Description

Mirant is a post-bankruptcy merchant power generator trading below its asset value, and at 5.3x EBITDA, well below its comps which trade at around 8x.  The discount is unwarranted, but its various moving parts and short post-bankruptcy history are confusing the issue.  It emerged from Chapter 11 in January with a very under-levered balance sheet and over $2.6 billion of NOLs.  It’s recently announced some very favorable actions, including large asset sales and a large share buyback in the form of a Dutch auction tender.  The tender should take place later this month.  When the asset sales are completed within the next year or so, Mirant will have a huge net cash position, and management has publicly committed to return further capital to shareholders.  The shares are worth $35-41, and with the proposed actions, the value gap should close relatively quickly.

BACKGROUND

Mirant started life as the unregulated utility division for Southern Company, and then became an independently traded firm in 2000 through an IPO and a subsequent spin-off.  In the frenzied industry environment of the late 1990s and early 2000s, just about every IPP pursued reckless debt-financed expansion and questionable power trading tactics, and Mirant was no different.  Its stock was a disaster during the short time it was public, and when the company couldn’t meet repayment deadlines in 2003, it was forced into Chapter 11.  Lack of liquidity rather than insolvency was the primary trigger to the filing, since Mirant possessed good assets and strong underlying cash flow.  The new MIR stock began trading in January, and the old equity holders were able to salvage a tiny amount of value for themselves, which speaks to the underlying asset value.

Mirant currently owns 17,575 MW of electricity generation capacity worldwide, with 14,230 across the U.S. mostly in urban coastal markets, and another 3,345 overseas in the Philippines and the Caribbean.  The U.S. assets are all unregulated, while the overseas assets are regulated.  Trading is an inconsequential part of the business.  Coal is about 45% of the mix, with the remaining mostly gas.

ASSET SALES AND RETURN OF CAPITAL

Mirant has put up for auction its Philippines and Caribbean assets, and also six U.S. gas plants that don’t fit into any strategic clusters.  Let me briefly run through what the likely sale prices of the various assets are.

Philippines:  A total of 2,306 MW capacity is owned.  Projected EBITDA is $375mil and $390mil for 2006 and 2007.  This is a very steady cash generator, since Mirant is the largest independent power plant owner in the country, operating on conversion contracts with the national government (Mirant takes virtually no risk on the cost of fuel or the sale price of its electricity generated).  At 8.0x 2007e EBITDA, this is worth $3.12 billion.

Caribbean:  Mirant owns 39% of PowerGen in Trinidad and Tobago, 80% of JPS in Jamaica, 55% of Grand Bahamas Power, and 26% of Curacao Utilities Co. in the Netherland Antilles.  Total owned capacity is 1,039 MW.  Projected EBITDA for Mirant’s share is $183mil and $190mil in 2006 and 2007.  At 8.0x 2007e EBITDA, this is worth $1.52 billion.

Six U.S. gas plants:  These plants have 3,504 MW of capacity, all peaking/intermediate, in Michigan, Georgia, Texas, Nevada, Indiana, and Florida.  Because these are geographically isolated for Mirant, management has decided it’s not particularly productive to own these.  Projected EBITDA is $81mil in both 2006 and 2007.  I value these plants at $250/KW (~40% of replacement cost), or $876 million.  Comparable transactions have been in the $200-400/MW range in the past couple of years.

The auction process for the international assets has already begun, and indications are that there are many interested parties.  The auction for the U.S. assets was just announced, and it’s too early to gauge its progress.  There should be minimal taxes paid on these sales, since the Philippines and Caribbean tax bases were written up to fair value before MIR emerged from bankruptcy, and the six U.S. plants will sell for below depreciated cost.  Obviously, if the international assets sell for more than what it’s carried at, it would incur a tax liability, but that would probably be incrementally good news, and the NOLs would shield the U.S. tax hit anyways.  Both the international asset sales and U.S. assets sales are expected to conclude by mid-2007, with a good shot at an earlier date, since final bids for the international assets are due later this year.

Concurrent with the Philippines and Caribbean divestiture announcement, Mirant announced a Dutch auction tender for up to 43 million of its shares (14% of outstanding) at prices between $25.75 and $29.00, to expire on August 21.  At the top of the price range, this will require a $1.25 billion outlay, and Mirant basically has the cash on hand to pay for it.  Additionally, management has publicly said that it plans on returning further capital to shareholders once the outcomes of these asset sales become clearer.  If the assets for sale obtain prices any where near where I’ve valued them (and I seem to be in-line with what others are projecting), Mirant will end up with a net cash position of well over $2 billion.  Needless to say, such a net cash position for a power company, even an unregulated one, is ludicrously under-leveraged, and management is planning on indicating how much will be paid out and in what form (buybacks or dividends) as the sales near completion.  From a pure balance sheet capacity standpoint, Mirant should be able to pay out $3-4 billion ($10-15/share) to shareholders in a year and still hold only modest debt, but it can’t do too much too soon because it would jeopardize the status of the NOLs.  An added benefit from the asset sales is that Mirant becomes a very attractive acquisition candidate.  I wouldn’t want to count on it, but it wouldn’t surprise me at all if Mirant were not independent three years from now.  This is clearly a consolidating industry, Mirant will have a focused portfolio of very attractive assets, and the long-term demand outlook for electricity is unquestionably good.

