Description

I first recommended Sierra Pacific Resources about a year ago. In the interest of full disclosure, my fund, which I joined since then, has a long position in the security. Although, the stock price is about where it was almost a year ago it has a lot less stand-alone hair on it and a much less turbulent ride to what I estimate to be $8.50 in fully-diluted book value and $0.75 in fully-diluted run-rate earnings by the end of next year. Therefore, based on typical and understandable market multiples for healthy utilities of around 1.2x book value and 12x earnings and those results, the Company’s stock should eventually trade above $9 per share. To review, the Company is a regulated utility holding company which operates two utilities in Nevada: the Nevada Power Company which sells electricity to 669,000 customers in Las Vegas, the fastest growing market in the country and the Sierra Pacific Power Company which sells electricity, as well as gas, to 318,000 customers in Reno. Sierra Pacific has found the operating environment particularly challenging over the last several years because the state has repeatedly attempted to deregulate the market and, failing that, to establish a rate system that would set a ceiling on customers’ electricity costs. In addition, due to the company’s (i) inability to develop new generation plants to keep up with its markets’ rapid growth and (ii) practice of entering into shorter-term supply contracts, Sierra Pacific was starkly exposed to the volatile and soaring energy markets of 2000 and 2001.

The breaking point for the company occurred in March 2002 when the Nevada Public Utilities Commission rejected the Company’s request to recoup, through increased electricity rates, some 40% of the $1.2 billion in energy costs (known as deferred energy assets) in excess of what it was previously allowed to collect through rates. Considering Sierra Pacific’s total book value was $1.7 billion prior to the disallowance, this was a substantial blow. In addition, the severe nature of this ruling, even allowing for imprudent prior actions by the company, raised concern of a very strained relationship with the all-powerful local utility commission. Since the company was now prevented from increasing its rates to service the debt it incurred in financing the disallowed deferred energy asset, S&P and Moody’s downgraded the debt of company and its utilities to junk status. Downgrades are particularly damaging for utilities since they are (i) typically highly levered, (ii) need to go to market often for financings, and (iii) have energy supply contracts that require either investment grade status or full collateralization.

As a result of these developments, Sierra Pacific’s shares trade below $5. At such levels, the company is trading at approximately 10x analysts’ estimates for 2003 earnings and, primarily due to anticipated higher debt costs, 12x 2004 estimates. While Sierra Pacific is, arguably, trading at a fair multiple of its earnings, it is an attractive opportunity for several reasons. First and foremost, as an owner of regulated utilities, the company’s operations are permitted to earn a 10-12% return on book value. Because of this, most regulated utilities trade at a small premium to book value while Sierra Pacific’s shares are trading at almost half of stated book value and 85% of the worst case scenario book value. Second, the company had dramatically improved its relations with the local public utility commission which lent substantial credence to the notion that it would ultimately earn the regulated return on its book value. All three commissioners stated that they were pleased with the steps management had taken since the deferred energy asset debacle and issued a much more favorable deferred energy asset ruling in May 2003. Third, most of the company’s business uncertainty had already been resolved as it refinanced most holding company debt (given, on worst possible terms) and locked in most of its power supply needs for the summer and beyond. Fourth, Sierra Pacific’s markets continue to enjoy 5% population growth and faster demand growth. Properly managed, as the company benefits from this captive customer growth, revenues and earnings should grow in turn, making the company worth a premium to its peers. In addition, Sierra Pacific still has well over $450 million of deferred energy assets to amortize over the next couple years, the cash flow from which will allow it to pay down a significant amount of debt and move its earnings back in line with its book value. Finally, the company currently earns one of the lowest regulated returns on equity in the industry, leaving it with the prospect of meaningful improvement in this figure as the result of its next general rate case.

Catalysts:
Resolution of Enron’s Liquidated Damages Suit and Corresponding Deferred Energy Asset – Recently the NYC court judge ruling over the Enron bankruptcy concluded that the Company must pay Enron’s full $300 million liquidated damages claim (through saying he lacked the authority to change the terms of a power supply contract). As indicated by the chairman of the Nevada Public Utilities Commission, who has become quite approving and supportive of the Company, there is still a lot of room for the Company to appeal this ruling. In the worst case scenario, the Company will have to pay the full $300 million by the end of this year and get nothing back from the public utility commission in higher rate, which, through the high amortization of its already approved deferred energy assets, it will almost generate in free cash flow in the second half of this year. Further, since the payments would be due from the utilities and not the Holding Company, they could borrow against their assets to fund any shortfall, which still have a lot of borrowing room. This worst case, would cost the Company about 87¢ of book value. More likely, the Company will reach some settlement with Enron, which will want to resolve most of these matters before emerging from bankruptcy, and then recoup a lot of the remaining liquidated damage costs through the following deferred energy case. I am assuming they settle for ½ of the $300 million and recoup ½ of that payment in rate through the approval of the corresponding deferred energy assets. In its last deferred energy case, it lost only 20% of its requested deferred energy claim from above market electricity contracts.

Upcoming General Rate Case – The Company’s utilities will file a general rate case later this year and the Nevada PUC will rule on it early next year. Since the Company’s utilities are currently receiving regulated ROEs that are on the low end of the spectrum, there isn’t room to lose from this case. I expect the Company to get increased rates to cover increased pension, insurance and interest rates, and to amortize goodwill. Utilities always get increased pension, insurance, and interest rates covered through rate increases and the Company has achieved the cost savings it told the Nevada PUC when it requested approval for the Nevada Power/Sierra Pacific Power merger which created the goodwill. To be conservative, I assume the Company recoups only ½ of its increased interest rates and goodwill and receives no increase in regulated ROEs, all of which would be upside to the previously stated valuation.

Return of Investment Grade Rating and Dividend Program – As the Company continues to generate significant cash flow by amortizing its deferred energy asset, it will be able to pare down its debt load and return to investment grade status, which will give it greater financial flexibility and the ability to reinstate its dividend policy. I am thinking this should happen by the end of next year.

Loss of Casino Customers – A bunch of the Company’s big casino customers have been threatening to procure energy from other sources. This seems to worry some, but in fact would benefit the Company greatly. The Company doesn’t make money on the energy it sells, it just burdens its balance sheet by entering into long-term supply contracts for power. However, the Company does make money on running electricity through its transmission and distribution lines, which all occupants of Las Vegas and Reno have to use even if they arrange to receive power from other sources.

Catalyst