Description
Investment Thesis:
USEC Corporation's ("USEC") equity has previously been written up on VIC on both the long and short side and these pieces provide sufficient background on the company. This piece focuses on USEC's only piece of publicly traded debt - the 2014 3% convertible debt currently trading at around $60-62. Over the past few weeks, the debt has traded down from $73 and currently yields 14.3%, despite significant asset coverage. The major driver of this decline was the announcement on 7/28/09 of the Department of Energy's ("DOE") rejection of USEC's loan application to fund the development of its American Centrifuge plant. The major reason behind the denial was concerns regarding the technical viability of the plant. As a result of the announcement, USEC's equity dropped from 35% with the convertible debt following along.
The decline in the equity price and consequent decline in the convertible debt has created this investment opportunity. As detailed in the prior USEC VIC submissions, the American Centrifuge plant would have required significant capital investment likely requiring equity and debt issuance on the part of USEC, but, if successful, would have provided for the long-term viability of the company. While the denial of the US loan guarantee has led to an effective cessation of this massive capital investment program and raised real questions about the Company's long-term viability, the USEC debt, while potentially losing the call option value of the equity, retains substantial asset coverage in the form of cash and inventory working capital in excess of its par value.
Finally, as an aside, please note that this write-up focuses primarily on the bond asset coverage and the VIC required earnings estimates are derived purely from bloomberg data and analyst estimates. FCF metrics reflect company guidance less maintenance capex and excludes American Centrifuge costs given the likelihood of the cessation of that project.
Company Description:
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). USEC currently operates a single facility at Paducah, which is relatively inefficient versus newer technologies due to its significant power demands. More efficient processes significantly reduce power consumption by 75% and there are competitors expected to enter the market with US-based alternatives in 2014/2015 timeframe.
Asset Coverage:
Set out below is a summary overview of the company's net asset coverage position at June 30th:
Excluding the cash position (discussed below), USEC has marketable inventory in excess of its outstanding debt by over 20%. USEC has an extremely limited ability to take on new debt at this time, given the limited prospects of the American Centrifuge plant and consequent reduced cash flow characteristics of the plant. The company does maintain a credit line which can be drawn upon to fund working capital uranium purchases; however, given its cash position, any draws on that line should be minimal.
The SWU and uranium inventory held by the company is valued at the lower of cost versus market. The market price of the company is higher than the company's cost and if the company was forced into a liquidation scenario and ceased operations, the excess SWU (very much integral to the nuclear generation process) would likely spike given the withdrawal of a significant supplier from the market. The uranium inventory belongs to the company and can be sold like any other commodity in the market. Obviously a significant decline in either of these two commodities would reduce coverage levels.
Aside from this working capital inventory, the Company currently has a positive net cash position and will continue to generate cash through the remainder of the fiscal year as detailed below:
The Eurodif settlement reflects the closure of a multi-year anti-dumping case that resulted in a positive legal settlement for USEC. While, on the surface, one could argue that USEC has significant additional cash reserves and such reserves would be available to creditors in a liquidation, its business cycle limits the use of the identified cash in a non-liquidation scenario. Specifically, nuclear reactors require repowering every 18 months during which time USEC generates the majority of its cash flows. FY2009 was one of the years USEC benefited from the repowering time table and it should use a significant amount of its free cash in FY2010 as repowering levels decline prior to an uptick in FY2011. In the absence of a bankruptcy filing, USEC will need to continue operating to fulfill its backlog and in an effort to be conservative, we have not considered its cash position in our asset coverage analysis.
Potential Catalysts:
- 1. Government Approval of Loan Guarantee - on August 4th, USEC announced that the government was reassessing its position regarding the loan guarantee and had entered into a process to facilitate a potential granting of the guarantee. There is substantial political pressure to provide the guarantee, as USEC is the only US-owned enrichment facility. While our investment thesis does not depend on any such loan guarantee, the approval of a guarantee would lead to an appreciation of the equity and a consequent significant rise in the convertible.
- 2. Government Final Denial of Loan Guarantee - if the government makes a final determination to not fund the American Centrifuge project, USEC will likely enter into a wind-down or sale scenario. In a wind-down scenario, a purchaser of the convertible debt is likely to receive full repayment given the extensive asset coverage detailed above and existing backlog.
Potential Risks:
- 1. Proceed with American Centrifuge Project on Standalone Basis - While theoretically possible, it is highly unlikely that the company could obtain the necessary financing given the current financing market and the hangover effect of the government questions regarding the technical viability of the project.
- 2. Dramatic Increase in Power Prices - While the company maintains retains long-term supply contracts, these contracts are not at fixed prices. A dramatic rise in power prices would lead to a decline in cash flows even in the repowering years.
- 3. Decline in Commodity Prices - a significant decline in SWU and uranium prices would lead to a reduction in asset coverage levels.
Catalyst
- 1. Government Approval of Loan Guarantee - on August 4th, USEC announced that the government was reassessing its position regarding the loan guarantee and had entered into a process to facilitate a potential granting of the guarantee. There is substantial political pressure to provide the guarantee, as USEC is the only US-owned enrichment facility. While our investment thesis does not depend on any such loan guarantee, the approval of a guarantee would lead to an appreciation of the equity and a consequent significant rise in the convertible.
- 2. Government Final Denial of Loan Guarantee - if the government makes a final determination to not fund the American Centrifuge project, USEC will likely enter into a wind-down or sale scenario. In a wind-down scenario, a purchaser of the convertible debt is likely to receive full repayment given the extensive asset coverage detailed above and existing backlog.