| 2007 | 2008 | ||||||
| Price: | 21.68 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 91 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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SUMMARY
Pennichuck
Corporation (“Company”), a New Hampshire water utility, is a long because it has
no downside, trades at a 25% discount to intrinsic value on a DCF basis, trades
at a 15% discount to its peers on a multiple basis, should receive substantial water
tariff increases over the next two years as it roughly doubles its ratebase,
and is highly likely to receive a favorable ruling in Q1 2007 regarding its
eminent domain lawsuit with the City of Nashua.
The stock has no downside as it stock currently trades at a slight
discount to the amount the City of Nashua (“City”) recently testified to the
New Hampshire Public Utilities Commission (“NHPUC”) it would pay for the assets
it seeks to seize plus the value of the assets the Company would retain. Furthermore, you get paid a 3.2% dividend as
these catalysts unfold. Disclosure and
CYA: we are currently long this stock and may sell at any time. We make no claims regarding the accuracy of
this analysis and strongly encourage readers to perform their own due
diligence.
COMPANY
OVERVIEW
The
Company is a non-operating holding company deriving income from 5 operating
subs:
-
Pennichuck Water Works (“Water Works”): a regulated water utility serving
25,000 customers in
-
Pennichuck East Utility: a regulated water utility serving 4,900 customers in
communities near
- Pittsfield
Aqueduct Company: a regulated water utility serving 2,100 customers in
communities near
- Pennichuck
Water Service Corp: provides non-regulated water monitoring, maintenance,
testing and compliance reporting for cities and businesses in southern and
central
-
Southwood Corporation: Pennichuck’s real estate division- owns 500 acres of
land outside of
EMINENT
DOMAIN LAWSUIT
In
April 2002, Philadelphia Suburban Corporation, the predecessor to Aqua America,
proposed a buyout of Pennichuck for $106 million, or $33/share. In response, the City of
(1) is the taking of the utility assets of Water Works in
the public interest? If yes, then;
(2) the “fair value” the City of
I
provide more detail on the lawsuit at the end of the write-up, but for now just
know the following facts:
-
In April 2006, the Staff of the NHPUC issued a 70-page report recommending that
the asset seizure NOT be allowed to occur.
-
On January 16, 2007, just four days into the NHPUC trial, the City and the
Company agreed to a 120-day postponement to work on a settlement. For agreeing to the delay, the Company demanded
and received a $250,000 cash payment. I
believe this payment is indicative of the strength of the Company’s case versus
the City.
Based
on the NHPUC Staff’s official recommendation and the strength of its arguments,
I believe it is 80%+ likely that the NHPUC rules against the asset
seizure. My thesis does not depend upon
this being the case, however, and I address alternate scenarios later in the
write-up. In valuing the Company as a
going concern, I first assume that the NHPUC rules that the City’s seizure of
Water Works’ utility assets is not in the public interest. I then
employ two methodologies in valuing the Company- a DCF analysis and one based
on a multiple of price/book. The
price/book analysis is highly appropriate as it is the primary valuation metric
employed in water utility transactions.
