time outlay, new plants will need to be natural-gas fired as renewables do not yet generate enough electricity to move the needle. Transmission lines take a long time to construct and permitting is quite difficult. As new natural gas plants are high cost power generators, market-clearing heat rates should continue to improve in Mirant’s locations. Also, the added natural gas demand coupled with declining US reserves and limited LNG terminals lead many to assume CO2 legislation will be a net positive to existing coal generation (i.e. higher natural gas costs and power prices will more than compensate for emissions costs).        

Conclusion:

Mirant is a US infrastructure play trading at a discount to intrinsic value. The sizable cash balance and FCF generation limits downside at current prices, especially considering management’s share buyback plan. Changes in the political landscape given concerns about the environment and interest in renewable energy should lessen the boom-bust cycle typically seen in power markets as many builders are in a wait-and-see mode. At the very least, delays and the long lead time for new builds should extend mid-cycle and peak market conditions for several years resulting in healthy cash generation for Mirant.

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