Description

Sierra Pacific Resources (the “Company”) is simply a pure-play regulated utility in Nevada that trades at less than ½ of its intrinsic value.
Through its two utilities, the Nevada Power Company (“NVP”) and the Sierra Pacific Power Company (“SPPC”), it services two of the fastest growing populations, Las Vegas and Reno/Lake Tahoe, respectively. In addition to a rapidly growing captive customer base, it also benefits from the good judgment of sticking to its regulated knitting, rather than overextending itself into capital-intensive ventures of unregulated wholesale energy/power trading, telecommunications, or international markets. However, it did lever itself up through paying too much for power in 2001 and after the Nevada Public Utility Commission disallowance earlier this year, it was left with $500 million of unrecoverable deferred energy costs ($300 million after-tax or $3 per share) and a non-investment grade credit rating. The market has overreacted to this quantifiable and containable problem, which the Company has already shown clear signs of correcting. It currently trades at $5.88 per share or $600 million in market value and has $3.7 billion of net debt and preferred. This represents around 5.5x forward earnings (under 5.0x run-rate earnings, which assumes a return to investment grade status) and less than 0.6x tangible book value. Historically, pure-play regulated utilities traded around 12x earnings and 1.5x book value. Since investors tend to invest in this sector for its security (since utilities are monopolies with guaranteed revenue rates) and dividend yield, they often trade inline with treasury yields – in low interest rate environments utilities trade at higher earnings multiples, in high interest rate environments at lower earnings multiples (10x – 14x). At the time of NVP and SPPC’s 1999 merger, they and their sector traded around 13x –16x forward earnings and 1.5x – 2.0x book value. On a run-rate basis, the Company should earn at least $1.20 in today’s dollars and have $11.00 in book value, which justifies a $14 per share valuation. Further it has a very serious offer on the table for the larger utility, NVP, from the state’s Southern Nevada Water Authority (“SNWA”) for $1.2 billion in equity value (and the assumption of $2 billion of debt) or approximately 11x run-rate earnings and 1.1x book value, which will immediately allow the Company to pay down debt and repurchase stock, leaving a smaller and cleaner utility with $0.80 per share earnings power and $11.50 per share in book value, creating at least $10 to $12 per share in immediate value.
The Company’s stock price originally traded down to current levels in May, due to the impact and risks created by the disallowance of the recovery of certain energy costs. It prompted S&P and Moody’s to downgrade the Company and its utility subsidiaries to non-investment grade, which (i) made funds more difficult and costly to borrow (important to utilities, which are highly levered entities) and (ii) allowed energy suppliers to demand complete collateral for their power supply contracts with the Company’s utilities and cancel contracts if the collateral requirements were not satisfied. This left the Company short power and funds right before the peak summer season and considering bankruptcy protection.
Since then, management arranged new sources of power and funds, made it through the summer and ran through what little was left of the high power contracts. It is now able to take advantage of an all time low power cost environment and to start paying down a lot of debt. The Company does not have any meaningful deferred energy costs that it needs to recoup and it has a terrific relationship with the power suppliers that stuck by its side through the difficult summer months. Its only risk is a significant lawsuit by Enron claiming liquidated damages in relation to certain high priced power contracts that Enron cancelled through its right due to the Company’s loss of investment grade status, which is being countered by the Company’s filing with the Federal Energy Regulatory Commission (“FERC”) that Enron and certain other suppliers artificially inflated power prices in the west in 2001 and prior years. In the unlikely case that the Company does not accept the offer from the SNWA, it will probably take over a year for it to return to investment grade and until such time it will have to offer high yield rates on refinancings and will have difficulty entering into long-term power contracts while costs are at all time lows (60% of the costs that are assumed in current regulated electricity rates). To confirm, the Company’s utilities are monopolies, with significant unencumbered assets, in a rising cash flow environment and therefore have no risk of insolvency. This became evident to the SNWA as well and that’s why it finally submitted its offer in August (recognizing it would not be able to buy it cheap and easy through bankruptcy).

Catalyst

The immediate-term catalyst and most likely case is that in light of the strong public and political support for the transaction, to avoid the tough road still ahead for the next year, and to have the opportunity to quickly correct the remaining problems and leave management with a strong and well capitalized SPPC (management’s original utility) the Company accepts the SNWA offer. Potential upside exists from other buyers, potentially well capitalized foreign utilities that have been waiting on the sidelines for the right time to build a U.S. presence.
If management avoids the takeover there will still be softer catalysts. The utilities will be generating a lot of cash and will be paying down a lot of debt, therefore getting closer to investment grade again and further away from its recent problems.
Other catalysts are (i) resolution of its Enron lawsuit, (ii) an award from its FERC filing, (iii) confirmation that it does not need to recover any more energy costs in its upcoming filing with the public utility commission, and (iv) completion of refinancings.