Description

PRI has been posted twice before, and those write-ups and discussions are worth a careful read.  That said, the current situation has changed enough that I think a new write-up would be helpful.  In summary, Primary has now completed its financial restructuring and has modest leverage (less than 3x debt to EBITDA), a simpler corporate structure (no more stapled securities, no longer controlled by EPCOR), is benefitting from quickly recovering steel industry utilization, and trades at a 30% FCF yield (which is also about 40% of asset replacement value). I believe that within one year, Primary stock could easily double.

Company Overview

• Owns and operates 4 waste-to-energy facilities and 50% of one pulverized coal facility co-located at U.S. steel mills (Mittal & US Steel).  These facilities generally capture wasted heat energy from steel hosts, convert it to electricity, and sell it back to the steel hosts under long term contracts.  These contracts have a larger fixed portion plus a smaller variable, volume-based portion.  283 MW electric capacity + 1,851 Mlbs/hr steam capacity.  The facilities generate power at extremely low cost (not counting the huge upfront capital costs already spent), and represent true clean energy.

• Steel mill hosts are known as high quality, low-cost facilities (this is a critical point).  In particularly, Mittal's Blast Furnace #7 (which drives the majority of Primary's operations) is well known as one of the lowest cost mills in the country and always operates at much higher utilization than industry averages.

History

• Primary was initially listed on the TSX in order to access the well established yield market, as an income trust-like security (not technically an income trust but paid no taxes due to huge depreciation and interest tax shields).  Stock still trades in Canada despite U.S. assets and USD-based financial statements.  Primary has, until recently, been controlled by an established, publicly-traded Canadian utility (EPCOR, recently renamed Capital Power Income Fund).  EPCOR retains an interest in the Primary but no longer controls the Primary.
• Primary suffered from combination of reduced profitability in 2009 as steel demand fell and an inability to refinance debt in new credit environment.  Previous credit markets had supported much higher debt levels and the stock (actually, stapled debt+equity) had traded at a 10% FCF yield after the larger debt load.
• Primary began its financial restructuring with a debt-for-equity exchange to remove the small standalone high yield slug ("bachelor bonds"), resulting in modest dilution to equity.  Then, Primary exchanged the former stapled Enhanced Income Security" (which was stapled high yield and equity) or EIS with common shares.
• However, to the surprise of many investors Primary was still unable to refinance its already-extended $130mm term loan, and ended up executing a $50 million rights offering that was back-stopped by a couple of large investors for a fee.  Using the proceeds from the rights offering plus a new $105mm term loan, Primary was finally able to complete its financial restructuring in November.  Post the rights offering, total debt is only 3x trough EBITDA (and 3x EBITDA less Capex), and Primary has $13 million of excess unrestricted cash on hand as well.
• Stock is now a true orphan, with no sell-side coverage, a Canadian listing despite a US business, no real comps (Covanta and Ormat would be the closest), 156 million shares outstanding, and an 0.84 Canadian dollar stock price.

Financials

• Note that the stock price is in C$, but all financials and the entire business is USD-based.  The numbers here assume the current exchange rate of 1.033 C$/USD.
• Also note that in the valuation table at the top, I have used EBITDA in the EBIT field (the VIC form has limited flexibility in this regard), as the EBIT multiples are not as relevant here.
• Looking through the noise of the messy capital structure and recent one-time problems, these assets have averaged around $45 mm of EBITDA over the years.  Over the first 6 months of 2009 (obviously a terrible business environment with reduced steel production at Primary's locations) Primary was on a run-rate of around $32mm EBITDA.  Demand and profitability are now improving, so that $32mm was clearly the trough.  Steel companies have announced stronger outlooks and industry utilization is significantly improving.  Primary publicly stated on the last earnings call that "normalized" EBITDA is at least $40 mm, and I believe the number is about $45mm.  2010 EBITDA might be between $40 and $45 mm (Primary provides no guidance).
• The beauty is that Primary has virtually zero capex (they conservatively expense virtually all maintenance outlays and the projects have remaining lives of multiple decades).  Also, Primary pays no cash taxes and won't for years due to large depreciation shield and NOLs.  So EBITDA less Interest essentially equals free cash flow.  As such, EBITDA is not really the most telling metric on which to value Primary (FCF is the best one).

