Description
USEC Incorporated (USU) is a “deep value” investment which is trading at a significant discount to its liquidation value and has imbedded optionality that could be worth 3-5x the current stock price. USU enriches Uranium for use in nuclear power plants. Based on varying assumptions, USU is worth $16-$20 per share upon liquidation. As a going concern, the company may be worth $25 - $64. The optimistic going concern values are premised on a combination of the dramatic rise in uranium prices over the last two years and value of the American Centrifuge plant which is expected to reduce manufacturing costs by over 70% beginning in the later half of 2007.
Many investors fail to appreciate the significant option value in the company as they do not fully understand the substitution effect of Uranium and SWU (the product produced by USEC). With Uranium prices at $29/lb. (vs. $15 in January 2004 and $10 in January 2003), prices for SWU may increase considerably in the near/intermediate term which should lead to significant appreciation in USU shares. The company is under-followed on Wall Street and is ignored by most investors as valuation multiples are significantly depressed due to the expensing of a significant portion of the cost of the development and commercialization of the American Centrifuge (.40 cents of EPS in 2005). In addition, USU has a dividend yield of over 4%, fairly enticing for a company with such significant growth prospects. I apologize in advance for the length of this write-up, uranium enrichment is not a simple industry.
The Business
USEC’s main business is to sell SWU – the effort necessary to convert uranium to an enriched state. A nuclear power utility purchases uranium from a miner (ie. Cameco) and provides it to USEC. USEC enriches the uranium and then returns the original Uranium + SWU (“LEU”) to the nuclear power utility. USEC bills its customers for SWU under 3-5 year contracts that generally include an inflation price escalator. The company also acts as an agent for the sale of Russian SWU into the United States as part of a government program called Megatons to Megawatts. The contract has been in existence for about 10 years and lasts through 2013. The contract with Russia allows USU to purchase SWU at a discount to market (for brevity I will avoid describing the full discount mechanism) which approaches 20%. In addition to SWU sales, USEC sells uranium off its balance sheet under long term contracts with utilities, and through a process called underfeeding, sells uranium generated from its Paducah Kentucky Plant into the spot market.
Option 1: Uranium Substitution
Enriched uranium is a partial substitute for natural uranium. This is a very complicated concept which I initially struggled with. It is the most misunderstood part of the USEC story and is the near/intermediate term catalyst that could turn this investment into a homerun. By adding additional SWU (more power) to Uranium, physics allow USEC to produce more LEU (SWU + Uranium) with less Uranium. In simplistic terms, customers currently have contracts with USEC to provide USEC with a set amount of Uranium for a set amount of SWU. As prices for Uranium increase, customers will opt to provide less Uranium to USEC and purchase more SWU. As demand increases, prices for SWU should increase. I provide an illustrative example in Appendix B. As prices for uranium increase (up from $21 per pound at the end of 2004 to $29 today and from $15.50 in January 2004), demand for enriched uranium will increase to a point a purchaser is indifferent between purchasing uranium vs. SWU. Based on uranium prices of $25 - $40 per pound, demand for SWU should increase between 10% - 30% or by 4 – 11mm SWU. Since there is limited additional supply available, SWU prices should move up to a price that would make utilities indifferent between purchasing uranium and SWU. It is possible that SWU prices increase $10-50 per SWU which would add 100-500mm in EBIT to USEC. Applying a 6x EBITDA multiple to this increase and this option is worth $7 - $35 per share.
Option 2: American Centrifuge
The company has been granted an exclusive license to use centrifuge technology developed by the US government and commercially deployed in the mid 1980’s. The technology is expected to reduce the cost of producing SWU by 70% by reducing electricity costs (60% of cost currently to 5% of cost), labor costs, maintenance costs and inventory costs. The plant will initially produce 1mm SWU in 2009/2010, 3.5mm SWU by 2010/11 and 7mm SWU by 2012/13. At current Term SWU prices of 108 – 30 (cost) = 78 gross margin per unit x 3.5mm units = 273mm of incremental margin. The cost to develop the first 3.5mm SWU will be 1.5B. The company expects to self fund the first 1mm SWU and once the technology is proven and easily bankable, find the remaining funding. The plant requires minimal capital expenditure once built (under $10mm per annum), so the cash generation will be tremendous. Using a terminal multiple of 8x 2013 volume of SWU (7mm units) at a 10% - 20% discount rate yields a value of $3 - $10 per share
(Note: since I provide the benefit of the SWU price increase in Option 1, I do not include it in Option 2. In reality Option 1 will not happen without Option 2. If the centrifuge does not work, the company will slowly liquidate until the completion of the Russian Contract in 2013 and will not realize the significant benefit of the SWU price increase).
Option 3: Increase in Nuclear Reactor construction
Various countries including India, China and more recently the United States, have indicated a significant interest in developing new nuclear reactors. Any real increase in the development and deployment of new nuclear reactors will have a clear benefit to USEC.
Liquidation Value
USU currently has three primary assets, a contract to resell Russian SWU, a gas diffusion plant located in Paducah, Kentucky, and working capital primarily comprised of SWU inventory and Uranium. The range of values indicated below are based on various assumptions for immediate term SWU pricing:
Russian Contract – 2005 – 2013 – Assumes no terminal value and a 10% discount rate (Russian sovereign debt trades at 6% yield and contract is with Russian government) – includes proportionate allocation of corporate overhead.
