Description

Business Description & Brief History

USEC has 3 different revenue streams: 

•  Enriching and selling uranium for utilities via the gaseous diffusion process. Gaseous diffusion is a technology that is very old, highly energy (electricity) intensive, and has low unit and incremental margins. While the production of LEU generates a great deal of USEC's revenues, the company does not actually make any money doing this.

• In the 1990s, the governments of the United States and Russia agreed to a program called "megatons-to-megawatts." Under this program, Russia agreed to dismantle a huge number of nuclear warheads and have the HEU contained in them "downblended" to LEU (basically diluting that 190 proof alcohol down to 10 proof for commercial consumption.) As a ward of the state, USEC got the right to be the "agent" for this deal, taking the HEU from Russia at a very good price and then selling the LEU to the market. Megatons-to-megawatts expires at the end of 2013, and Russia has made it very clear that they do not intend to extend the program. This is a problem for USEC, since this has historically been an extremely lucrative project for them.

•  For prolonged periods in USEC's history, it has made money by a process known as underfeeding uranium. A utility can use LEU that is enriched anywhere between 3% and 5%. There are basically two units to the cost of LEU - there is the cost of the raw uranium and there is the cost of enrichment, which is priced in something called Separative Working Units ("SWU.") For years, the price of uranium was very low, so utilities would order their LEU enriched to only 3% to save on SWU costs. USEC would go ahead and enrich to 5%, and keep the extra volumes for themselves. They were then able to sell the extra inventory on their own for a profit. As the price of uranium rose rapidly in the mid-2000s, and USEC increasingly had difficulty accessing cheap electricity to perform the enrichment process, this revenue stream declined. The prospects for underfeeding going forward are poor due to the age and inefficiency of the Paducah plant and the scarcity and price of electricity from USEC's power supplier (TVA.) USEC's electricity contract with TVA expires in May 2012, and our checks indicate that TVA will not grant them the right to enough electricity to allow them to underfeed going forward.

 The American Centrifuge

USEC management has long known that they would ultimately need to replace their gaseous diffusion process due to the age of the facility, its inefficiency and its inability to compete cost effectively as more modern enrichment capacity was added around the world. Modern enrichment technology is performed via centrifuge, and there are 2 basic centrifuge designs that have been successfully built and operated over the last 20 years. Because they were a former ward of the state (and b/c they couldn't get the right to license the proven centrifuge technology), USEC management decided to go in a different route to develop their next-gen technology, and revive a 1970s era DOE project called the American Centrifuge Project ("ACP")  rather than use proven centrifuge technology already in use by companies such as Areva and Urenco.

In short, ACP has been a disaster. From initial cost estimates of $1.8B, the total cost of the ACP has today ballooned to $4.8B and counting. I have spoken to nuclear engineers, physicists, veterans of the enrichment industry, and even people who worked on the original ACP in 30+ years ago, and I am utterly convinced that not only is the project wildly uneconomic, the technology itself simply does not work. USEC will happily produce all sorts of data that show you that ACP will produce LEU, but the multitude of experts I have spoken to are unanimous in saying that the project will never work at commercial scale.

For years, USEC management used the cash generated from the megatons-to-megawatts program and underfeeding uranium to fund research, development, and construction of ACP. In 2007 they stepped off the cliff, raising $1B+ in an equity and convertible debt offering to finance the project. At that point, they were still telling investors it would cost $1.8B; within a year of the offering, this cost estimate had risen to $3.5B, and today stands at $4.8B (it will go over $5B total as the $4.8B does not include financing costs.) Because the legacy business is winding down, USEC can't borrow anymore money, and because the stock price is <$5, the company can not effectively raise equity, so they are looking to the U.S. government for a $2B "loan guarantee." It shouldn't be called a loan guarantee, because in reality it is just a flat out loan.

 In a process that has been ongoing for over 2 years now, USEC keeps insisting that the DOE loan them money, and the DOE keeps not doing it. Our checks indicate that this is for some combination of the following reasons: 1) DOE knows ACP won't work (they should, it's their technology); 2) DOE knows such a loan would be a horrible investment, even if it ACP did work (it would be, there is plenty of other enrichment capacity coming on line both in the US and globally to keep SWU prices low for years to come); and 3) the DOE staff simply dislikes USEC management because they think they have been vastly overpaid for being very bad managers (plenty of evidence to support this.)