VALUATION

To do an enterprise value calculation, first let me reconcile Mirant’s capital position at June 30, 2006 with my projections for June 30, 2007, taking into account the announced actions.

Net Debt, June 30, 2006:         $2.69 billion

   Dutch auction                         1.25

   Philippines sale                      (3.12)

   Caribbean sale                       (1.52)

   6 U.S. gas plants                   (0.88)

   Free cash flow, NTM            (0.77)

Net Debt, June 30, 2007:         (2.35) billion

To calculate the share count, I take the 300 million basic shares outstanding, assume cashless exercise for the 53 million warrants outstanding, and then subtract the maximum buyback number from the Dutch auction.  I ignore the 2-3 million options outstanding for the sake of simplicity, since the impact is minimal.  The company reports 308 million fully diluted shares, so I’m more conservative here.

Shs outst:                      300.0 million

   Warrants dilution         11.6

Fully-diluted shs:           311.6

   Dutch tender              (43.0)

Shs outst, pro forma:    268.6 million

So the stock market is valuing the enterprise, pro forma of the asset sales and Dutch tender, as follows:

Aug 11 share price:       $27.47

Shs outstanding:            268.6 million

Market Value:              $7.38 billion

  Net Cash                    (2.35)

  Wkg Cap needs           0.50

NOLs                         (0.61)

Enterprise Value:          $4.92 billion

Two items above need explanation, working capital needs and the NOLs.  Management has disclosed that the businesses remaining after the divestitures will need about $500 million in liquidity for working capital, so I back it out of the net cash above.  As for the NOLs, Mirant has $2.6 billion or $3.7 billion depending on an IRS election they need to make by next year (the $2.6 billion has no limits on usage, while the $3.7 billion has annual limitations).  I tax-effect the $2.6 billion at 35%, and then haircut the result by one-third to assign it a $607 million value.

The stock is thus trading at an EV/EBITDA multiple of 5.3x based on management’s projection for $924 million in pro forma EBITDA in 2007.  This is well below the three closest comps NRG, Reliant, and Dynegy, which trade between 7.6-8.2x EBITDA estimates for 2007.  This makes absolutely no sense.  Once the divestitures are done, Mirant will be a highly focused company left with its crown jewels: 10,726 MW of a mix of baseload, intermediate, and peaking capacity clustered in four urban areas: Mid-Atlantic (esp. D.C.), New York, California (Bay Area), and New England.  These are very valuable assets in areas with growing demand and little new capacity; reserve margins in these markets should tighten quite a bit over the next five years or so, giving Mirant a very good profit growth profile for the next several years.  Also, even after any hefty payout to shareholders, the balance sheet will remain very solid, much better than any of its comps.  Offsetting this somewhat is that Mirant's plants are older in nature, creating higher environmental compliance costs.  Altogether, Mirant shares deserve at a minimum to trade in-line with its peers, and probably a premium.  At an in-line 8.0x EBITDA multiple, Mirant shares are worth $35.45/share.  At 9.0x, it’s worth $38.89/share.  That’s upside of 29% to 42% from today’s level.  With all the asset sales and return of capital slated, I think this value will be unlocked within the next year or so.

There are always risks to any EBITDA forecast, but I think they’re mitigated here by a couple of factors that bias the 2007 EBITDA upward, and which could be considered in appraising the share value.  First, Mirant reached a settlement in May with PEPCO over a disputed power purchase deal that was to run through 2021.  If this settlement is approved by the courts, it would add $32 million to 2007 EBITDA.  Second, Mirant has been embroiled in a property tax dispute in New York, and if a settlement is reached, that could add another $40 million to 2007 EBITDA.  These two points raise the range of Mirant's per share value at 8.0-9.0x EBITDA to $37.60-41.30, or potential 37% to 50% gains.

RISKS

Natural gas prices plummet.  Mirant is largely hedged for 2006, and about two-thirds hedged for 2007.  Management has estimated that every $1 move in gas prices will impact 2007 EBITDA by $62 million.  There’s a small cushion, since prices have moved up a little since the 2007 EBITDA projection was made a few weeks ago.

Management does something stupid.  Many thought that their recent hostile bid for NRG was stupid, and Mirant pulled the bid after several shareholders complained vociferously.  I actually don’t think it was such a horrendous idea, but I think it’s close to moot now.  They’ve reversed course magnificently with the asset sales and capital return proposals, and they’ve even recently hinted that being acquired may not be such an unlikely thing, either.

Environmental compliance costs rise.

Assets for sale fetch significantly less than I estimate.

Catalyst