Value $6 - $8
Paducah – Assumes plant shuts down in 2011 with the federal government is on the hook for the majority of the shut-down costs (company actually received an NPV positive contract to manage the cold standby of the Portsmouth facility). This plant is terribly inefficient and only has real value if SWU prices increase to reflect Uranium prices. DCF at 10% discount rate and no terminal value - includes proportionate allocation of corporate overhead. Assumes no value for the benefit of underfeeding plant (could be worth as much as $75mm per year).
Value $2 - $4
Working Capital – USU has significant hard assets on its balance sheet including 1.2B in uranium and SWU inventory. The company is currently liquidating its uranium inventory and should complete the uranium liquidation by the end of 2007. The significant SWU inventories are kept as a buffer for downtime at the Paducah plant (if there is a problem, the whole plant has to shut down) and to buffer a late delivery from Russia. The company has over 1 year of inventory at the end of the first quarter of 2005. I do not DCF the liquidation proceeds as I am using a book value of the assets that is below market value and I assume that the DCF impact is offset by the fair market value. Current Assets (including long term inventory) – Total liabilities (excluding pension costs) – Net Pension Cost = Liquidation Value
1,488+147 – 931 -64 = $7.50 per share
Total liquidation Value $15.50 – $19.50
(liquidation value gives no value to consulting company NAC acquired in 2004)
Total Range of Values – Going Concern
Liquidation Value 15.50 – 19.50
Option 1 7.00 - 35.00
Option 2 3.00 – 10.00
Total 25.50 – 64.50
The Present:
USEC expects to spend 110mm for the American centrifuge in 2005. Including the cost of the centrifuge, USEC has guided that it will end the year with 200-220mm of cash. This would imply that pre-centrifuge and dividend, the company expects to generate 183 – 203mm in free cash flow from operations. In addition, the company’s guidance was prepared in September 2004 under former management when Uranium prices were at $19/pound vs. $29 currently and did not assume any material reduction in SG&A. The new CEO James Mellor has indicated that he expects to reduce SG&A by 20mm run-rate by the end of the year. Assuming half of the cut is obtained in the current year would add $10mm of EBITDA and 7 cents in EPS. The company has bonds due in January 2006 at 6.625%. As the bonds trade above par, I doubt the company will have a difficult time refinancing them at similar interest rates.
Paducah Plant
The Paducah plant is very inefficient and currently generates minimal operating income from SWU sales. In addition, the plant has an electricity contract that comes due in mid-late 2006, which may negatively impact operating results. Electricity is 60% of total Paducah costs and assuming a 10% increase in electricity prices, Costs will increase by 6%. This will partially offset the benefits of underfeeding which is described in Option 1 above.
Appendix A:
Historical SWU Pricing and Market
4 companies control 94% of the market for enriched uranium and barriers to entry are very high. USEC controls 28%, Tenex (Russia) 24%, Cogema 23% and Urenco 20%. USEC is the only industry participant that is not government owned. USEC and Cogema produce SWU using gas diffusion technology, which is very expensive and Tenex and Urenco uses more efficient centrifuge technology (although Tenex uses very old centrifuge technology). Urenco and Cogema are fully contracted while Tenex has modest additional capacity but can not access the US market until 2013. The nuclear power industry grows at 2-3% per year and Urenco has been adding capacity annually to meet the increased demand (about 1mm SWU per year). In the mid to late 1990’s SWU prices declined precipitously due to a combination of SWU oversupply and a decline in the value of the Euro relative to the Dollar (chief rivals Urenco and Cogema have 100% of costs in Euro markets). This was rectified by a trade case filed by USEC against its European counterparts (the government ultimately determined that there was no dumping) followed by the closure of USEC’s plant in Portsmouth, Ohio (5mm SWU or 13% global supply reduction), a move in the Euro/$ from 0.80 to 1.30 and annual growth in the industry of 2-3% for a few years.
Historical SWU Pricing
Prior to 1996 – 130/150
1996 – 97
1997 – 90
1998 – 85
1999 – 80
2000 – 80
2001 – 100
2002 – 102
2003 – 105
2004 – 107
2005 – 108
Appendix B: Illustrative Example – Substitution/Underfeeding
A utility provides 4 pounds of uranium and in return receive sufficient enriched uranium from the pound of uranium to operate its utility (1 SWU). USEC has the right to further enrich the uranium (1.25 SWU) but take out 1 pound of uranium and sell it into the open market. This is called underfeeding. In this simplistic case, the economics are as follows – uranium in the open market is worth $29 per pound x 1 = 29 less the incremental unit cost per SWU of $75 x .25 = $18.75. The net benefit is $10.25. Again, these numbers are for illustration only. As uranium prices increase, USU will be able to generate additional underfeeding and higher cash flows and earnings. But, the value of underfeeding is minimal in relation to the benefit of increasing SWU prices – with 5mm SWU in sales, I estimate USU can only generate 5mm pounds of underfeeding (at $15 per pound or 75mm of annual EBIT but dependent on the continued operation of the Paducah plant).
Catalyst
SWU Price increase
Test results from American Centrifuge
Cash generation
SG&A cost reductions
Underfeeding Profits
Increased development of nuclear reactors