*DCF Analysis*
(in millions) 2003A 2004A 2005A 2006E 2007E 2008E 2009E
Revenue 20.97 22.83 23.77 24.92 28.98 33.34 36.98
EBIT 5.20 6.24 4.85 4.29 6.42 8.34 9.39
EBIT
Margin 24.8% 27.4% 20.4% 17.2% 22.2% 25.0% 25.4%
NOPAT
(39% tax rate) 2.62 3.92 5.09 5.73
WACC:
6.1%
Terminal
growth rate: 3.0% (appropriate given long-term water infrastructure capx
requirements)
Total
debt: $47 million at 12/31/06
Shares
outstanding: 4.21 million at 12/31/06
PV
/ share: $27.07 (25% premium to current price)
*P/B
Multiple Analysis*
Price/book is the primary
valuation metric of water utilities as book value is an accurate proxy for
their ratebase, which is the basis for PUC rate-setting. Pennichuck’s price to book is 1.8x, far below
the sector average of 2.4x. Furthermore,
recent water utility transactions (
(in millions) 2003A 2004A 2005A 2006E 2007E 2008E 2009E
Revenue 20.97 22.83 23.77 24.92 28.98 33.34 36.98
EBIT 5.20 6.24 4.85 4.29 6.42 8.34 9.39
EBIT
Margin 24.8% 27.4% 20.4% 17.2% 22.2% 25.0% 25.4%
EPS 0.39 0.57 0.13 0.05 0.19 0.27 0.28
Book
value/share 9.44 9.36 10.89 10.26 11.70 12.42 12.79
Low
Case Base Case High Case
Probability 20% 60% 20%
2008
BV/share 11.50 12.50 13.00
P/B
multiple 2.1x 2.3x 2.5x
Implied
price/share 24.15 28.75 32.50
PV/share
(24 mos @ 8% discount rate): 24.50
(14% premium to current price)
BACKSTOP
PROTECTION TO VALUATION
It
is the attractive risk/reward that makes this situation particularly
compelling. The stock has no virtually
no downside in the event that the NHPUC allows the City’s seizure of Water
Works’ utility assets by eminent domain.
The stock currently trades at a slight discount to what the City has
testified to the NHPUC it would pay for the assets it seeks to seize plus the
value of the assets the Company would retain.
If the NHPUC determines that
the taking of the assets is in the public interest, they are required to determine
the price the City is to pay for the assets.
If the price is unacceptable, the Company would appeal all
the way to the New Hampshire Supreme Court, if necessary, a process which would
take at least two years. If this occurs,
the Company will continue its capital expenditure program. The City has already
filed testimony with the NHPUC that it values the assets at $85 million as of
Dec 31, 2004, plus any capex spending completed between end of 2004 and the date
the transaction closes. The Company has
since completed exactly $30 million of capex, bringing the total to $115
million as of Dec 31, 2006, or $16.50/share after adjusting for $45 million of
debt. The remaining $20 million of capex
would be completed by the time the Company’s appeals are complete (1-2 years)
if they don’t like the NHPUC’s initial valuation, bringing the total payment to
approx. $135 million, or $20/share after adjusting for $55 million of debt (my
forecast calls for the issuance of $10 million of addt’l debt over next two
years).
Furthermore, even if the
seizure occurs the Company would retain the following assets:
- 2 regulated water utilities
serving a total of 7,000 customers (approx ¼ the size of the seized system)
- an Operations &
Management business (operates several municipal-owned systems in NH) doing $2.5
million/yr @ 15% operating margins
- 500 acres of land outside
If we assume that each of the
Company’s remaining water utility customers are only half as valuable as each
seized customer , value the O&M business at 8x EBIT, and value the land at
$8,000 per acre, the total value of the remaining assets is approximately $4.00
per share. Add that to the $16.50 per share the City has testified to the NHPUC
it would pay for the seized assets and we arrive at a worst-case scenario
valuation of $20.25 per share, slightly above the current price of $19.80.
Asset $/Share
(worst case) $/Share (base case)
Remaining 7,000 regulated
water customers $ 2.00 $ 2.00
O&M business $ 0.75 $ 0.75
Zoned land $ 1.00 $ 1.00
---------------- ------------ ----------
Total value per share $20.25 $27.75
POTENTIAL UPSIDE
- The Company has stated that
if the fair value figure determined by the NHPUC is high enough, they would not
appeal the decision. The Company has not
stated what their reservation price is, but they rejected an offer from the
city in Nov 2003 for $121 million. The
“independent” water utility valuation expert the Company hired testified to the
NHPUC that fair value for the assets in question is $248 million (the actual
report is available on the NHPUC website), equal to $48.20 per share, based
primarily upon replacement cost less depreciation.
