| 2007 | 2008 | ||||||
| Price: | 20.20 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 1,766 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
| Borrow Cost: | NA | ||||||
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USEC Corporation
There is a great opportunity to short USEC (ticker USU). The stock was the subject of a positive writeup by mark81, which was a great call when he made it in 2005. USEC is often touted in the financial media as one of the few ways to play the “uranium renaissance,” but the company’s recent performance and its prospects don’t live up to the hype.
USEC enriches uranium into fuel suitable for nuclear power generation (low enriched uranium, or LEU). They also are the exclusive agent for the sale of LEU from decommissioned Russian nuclear warheads (under the Megatons to Megawatts program, or M2M).
As mark81 predicted, the price of uranium has soared, making USEC’s enrichment services more valuable. USEC’s stock is up 70% since May 2005. To put this into perspective, however, over that same period, the spot price of uranium has increased more than five-fold, from $25 to $130 per pound.
I’m publishing this as a separate piece because circumstances have changed considerably in the last two years, and it’s time to take the other side of this trade. Costs have increased (USEC’s gross margins declined 26% from 1Q06 to 16% in 1Q07, largely on increased electricity costs, with management projecting 9% for FY07, and further future deterioration); the company’s source of below-market price uranium from Russia is on shaky ground; the company’s ability to extract excess uranium from its operations has diminished; the dividend is gone; management has become downbeat in its communications with shareholders in an attempt to get subsidies from the US Department of Energy (DOE) that the company isn’t going to get; and USEC will need to raise significant equity in 2H07 to fund it’s behind-schedule and over-budget modernization project (the American Centrifugation Project, or ACP). Despite the favorable uranium market, management has guided to a breakeven year for 2007 and an operating cash flow burn around $70 million (this doesn’t include capital expenditures).
My price target is $12, which I expect the stock to reach this year as the company struggles to remain profitable and to raise the funds it needs to revamp its technology.
Not Quite Playing In Paducah
The Paducah plant, currently the only commercial enrichment facility in the US, employs outmoded gas diffusion technology, which uses 20 times as much electricity as does modern centrifugation technology to perform the same enrichment. With the rapid increase in electricity costs over the last year, USEC’s production costs have skyrocketed.
At Paducah, USEC processes uranium supplied by its utility customers into LEU, mostly under long-term contracts. A utility will provide raw uranium to USEC for enrichment, specifying the level of enrichment in terms of a tail assay, meaning the concentration of U-235 in the depleted uranium after processing. USEC keeps the depleted uranium (what’s left after removing the LEU). Historically, the company has squeezed out additional SWUs by over-enriching, in a process called underfeeding. USEC keeps the excess SWUs from underfeeding for sale on the open market.
A lower tail assay means that USEC delivers more SWUs to the utility, which increases USEC’s revenues. Enrichment to a lower tail assay also costs USEC more to process, because it takes more work to get more SWUs out of a given supply of raw uranium. Finally, at higher SWUs, less uranium is left in the tailings for USEC to obtain by underfeeding.
USEC presold most of its enrichment capacity for the next several years in the 1990s at prices below current per-SWU levels. The prices in old contracts do not incorporate the large increase in SWU pricing (according to Klaus Lohrey of NUKEM GmbH, a nuclear consulting firm, prices climbed from $83 to $132 per SWU between 2000 and 2006) or USEC’s increased electricity costs. Most of the company’s enrichment contracts give customers considerable flexibility in determining the level of enrichment that USEC must provide (typically 0.2% to 0.35%), though current contract terms specify a much narrower range. In a time of rising uranium prices, customers are demanding more SWUs at below-spot market prices at precisely the time that USEC’s per-SWU costs are increasing. To add to the pain, low tail assay specificiations restrict USEC’s ability to underfeed. USEC is losing money on its enrichment operations.
In June, USEC signed a long-term power agreement with the Tennessee Valley Authority. That contract includes adjustments for TVA’s cost, so the new contract should not significantly ameliorate USEC’s energy cost problems unless energy prices fall dramatically.
Megatons To Megalosses?
USEC remains solvent because it imports LEU from Russia at below-market rates for resale in the US under M2M. That program expires in 2013, and is subject to cancellation by Russia on 60 days’ notice. Russia, which has excess enrichment capacity based on centrifuge technology in addition to its highly enriched uranium (HEU) from nuclear weapons, signed a suspension agreement in the 1990’s with the US, under which Russia cannot export LEU to the US outside the M2M program.
