Description

Primary Energy Recycling Corporation ("PRI" or the "Company") (TSX: PRI) is a British Columbia based corporation that captures and recycles waste energy from industrial processes and converts it into reliable and economical electricity and thermal energy for its customers' use.  As such, PRI provides a "green" solution to supplying its steel mill customers with low-cost energy.   PRI indirectly owns controlling interests in four recycled energy projects and a 50% interest in a pulverized coal facility (called Harbor Coal).  The projects have a combined electrical generating capacity of 283 megawatts and a combined steam generating capacity of 1,851 Mlbs/hour.  PRI's projects provide a very stable cash flow stream, have no direct commodity price exposure and are situated on-site at some of the most efficient steel facilities in North America.  PRI has been written-up twice in the past - once by me (9/18/07) and again by Grant387 (4/3/09).  These write-ups have comprehensive descriptions and we therefore use this as an opportunity purely to update VIC on several key events that have led to what we think is a very compelling idea.  We have known this company for several years and are very intimate with the details.  We believe an investment in the stock would provide an expected 32% IRR over a 3-4 year investment horizon and a multiple of invested capital of roughly 2.5x, with limited risk and the potential for even higher returns. 

PRI's $131 million term loan (and only existing debt) was set to mature on August 24, 2009; however, at the last minute the Company was able to extend the loan until February 24, 2010 by converting its then outstanding subordinated debt into common equity and agreeing to higher interest rates and fees.  PRI then completed a refinancing of the bank debt on November 13, 2009, replacing the old facility with a new $105 million amortizing term loan.  The new facility has a five-year term, with interest at L+350 bps with a 2% LIBOR floor.  The loan is amortized through a full cash sweep, which leaves the Company unable to pay dividends until this facility is retired. The Company stated that the facility should be repaid in full in approximately three years as a result of the cash flow sweep.  As the new facility only provided enough cash to partially repay the old one, the Company also raised $58 million through a rights offering.  In addition, PRI arranged for a termination provision in its management agreement with EPCOR USA, and eliminated the allocation agreement that inhibited growth prospects.  Now with its own employees, the Company will be in much greater control of its own destiny.  Importantly, the former CEO (John Prunkl) also returned to oversee completion of the refinancing and lead the Company going forward.  John is honorable, intelligent and understands PRI's assets thoroughly.

As a result of the refinancing, the Company has virtually eliminated its balance sheet risk, as well as greatly simplified its capital and corporate structure.  The unusual EIS structure has been replaced with a standard corporate structure.  The shares remain listed on the TSX and trade under C$1, but we expect that a near-term reverse split and an eventual (though not guaranteed) U.S. listing will encourage greater investor awareness and participation.  For now, PRI remains an orphaned stock as dividend-focused income trust investors have fled, leaving a vacuum in their wake.

Now that the balance sheet is fixed, we can turn to some of the other risks in this investment.  One is steel.  In addition to the refinancing-related issues, PRI faced a test in 2009 in terms of its exposure to steel mill customers.  The types of blast furnace steel that PRI's customers produce faced unprecedented declines, and inventories and capacity were reduced significantly in response.  In rough terms, by July demand and inventory declined about 50% from before the meltdown, while nearly 60% of capacity was removed.  Since then conditions have been improving, though they remain meaningfully below prior levels.  We can look at 2009 as the perfect storm for PRI, and what is telling is that EBITDA bottomed at around $30 million annualized.  This is partly because around 60% of PRI's revenues are from fixed fees that it receives regardless of volumes.  Also, PRI's particular mill hosts are among the most efficient in the country (particularly Mittal's very large blast furnace #7) and were therefore run at higher capacities than the industry.  The 2009 performance serves to put a floor on earnings for valuation considerations.   

The other major risk relates to the contracts - whether and at what levels they will be renewed.  Three reasons why we think this risk is unlikely to be an issue:

1.      PRI provides energy at substantially lower cost than alternative sources, so it is unlikely to be shut off as long as the host is operating. 