RISKS
- In the event of a purchase of Water Works’
utility assets by the City, the Company will incur a capital gain equal to the
purchase price less its costs basis in those assets, taxed at 35%. The Company has not publicly disclosed its
cost basis, but in its Nov-2003 offer, the City estimated the tax liability
triggered by the sale to be $15 million.
I do not account for this tax liability for two reasons: First, Section
1033 of the Internal Revenue Code provides that real property that is the
subject of a compulsorily or involuntary conversion from an eminent domain
proceeding (condemnation by local, state or Federal government) can be exchanged
on a tax-deferred basis for property that is similar or related in service or
use to the property that was involuntarily converted, as long as the conversion
occurs within two years. I should note
that the Company’s CEO was a tax partner at E&Y for 10 years. Second, the City’s Nov-2003 offer of $121
million was comprised of two parts: $106 million for the assets AND $15 million
to cover the Company’s tax liability triggered by the asset sale. It is likely that the tax liability generated
by the asset sale will be factored into the price determined by the NHPUC or
one offered by the City prior to the hearings.
- The lawsuit drags on for
several years. Whoever loses the NHPUC
ruling may appeal, and the process may drag out for another three to four
years. The Company would continue
incurring substantial legal expenses, and the eminent domain overhead would
continue to be a drag on the stock. But
the longer the case drags on, the more plant upgrade expenditures are incurred
which ultimately increases the enterprise value of the Company.
WHY IS THE MARKET
MIS-PRICING THE STOCK?
The stock has experienced a
“perfect storm” of bad news over the past few years:
- It has suffered from
investor fatigue due to a 3-year legal battle with the City of
- Financial performance has
also suffered as eminent domain-related legal expenses have been significant
($0.39/share in 2006).
- It has no analyst
coverage. All sell-side coverage of the
stock ended when the eminent domain case began.
- Pennichuck’s highly
respected CEO Don Correll recently left to take the CEO job at American Water,
German-giant RWE’s
APPENDIX: DETAIL REGARDING
THE NHPUC STAFF RECOMMENDATION
In April 2002, Philadelphia Suburban
Corporation, the predecessor to Aqua America, proposed a buyout of Pennichuck
for $106 million. In response, the City
of
(1)
is the taking of
the utility assets of Water Works in the public interest? If yes, then;
(2)
what is the “fair
value” of the assets seized to be paid by the City of
The Staff stated that while
there were a number of reasons why it reached this conclusion, it was the
combination of such reasons that solidified it. The Staff stated such reasons,
in order of importance, as follows: (a) the Staff's belief that Water Works and
its regulated affiliates, and to some extent its non-regulated affiliate,
"constitute a true regional water utility" with a record of
cooperating on water supply and distribution issues, and the Staff's belief
that the evidence in the docket shows that a taking of Pennichuck Water's
assets would eliminate such important benefit to the State; (b) the Staff's
belief that the evidence in the docket shows that the taking of Water Works’
assets "would adversely affect rates" in the Water Works’ regulated
affiliates and "would cause substantial harm" to its non-regulated
affiliate; (c) the Staff's belief that the City's proposal "contains
uncertainties and lacks evidence demonstrating that important functions such as
customer service and billing and collections [would] be adequately
addressed"; (f) the Staff's belief that acquisitions of "small
troubled water systems" by the Company and its affiliates would not be
likely to continue if the City were to succeed in its eminent domain effort;
(g) the Staff's belief that the City's "projection of a lower cost of service"
under its contracts with third party operator and oversight contractors
"is speculative" as the City's rate projections are based on the
City's estimated value of the assets, which has not been established; and (h) the
Company serves customers in stand-alone systems beyond the boundaries of the
City, and the Staff's concerns, based on one of the City's stated reasons for
the taking--that it no longer wishes for the City's customers to subsidize the
rates of those systems, as to whether the level of service and capital
improvements those systems currently receive under Water Works’ would be
compromised by the City's ownership of Water Works’ assets.
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