Description

Primary Energy Recycling ("PRI") is an enhanced income security ("EIS") that like so many other companies has been taken out to the woodshed and been beaten.  Today it trades at CD$2.82 and pays a monthly distribution at an annualized rate of CD$0.80 equating to a yield of 28.3%. 

Quick refresher: 

Primary Energy owns four recycled energy projects and a 50% interest in a pulverized coal facility.  The projects have capacity generate just over 280 MW and throw off consistent cash flow.  The Company is positioning itself to be sold and has hired the requisite croupiers.  Were they not to sell out, their relationship with the Manager of business (Epcor Power LP) puts them in a favorable position to bid on over 470MW of new projects. 

In September 2007, madmax989 wrote an excellent write-up on VIC on PRI detailing the specifics of the EIS, the structure of PERC and the various entities involved.  I will not regurgitate those facts here as they were presented with great clarity.  While obviously a lot has changed in the external financial environment since then, the only thing that has changed materially for the Company is that the uncertainty regarding a large contract (Harbor Coal) has been cleared up.  The result was a more stable business model albeit at slightly lower overall earnings from historical peak amounts.  The details of the Harbor Coal agreement can be found later in this analysis.

Here's the gist of the idea.

• The current credit market has created numerous high yield opportunities. This is another in the long line of those ideas.
• The "backing" of the assets that generate cash flow at Primary Energy are a) long lived power generating assets, b) some of the most efficient producers in the country, c) at some of the most efficient steel mills in the country, d) thus producing stable cash flows.
• Past two years look a tad messy due to renegotiation of Harbor Coal contract....but reality is that cash flow earning power is still intact and consistent.
• Current yield of security (28%) is essentially pricing in a 95% dividend cut to equity (even assuming an above market yield on the sub-debt portion of the EIS).
• Market seems to be completely ignoring one highly probable scenario which is as follows:

In these turbulent times why would a lender want to "force" a workout?  I think the answer is they don't want to.  Primary is in compliance with covenants and the business is stable.  As the deadline draws near it seems reasonable that the lender lets Primary to continue to roll on while they focus on more pressing lending issues.  Thus Primary Energy will "roll over" their debt successfully with some sort of "pound of flesh" given to make the bankers look good.   The $135M term loan matures in August 2009.

 We speculate that a potential banker punishment is a reduction in the divided.  We use a 75% reduction in the dividend to arrive at our downside case.  Under this assumption we still see ample upside, coupled with a strong double digit yield. 

 The capital structure is somewhat convoluted - but the cash flows to the owners of the EIS are not.  They are real.  They show up in my account every month.  So, I'd be happy to answer questions you may have but I'm not going to lay out all the detail here as the previous write-up did a nice job.  Suffice it to say that the current price of the EIS is only C$0.30 above the value of the debt portion of the EIS (C$2.50).

 This table pretty well sums up my view:

On top of the stable cash flows, the potential sale, and the potential growth the Company really is in a nice spot to take advantage of the "green" / alternative energy future.  They are a recycler pure and simple.  They have executed very well over the past few years and they should benefit from energy hungry companies that are looking to become more energy efficient. 

 A comment about the potential sale.  This may be a situation given the current environment that this is a good news/bad news.  Good news because the price may be a nice "pop" and good implied annualized IRR.  But bad news in that given the depressed multiples we may see only a $$6.50 - 7.00ish offer.  If this is not sold and the market believes the consistency of the numbers I think this could go higher.....and I'd like to see the company execute on some of the new opportunities anyway. 

 Harbor Coal -  As taken from the 2008 Annual Financial Statements, the Harbor Coal contract was renegotiated in March 2008, with the following details:

The Company has an indirect ownership interest in a joint venture through PERH's wholly owned subsidiary Harbor Coal LLC ("Harbor Coal"). Harbor Coal owns a 50% interest in PCI Associates, a partnership that operates a pulverized coal facility. The investment is accounted for using the proportionate consolidation method in accordance with Canadian GAAP requirements. The carrying value of Harbor Coal's interest in PCI Associates reflects a purchase price allocation to adjust the values ascribed to long-term assets to fair value as of August 24, 2005. The excess purchase price allocated to property, plant and equipment and intangible assets has been recorded in the books of Harbor Coal.

The consolidated financial statements for the years ended December 31, 2008 and 2007 include $3.3 million and $8.6 million, respectively, of related depreciation and amortization. On March 14, 2008, the PCI Partnership Agreement was amended retroactively to January 1, 2008, with the term of the PCI Partnership Agreement extended by twelve years to August 31, 2025. Beginning on January 1, 2008, Harbor Coal's share of PCI revenue is based on tons of coal consumed multiplied by a fixed rate per ton. Under the amendment, inventory adjustments are assumed by the site host and, except for certain defined shared expenses, (property taxes, insurance and depreciation), operating expenses are assumed by the site host subject to specified thresholds. Operating expenses above specified thresholds are shared ratably. Additionally, the amortization periods for contract value intangible assets recorded on the books of Harbor Coal and the depreciable lives of the property, plant and equipment held by PCI Associates have been extended to correspond to the new expiration date of the PCI Partnership Agreement.  For periods prior to January 1, 2008, revenue at PCI Associates was determined based on the displacement of certain defined commodities by coal. The value of the displaced commodities net of the cost of coal utilized represented revenue.  The amount of displacement was impacted by physical inventories of the commodities utilized by the joint venture's host. The amount of coal consumed also determined the service fee paid to the manager of the partnership and was recorded in operating expenses. For the year ended December 31, 2007, Harbor Coal recorded a negative revenue adjustment of $7.2 million based on reduced consumption associated with physical inventory adjustments recorded by the facility's host.    

For the years ended December 31, 2008 and 2007, Harbor Coal's recorded share of PCI Associates depreciation was $0.8 million and $1.7 million, respectively. For the year ended December 31, 2008, Harbor Coal's share of excess operating expenses of PCI Associates was $0.9 million.

 Catalysts:

Narrowing of yield.

Potential sale of Company.

Successful restructure of debt.

Catalyst