2.      PRI's projects reduce environmentally hazardous emissions for the host facilities.  Without PRI this role would need to be replaced.  This is becoming more important as government increases its focus on environmental issues and clean technologies.

3.      The replacement costs of the projects are very high and a replacement provider would need to rebuild the facilities and earn an adequate return to be competitive.  The economics do not pencil for a new entrant, nor is capital readily available for these types of projects.

We have done detailed work to support these claims and would be happy to discuss them in the Q&A if anyone is interested in drilling down.  Now that the refinancing is behind them, management is 100% focused on renewing the contracts and extending them for long periods.  If Harbor Coal is any indication, there is reason to be optimistic.  The Company was able to negotiate a very fair outcome while working from a position of weakness - a bad balance sheet and a bad contract.  Harbor Coal was not only reworked favorably, but was recontracted through 2025.  The remaining projects are much more straightforward and play mission critical roles for the hosts' operations.  Given management's focus on this issue, we expect the extension of contracts to act as a major catalyst for the stock.  Three of the five assets are up for renewal by 2013.

            From a valuation perspective, what is most compelling about PRI is the inherent stability and quality of earnings.  Even in the worst of times, the Company produces $30 million in EBITDA.  As virtually all capex is taken through the P&L as maintenance expense, EBITDA drops down entirely to cash flow available to service debt.  Now that the EIS structure has disappeared, the Company is a full tax payer, so these earnings are taxable.  The Company lost most of its NOL through the restructuring process.  Turning back to EBITDA, in order to understand underlying historical performance we separate the Harbor Coal asset from the rest of the projects.  This is because the Harbor Coal contract was materially altered in April 2008 (and applied retroactively to the beginning of 2008) to reduce the volatility of cash flows to PRI and virtually eliminate any associated commodity risk.  Please refer to our earlier write-up for more details.  For 2008 and 2009, the Harbor Coal results are valid.  EBITDA for the projects ex-Harbor Coal ranged from $31 to $36 million from 2004 to 2008, while Harbor Coal contributed $6.4 million in EBITDA in 2008.  On a consolidated basis in 2009, we think EBITDA will be in the $33-$35 million range.  We can conclude from history that normal consolidated EBITDA should be around $38-$43 million.  After $7.4 million of annual interest (which will reduce over time as the loan is paid down), it leaves pretax cash flow of around $31-$36 million, and aftertax cash flow of around $20-$23 million. 

            The market valuation is currently as follows:

Price/sh: C$0.85

Shares: 156.5 million

Market cap: C$133 million = US$128 million

Debt: $105 million

Cash: $13.5 million

Enterprise value: $219 million

EV/EBITDA = 5.1-5.7x

P/FCF = 5.5-6.5x (yield = 15-18%)

Our DCF analysis points to present value of around C$1.50 per share, or 75% upside, using an undemanding 11x FCF exit multiple and assuming no replacement of debt as it is amortized.  If intrinsic value is realized at the end of 2012, the IRR is 32%.  We think there is significant margin of safety in these numbers - even at $28 million of recurring EBITDA, we come to a share price above the current market price. 

The scenario painted above assumes "life as usual".  There are some elements of potential upside that could be considerable:

1.      Refinancing of credit facility with permanent debt, allowing payment of dividend and stock that trades on yield

2.      Sale of the company - several parties showed interest in the assets before the refinancing took place, and it would be easy to eliminate duplicative corporate overhead by tucking the PRI projects under a larger corporate entity

3.      Monetization of carbon credits / environmental incentives

4.      "Growth" multiple awarded by market as new balance sheet eventually affords Company the opportunity to raise and allocate capital to additional projects - recycling waste energy is a huge and potentially attractive area for industrial companies of all sorts

While we cannot put a number on the potential value, any of these could result in meaningful upside.

Catalyst

Contract renewals

U.S. listing