Description
Company Description/Thesis:
Allegheny Energy (AYE) is an integrated energy business that owns and operates electric generation facilities and delivers electric services to customers in Pennsylvania, West Virginia, Maryland and Virginia. The company has two business segments – (1) Delivery and Services; and (2) Generation and Marketing. The majority of Allegheny’s generation facilities is coal plants, which provides AYE a pricing advantage relative to natural gas.
Due to certain “upside drivers” – most of which are essentially locked in, or will be locked-in in the near future -- we believe that AYE can earn in excess of $6.50 in 2011, which should yield an equity value exceeding $90. Given the relative certainty of the majority of AYE’s current and future earnings streams, we believe that this IRR of 18%+ provides a compelling investment opportunity
(For purposes of focusing on the core earnings power of this business, we will not distinguish between the various subsidiaries of AYE, and will instead characterize all as Allegheny.)
Core Business/Current Earnings Power (through 2010)
AYE should make approximately $2.00-$2.25 in EPS this year. AYE also has an NOL, which should shield taxes thru sometime in 2009. While near-term cash flow should trail EPS due to major capital projects for the construction of scrubbers and transmission lines, EPS should ultimately mirror cash flow.
Using the current starting point of EPS, Allegheny has a locked-in rate increase (annual) in Pennsylvania through 2010 (where most of their generation is delivered), potential rate increases in other states, and has implemented initiatives on both the cost side as well as efficiencies (e.g. coal plant equivalent availability) that will lead to a “core” EPS of approximately $4.25-$4.50 in 2010. The company does an excellent job of laying out such incremental earnings drivers in their presentations. Starting in 2011 (when the Pennsylvania Rate agreement expires), there are several additional “upside drivers” that should enable Allegheny to earn in excess of $6.50.
“2011 Upside Drivers”
- Pennsylvania Rate Case
Allegheny will most likely go before the PUC (the regulatory commission) to implement a further rate increase starting in 2011. Given that the rate that AYE currently earns is well below market (as well as the much higher rate that PPL will be receiving), it is anticipated that AYE will receive a significant increase in their current rates, and such increase should ultimately be locked in. AYE will most likely approach the PUC at some point later this year/next year to initiate the process. Under the current agreement, AYE will be charging $52.50/MwH in 2010. The current market suggests rates in excess of $60-$65
- Transmission Lines
Allegheny has received approval (to varying degrees) to build two transmission lines, which should yield an incremental $0.35-$0.45 of EPS for each line. The first line, “TrAIL”, is scheduled to be completed sometime in 2011. The second line (“PATH”), is a joint venture with AEP, which has received PJM approval. This line should be completed in 2012. AYE is currently awaiting approval at the state level for both of these lines. Additionally, should the lines be approved, this would have the added benefit of increasing the pricing in AYE’s regions, and such a secondary effect could have a decent impact on EPS as well.
- Capacity Payments
Under the current PJM framework, AYE’s generation will receive capacity payments over the next several years. The most recent capacity auction resulted in $112/MW-day for the 2008/09 timeframe (though most of AYE’s generation doesn’t become available until after the current Pennsylvania POLR agreement expires). Additional ones are scheduled to be conducted in October and January. Under the projected price, AYE should make an additional $200-$250mm of operating income.
In total, we believe that the anticipated rate increase approaching market rates in 2011 should alone enable the company to earn nearly $5.00. Transmission lines and capacity payments should bring the earnings power to well over $6.00-$6.50.
Management
Management is considered among the best in the industry. Since taking over in 2003, Paul Evanson has navigated a complete turnaround of the company – from the brink of bankruptcy to an incredibly cash-generative company with lots of earnings upside in the near future. He recently signed an extension of his employment contract, and will manage the company through its regulatory proceedings, rate cases, etc. through 2010. Moreover, Evanson, along with the rest of the management team, has proper incentives, as they own a significant amount of stock.
Risks/Downside
Most of AYE’s earnings upside post-2010, though visible in their range and scope, are still dependent on regulatory action (both at the state and federal levels) to varying degrees. On the one hand, Allegheny can make a very compelling case for virtually all of its initiatives. At the same time, given the ultimate uncertainty inherent in any regulatory proceeding, there is certainly a degree of regulatory risk
Another potential risk is a cratering of natural gas prices, which would impact the rate AYE would be able to receive.
Catalyst