Russia, which has repeatedly said that it will not renew M2M after 2013, is also pushing to abrogate the suspension agreement, which would let Russia terminate M2M and sell LEU directly to US utilities. That may well be the price the US needs to pay to gain Russian cooperation to prevent the development of nuclear weapons in Iran, which is the Bush administration’s top diplomatic initiative vis-a-vis Russia. (Although Iran is the main threat, the US also wants broader Russian participation in the Global Nuclear Energy Partnership initiative that would expand the use of nucelar power while limiting access to weapons-grade production materials worlwide.)
On July 2, Presidents Bush and Putin signed a nuclear cooperation agreement (known as a 123 Agreement, after the section of the Atomic Energy Act that sets the terms for commercial nuclear cooperation pacts). A 123 agreement becomes effective automatically unless both houses of Congress pass a joint resolutions within 60 days (while they are in session) disapproving the deal.
Although the terms of the 123 agreement are not yet public (I will publish the text as a comment here when the government releases it), the two governments released a “Declaration on Nuclear Energy and Nonproliferation Joint Actions” at the summit indicating the intent of both countries to cooperate in efforts to prevent nuclear proliferation. Notable among the declared activites is a pledge to provide to other nations
“nuclear fuel services, including taking steps to ensure that the commercial nuclear fuel market remains stable and that states are assured of reliable access to nuclear fuel and fuel services for the lifetime of reactors, including through establishment of international nuclear fuel cycle centers, to provide nuclear fuel cycle services, including uranium enrichment....”
Any market stabilization or establishment of enrichment centers would increase competition for USEC. If the price for Russian cooperation in Iran is opening the US market to Russian LEU, that’s a hands-down winne for the US, and one that the US nuclear generating industry (USEC’s customers) would gladly support.
One fly in this ointment is the Iran Counter-Proliferation bill currently awaiting approval in the US House of Representatives (the House Foreign Affairs Committee approved by a 37 to 1 vote), which would prohibit new cooperation agreements or contracts between the US and countries that facilitate the Iranian nuclear program or that sell sophisticated weapons to Iran. This section takes dead aim at Russia. While this provision, if enacted, could support M2M (by limiting the ability of the US to abrogate the suspension agreement), Russia would likely view this as a slap in the face, and might well respond by terminating the M2M program.
Competiton
Worldwide, currently operating nuclear power plants consume around 45 million SWUs annually. USEC (excluding M2M) provides approximately 10% of annual SWU production. Russia, with 40% of the world’s enrichment capacity (nearly all centrifuge-based, and much of it sitting idle) is well placed diplomatically (as discussed above) to gain import concessions from the US. Moreover, Russia and Kazakhstan have just agreed to build a 5 million SWU plant in Siberia by 2013.
Even excluding Russian competition, USEC faces several competitive threats. French nuclear engineering firm Areva and Urenco, a Brtish/Dutch/German uranium enrichment consortium, expect their 8 million SWU capacity centrifugation plant in France to begin initial operations in 1H09. Under a 2005 ruling by the US Court of Appeals for the Federal Circuit, enrichment contracts are deemed services that are exempt from antidumping and countervailing duty laws (the US government is still collecting countervailing duties pending further action in the Court of International Trade and by the International Trade Commission).
Lousiana Energy Services (LES, a syndicate led by Urenco) has started construction of a 3 million SWU plant in New Mexico. Areva also hopes to start construction on another US 2 million SWU centrifugation facility in the US in 2010. Both of these plants will use centrifugation technology that has already proved successful in commercial use in Europe.
Finally, other promising technologies are on the horizon. Most notably, General Electric and Silex are preparing to build a laser enrichment demonstration plant in the US (USEC had initially licensed the Silex technology, but backed out in 2003 to focus on ACP).
USEC’s Future: American Centrifugation Project
USEC’s hopes for the future rest on the American Centrifugation Project (ACP), a centrifuge-based plant the company is building in Ohio. This is a good strategic move for USEC—they can’t survive without switching from gas diffusion to a more efficient technology, especially since they will lose M2M cashflows in 2013 (if not earlier). USEC’s centrifugation technology has not been tested commercially, so there are some performance risks associated with ACP that Urenco and Areva (the other firms building US plants) do not face.