 Last year, DOE put in a requirement that for USEC to be considered for a loan guarantee, they would have to raise private capital. Enter Toshiba and Babcox & Wilcox, who entered into an agreement to invest $200MM for a 20% stake in USEC in 3 tranches. Toshiba is a huge player in nuclear globally and the Japanese are worried about security of supply; B&W presumably wants the contract to build ACP at commercial scale (what do they care if it doesn't work if they get a $3B cost-plus contract to build it?) The 2^nd tranche of the Toshiba-B&W investment is contingent upon USEC receiving the DOE loan guarantee; if that doesn't happen by June 30, 2011, they can walk away from their remaining $125MM commitment. Interestingly, even after the investment from Toshiba and B&W, and even assuming they get the DOE loan, USEC management readily admits they will need additional capital to complete the ACP. Their goal for the last year has been to get this from the Japanese export credit agencies.

 It is my opinion (and only my opinion) that based on everything I know about the ACP, how DOE feels about USEC, and the current economic/political climate, that there is very little chance USEC gets a DOE loan guarantee in the next 6 weeks. Consider: this company could not get a $2B loan/bailout/gift from the United States Government, to fund an "alternative energy" project in 2009 or 2010, when no one cared about the deficit, when the government was giving away money and when nuclear was "cool."  What are the odds of that project getting funded in a world where every politician is talking about the deficit and where nuclear is (sadly) a "dirty word" following the tragedy in Japan? Furthermore, what are the odds that a quasi-governmental agency in Japan is going to pony up $1B to fund a nuclear enrichment project post-Fukushima?

 The End Game

I think the end comes for USEC when the DOE declines to fund ACP and Toshiba and B&W exit stage left (you can forget about Japan funding them at that point.) USEC will be left with a business that does not produce any cash, a facility that needs to be shuttered, no guaranteed supply of electricity to continue underfeeding uranium, and a re-negotiated megatons-to-megawatts program that will not allow them to make any profits.

 The balance sheet is not a disaster, and yet it will be the convert they issued back in 2007 that finally does them in. This $575MM piece of paper is due in 2014 and is far, far underwater (converts at $12/share.) USEC won't be able to convert with a sub-$5 share price, and they certainly won't be able to refinance it with no cash flows.

 One issue we have struggled with - is their hidden value here? Could they cancel ACP tomorrow and run the legacy business for cash? They actually could have 4 or 5 years ago, but it's too late now due to the debt on the balance sheet and the very short lifespan of those cashflows today. It is tempting to point to USEC's $1.3B in shareholders' equity and posit that the company is trading for less than half of book value today. Unfortunately, upon examining the components of that equity, it turns out almost all of it is in PP&E. What is the repurposed value of a 50+ year old gaseous diffusion enrichment plant in rural Ohio? Or that of the massive, empty building next door meant to house the ACP? Or the xxx test centrifuges that will have to be mothballed once ACP is mercifully put to sleep? Given the massive legacy costs associated with decontamination and decommissioning Paducah, I actually think that, far from their being "hidden value" on the balance sheet, there is hidden liability.

 The Risk

What if I'm wrong and the DOE does bend to the will of the Republican led legislators from the state of Ohio and issue a $2B loan for the ACP? It will be a bad day. The stock will be up (probably a lot - 25%?) But here is the interesting part. ACP is such a horrific ROIC investment, and they will take so much dilution from Toshiba-B&W, that even then it is difficult seeing USEC stock worth more than today's share price. Fukushima has set development of nuclear reactors back at least a generation, and numerous other enrichment projects are set to open in the next 5 years that will add 40% to world supply. Even prior to the tragedy in Japan, the enrichment world would have struggled to soak up all the supply coming online - now we will be in a state of oversupply for a very long time. As the member of the industry with (by far) the highest capital costs, USEC will literally never make any money on a hypothetically-built ACP.

Catalyst