  Issues/Risks

• Why was the refinancing so difficult despite apparently strong credit ratios and a huge margin of safety versus asset value?
  • The main reason was a very conservative lender approach regarding contract renewal, wherein the lenders would not consider any cash flows post the current expiration dates.  As a result, Primary could only get the $105 million term loan, and has a 100% excess cash flow sweep (so can't pay dividends or buy back stock).
  • A secondary reason is botched execution by Primary's management team, Board, and lead banker (CSFB).  By all accounts Primary did not create any competition among lenders, and engaged CSFB without a reasonable commitment to actually lead the bank group with a sizeable capital commitment.
• What is the contract renewal risk?
  • This is really the key question right now.  Three of the five contracts expire within 3 years, including one in 2011.  I think the answer is that there is a virtually 0% chance of the contracts not being extended on reasonably similar (or even superior) terms.  If Mittal or US Steel declined to renew the contracts, they would be faced with the choice of either (a) constructing replacement facilities (themselves or with a partner), or (b) purchasing grid power.  Upon examination, each of these scenarios is implausible.
  • Replacement facilities would have 2 year lead times for design and construction, and would cost easily over $500 million (for all 5 facilities together, that is).  This is not realistic given tight capital budgets and the presence of perfectly good facilities on site. 
  • Purchasing from the grid would be significantly more expensive for the steel companies based upon current grid prices, even before a potential doubling of industrial power prices (NIPSCO rate case happening this year).  This would also likely lead to an outcry over the lost environmental benefits that Primary currently provides. 
  • The reality is that both Primary and the steel hosts really need each other, and a continuation of the relationship is sensible.  It should also be noted that with a significantly de-levered capital structure, Primary will have the ability to play hardball if necessary and won't be constrained by lender demands.  And, for at least some of Primary's facilities, Primary would have the right to continue operating even if the contract were terminated, and could sell the power to the grid as an alternative.
  • For anyone who really struggles with this issue, I would encourage you to visit the facilities and see the scale of the capital involved and the integration with the steel hosts.
  • I would expect, though, that negotiations will not be quick and easy, and the 2011 North Lake contract could go down to the wire.  As a result, the market could certainly be spooked by the impending deadline.
• Could new carbon emissions regulations impact Primary?
  • This is possible.  Ultimately, Primary is a clean energy company that helps the environment, and therefore should not fare poorly if the legislation is sensible.  But without knowing any details, this is tough to predict and is an issue worth keeping an eye on.  At this point I do not believe this is an issue that the market is worried about regarding Primary.
• What is the quality of management?
  • I think this is a bit of an open question.  My take is that they are solid operationally but not expert financially (as evidenced by the refinancing issues).  Currently they do not have any meaningful stock based comp, which is troubling, but I understand that this issue is under Board consideration now that EPCOR's control of Primary has been eliminated.

 Outlook

Given the 100% excess cash flow sweep, Primary does not currently have any opportunities to create value through share repurchases or institute a dividend policy (with the exception of the $13mm of unrestricted cash).  So, for the next year or so I would expect Primary to pay down debt and work on contract extensions.  I believe that Primary is also considering a reverse split and a US listing (as mentioned on the last earnings call).  Once the extensions are complete (maybe late 2010 or early 2011), Primary will have the chance to create value by (i) refinancing its restrictive debt (102 takeout declines to 101 next year) with a more flexible loan that would allow share repurchases or dividends, and/or (ii) buying out EPCOR's equity stake while simultaneously terminating EPCOR's management services agreement to completely sever the EPCOR relationship (cost of $8mm now that declines monthly).  Primary has indicated that it expects to be able to repay 100% of its debt over the next three years, and this paydown will create a lot of value and a lot of opportunity for accretive financial engineering.

With a normalized FCF per share of 0.24, I see fair value of $1.60 per share right now (15% yield).  That fair value would increase as FCF is generated over time and would certainly increase with accretive share repurchases.

In summary, with the completion of the financial restructuring and the greatly improved steel outlook, I think Primary has finally reached an inflection point.  For investors willing to be patient over the next 12-18 months, I think this is a likely double.

Catalyst

Extension of contracts.

Reverse split/US listing which could increase the universe of interested investors.

Buyout of EPCOR stake.

Refinancing of senior debt in one year, creating share repurchase/dividend possibilities.

Valuation.