ACP will incorporate Department of Energy technology, so DOE will receive royalties from ACP operations. DOE has rights, which may include termination of USEC’s technology license or the termination of the M2M program, if USEC fails to meet stated milestones, including the securing of financing for a 1 million SWU centrifugation plant by January 2008 (this deadline was already extended by DOE by one year). USEC currently projects reaching 3.8 million SWU capacity by 2012.
The most critical issue the company faces in ACP, it’s most important project, is financing. USEC expects ACP to cost $2.3 billion , at a total cost of $2.3 billion (up from their original $1.7 billion estimate, and still a highly dubious number) over the next six years.
The company has well deserved junk credit ratings (CCC from S&P, Caa2 from Moody’s), so financing options are limited. In the last earnings call, management reiterated its guidance that it will burn $65 to $75 million in cash from operations in 2007, which doesn’t include around $200 million in capex for ACP this year, with another half a billion dollars in ACP committments next year. They had $288 million of cash on hand at the end of 1Q07, but have $150 in debt to repay over the next two years. Project costs for the first 1.1 million SWU from ACP should run around $1 billion, assuming no cost overruns.
The company stated in their FY06 10-K,
“Given the declining level of cash generated by our existing operations due primarily to increases in electric power costs, the increase in cost to complete the American Centrifuge project and the current level of perceived risk in the project, we will need some form of investment or other participation by a third party and/or the U.S. government to raise the capital required in 2008 and beyond to complete the project on our deployment schedule.”
Among the technology risk, the history of delays and cost overruns in ACP even before construction has begun, and the company’s unfortunate balance sheet, USEC must do a substantial equity raise in 2H07 to attract lenders to ACP by the January 2008 deadline.
USEC’s Dubious Present
Federal Loan Guarantees
USEC has applied for loan guarantees under Title XVII of the Energy Policy Act of 2005 (EPA 2005). DOE, which (in consultation with the Treasury Department) controls the awards of guarantees, currently has authority to guarantee up to $4 billion in loans to commercialize pollution reducing technologies. DOE has limited the initial $2 billion of guarantees to ten specified categories that do not include nuclear projects, so USEC appears to be ineligible for the initial set of loan guarantees.
DOE received 143 pre-applications, requesting $27 billion in guarantees for projects with total cost estimates of $51 billion in the first round. They say they “will seek to have a broad portfolio of large and small projects, for a wide variety of technologies.” Given that only $2 billion in loans can be guaranteed in the first round, this does not bode well for a meaningful guarantee of USEC’s $1 billion plus project.
The funding bill that the House Appropriations committee approved in June would give authority to DOE to guarantee another $7 billion in 2008 ($2 billion less than the Bush administration had requested), but specifically would carve nuclear power plants out of the appropriation request. While this would not technically prevent DOE from guaranteeing loans for ACP, it’s unusual for an agency to raise the hackles of the appropriating committees.
Any guarantee would require by law a substantial equity contribution, a reasonable prospect of payment of any guaranteed loan, and an independent review of the expected credit subsidy cost (the present value of the expected costs to the government upon default) of that guarantee. Financial review would require the submission of a credit rating from a nationally recognized rating agency. Rating agency policy in general prohibits issuing ratings that are conditional on the success of the project (i.e., they won’t say “AAA rating provided the project works”).
If USEC’s pre-application, filed last year, is rejected (which I believe will happen), it will not be able to receive guarantees under subsequent solicitations for applications until the January 2008 extended deadline for financing ACP has passed.
In the unlikely event that USEC does receive a DOE guarantee this year, several features of the guarantee program significantly reduces the value of the guarantee to potential project finance lenders: The amount of guaranteed loans is capped at 80% of the value of a project by statute, and DOE has proposed a guarantee limit of 90% of any loan. Absent a specific appropriation by Congress, EPA 2005 requires borrowers to deposit an amount equal to the subsidy cost with the
High Assay Tailings
DOE has ambitious plans to sell uranium from its inventory under its proposed long-term uranium sales strategy. Of particular interest to USEC is the stockpile of high-assay tailings (depleted uranium that remains from previous enrichments; with the increase in uranium prices, it is now economical to reenrich those tailings to obtain additional SWUs). The increase in the price of uranium over the last six years has made further enrichment of these tails economically desirable. USEC has the only currently operating US-based facility that can process these high assay tails, though European enrichment plants could also do this work. Moreover, USEC is not the only company with hat in hand on the DOE’s doorstep. LES has asked for some free uranium, too, as has uranium ore processor ConverDyne.
