Description

Primary Energy has been covered extensively on the VIC, however, I believe a series of recent events de-risks and simplifies the company and justifies a fresh look. The company has a complicated history: stapled/hybrid/enhanced income security (EIS), controlled/managed by EPCOR/Capital Power/Atlantic Power, debt-for-equity exchange, replacement of EIS with common shares, rights offering, Canadian listing/US assets, etc. See excellent write-ups by madmax989, grant387 and rainman1080 for additional information and an historical context.

Primary Energy’s core business is operating “energy recycling” facilities at steel mills. The company defines energy recycling as “the recovery of energy that would normally be wasted in industrial processes by flaring, exhausting to the atmosphere or operating low efficiency equipment, and converting it into electricity or thermal energy (steam).” To simplify, the company’s facilities take waste energy/heat and convert it into electricity/steam to be re-used in the steal-making process. Primary Energy owns and operates five energy recycling and CHP (combined heat & power) facilities that serve low-cost steel mills in Indiana:

• North Lake: 75 MW (upgrading to 90 MW) electrical capacity, contract with ArcelorMittal expires in 2042+
• Portside:  63 MW electrical & 495 Mlbs/hr steam capacity, contract with United States Steel expires in 2028
• Cokenergy: 95 MW electrical & 896 Mlbs/hr steam capacity, contract with ArcelorMittal expires in 2013
• Ironside: 50 MW electrical & 560 Mlbs/hr steam capacity, contract with ArcelorMittal expires in 2020
• Harbor Coal (50% interest): 110 tons per hour coal capacity, contract with ArcelorMittal expires in 2025

The company has taken several steps over the last few quarters to improve its profile:

• Simplified corporate structure: repurchased non-controlling interest and terminated external management agreement
• Refinanced into more flexible capital structure: reduced cost of capital to 5.1% from 6.9% (based on current Libor), reduced cash sweep from 100% to 50%
• Extended several key contracts: leaving Cokenergy contract renewal as primary focus

Cokenergy Renewal
The next step in the evolution of Primary Energy will be extending the Cokenergy contract which expires October 2013. The Cokenergy electricity/steam facility is integrated into the coke-making operation (owned by SunCoke Energy (SXC), contract also expires October 2013) which supplies ArcelorMittal. SunCoke is currently in negotiations with ArcelorMittal and plans to spend $50mm over the next 3 years to refurbish the facility. After SunCoke and ArcelorMittal have made significant progress/reached an agreement, I believe the Primary Energy/ArcelorMittal negotiations will advance beyond preliminary meetings and yield a favorable agreement. I believe the contract will be renewed based on the facility’s deep integration into the coke-making operation as the pollution control device, Primary Energy’s $12-14mm major maintenance/CapEx plans for 2012-13 and the facility’s low-cost source of electricity and steam.

The economics of the Cokenergy plant are difficult to estimate. For illustrative purposes, assume Cokenergy is 40% of Primary Energy total revenue: this implies Cokenergy revenue of $22mm. Assigning no value for the steam or pollution control implies an energy price of $33/MWh. The MISO-NI Hub forward curve is in the mid-$30/MWh range for peak/off-peak service over the next few years which gives me comfort a favorable agreement will be reached.

Valuation
Primary Energy generates significant recurring revenue (63% of total, likely declining under new contracts), strong free cash flow from its strategically positioned assets (at high quality host mills, low maintenance CapEx). All financials are USD & pro-forma for the new debt (estimated) and repurchase of the minority interest.

Price: $4.64 (converted from CAD)
Shares: 45mm
Market cap: $207mm
Cash: $35mm
Debt: $85mm
Enterprise value: $257mm

I estimate PRI is conservatively worth C$8-9 per share based on the likely Cokenergy renewal (at similar EBITDA level) and high quality, recurring free cash flow (contracts expiring in 2020, 2025, 2028, 2042+).

Run-rate EBITDA is approximately $36-40mm ($38mm mid-point, 6.8x EV/EBITDA). The company has a $50mm NOL (potentially additional $30mm from COD income) and should not pay cash taxes for 3-5 years. I estimate $0.70 normalized FCF per share (normalized maintenance expenditures & CapEx, no cash taxes). Based on the current share price, the stock is trading at 6.5x my estimate of normalized FCF. Excluding Cokenergy’s estimated 40% contribution to company-wide EBITDA, results in $0.37 normalized FCF per share (12.5x).

My forward valuation model assumes a base EBITDA of $38mm that grows 2% annually. By 2015, the company will be in a $50mm net cash position and generate $0.79 FCF per share ($0.68 fully-taxed FCF per share).

There are no direct comparables (or recent private market transactions) for PRI, however, I believe independent power producers (IPPs, 7-10x EBITDA), industrial gas companies (8-11x) and renewable energy companies (12-13x) exhibit similar characteristics.

If you assign no value to the steam capacity and Harbor Coal, Primary Energy’s 283 MW capacity is being valued by the market at $910/kW. This compares favorably to new power plant construction (natural gas: $1000/kW, see http://www.eia.gov/oiaf/beck_plantcosts/pdf/updatedplantcosts.pdf).

PRI is likely to reinstate its dividend. Assuming the company pays out $0.33 per share (50% of normalized, full-taxed 2014 FCF), the stock would trade at C$8.38 with a 4% yield.

Catalyst