The mood in Congress is unfavorably disposed to a gift of high assay tailings to USEC. In particular, John Dingell, the influential Chairman of the House Energy and Commerce Committee, will closely scrutinize any such transaction. Dingell has asked “whether we should be allocating this $2 billion or $3 billion to children’s health insurance instead of subsidizing executives who have mismanaged their companies.” The Chairman added that USEC had “squandered resources on multimillion-dollar golden parachutes, stock buybacks, and dividend payments that frequently exceeded their earnings.”
Dingell and other Congressment have asked the Government Accountability Office (an investigative agency within the US Congress that scrutinizes federal expenditures) to evaluate DOE’s options for disposing of their surplus uranium, asking specifically for an analysis of DOE’s legal authority to transfer uranium and the government’s options if USEC shuts its current enrichment facilities or fails to commercialize ACP. (See http://energycommerce.house.gov/Press_110/GAO%20Letter%20%20-%20USEC%20May%2023%202007.pdf). I understand that GAO will meet with Congress in the next several weeks to discuss these issues.
Things don’t look much brighter on the Senate side. The chairman of the Senate Energy Committee (Jeff Bingaman, D-NM) and the committee’s ranking minority member (Pete Domenici, R-NM) are both from New Mexico, the site of the LES centrifuge project, so they are not likely to look with great favor on subsidies for a competing out-of-state project. New Mexico is also one of the five candidate states for the location of Areva’s proposed US centrifugation facility.
Given the current budget deficit, the stated commitment of the House Democrats to “pay as you go,” the overall Democratic Party antithesis toward nuclear power, and the negative view of powerful Congressional leaders, getting free uranium tailings will be a hard sell for USEC. It is more likely (though hardly certain) that DOE might sell the high assay tailings to USEC. However, running more uranium through USEC’s high cost plant will not be a significant boon to the company without some form of cost subsidy from DOE, and that I don’t think they can get.
Spinning Out of Control
Management has already started making with downbeat public statements, which I believe are intended to cajole DOE into providing assistance to USEC (though, in fairness to management, I do think the picture is relatively bleak). We will see more gloom and doom forecasts as they approach the 1Q08 ACP financing deadline. I highly recommend reading the company’s latest 10-K, 10-Q, and related earnings conference calls to see how management has already set this process of reducing expectations in motion. It is quite artfully done.
The main difficulty with USEC’s use of the “nuclear option” is that they are belittling their prospects at the very time they need to raise a lot of new equity.
Conclusions and Catalysts
The bull case for USEC requires all of the planets align: a return to profitability at Paducah, no early termination of M2M, no entry of Russia into the US LEU market outside M2M, and successful completion of ACP on time, on budget, and with some form of DOE subsidization that eliminates the large dilution from the inevitable equity raise later this year. However, several upcoming catalysts with likely negative outcomes make this stock a prime short.
Price Target
Price targets in the $20’s from the sell-side analysts, are based on what I believe are unrealistically optimistic scenarios. If any piece goes wrong, USEC shares should plummet. My $12.00 valuation is supported by the drop in price from $22.00 to $18.00 on a negative report the New York Times ran in mid-June discussing some of the issues I have raised. The impact from the negative events when they are announced should be considerably greater than $4.00. The stock has recovered to $20.00 in the last three two weeks, without positive news, which is why I believe that this report is timely despite the bad press.
Risks
USEC could succeed in getting a large government handout or DOE loan guarantees, though I think that’s unlikely given Congressional scrutiny and the limitations of the initial solicitation guidelines under the DOE guarantee program. Energy costs could fall dramatically, reducing the cost disadvantage under which USEC’s gas diffusion plant operates. Competing projects could experience delays or (particularly in the case of GE’s laser project) could be scrapped due to technological or regulatory impediments. Finally, there have been intermittent rumors that USEC is involved in merger talks, which I discount—with USEC’s heavy debt burden and negative free cash flow, who would want to buy this train wreck?
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