Aquila ILA
July 06, 2007 - 8:02pm EST by
chris815
2007 2008
Price: 4.08 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,500 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Thesis
Aquila, Inc. (ILA) is a regulated electric and gas utility serving customers in the Midwest. ILA’s shares trade at a substantial discount and have for some time. The company’s pending merger with Great Plains Energy Inc. (GXP), however, is likely to unleash ILA’s value.  Interestingly, the combined company’s rate base is expected to grow by 60% over the next three years but, by our calculation, they will need to dilute their current equity base by about 10% to support this growth.
 
Introduction
There are three aspects of ILA which need to be considered in order to understand the value currently being overlooked by the market:
 
  • Balance sheet: $1 billion PP&E, $800 million value of NOLs and immediate interest savings.
  • Additional cost savings: $53 million per year.
  • Rate base growth: up 62% by 2011, new equity issuance ~ 10%.
 
First we outline the basic parameters of ILA’s pending asset sale to Black Hills Corp. (BKH) and subsequent merger with GXP.  We will offer some comments on GXP then discuss the three elements of value (balance sheet, cost savings, rate base growth).
 
The following table summarizes ILA’s balance sheet as of 4/1/07 and adds-back our estimate of the value of their Net Operating Losses and savings from lower interest rates as their debt re-sets when they become investment grade and, eventually, as their debt is refinanced at more normal utility company rates.
 
 
(000)
Current assets (sans cash) minus current liabilities (sans debt)
87,600
Non-current tangible assets (sans utility PP&E) minus non-current liabilities (sans debt)
131,300
Cash, 4/1/07
563,400
Debt, 4/1/07
(1,423,000)
Replacement cost of Missouri generating assets
1,076,928
Tax assets
399,000
Cash to be received from assets being sold to BKH
940,000
Immediate value of interest rate savings when ILA becomes investment grade
391,040
Additional value of interest rate savings when ILA debt is refinanced @ GXP's rates
336,960
Theoretical tangible book value / replacement cost
2,503,228
 
 
Actual tangible book value, 4/1/07
1,201,200
Actual market capitalization, 7/6/07
1,534,232
Implied appreciation: tangible BV to achieve parity  w/ theoretical BV
108%
Implied appreciation: market cap. to achieve parity w/ theoretical BV
63%
 
Pending asset sale and merger
 
On February 7, 2007 ILA, GXP and BKH announced an asset sale and subsequent merger as follows:
 
  1. ILA will sell its gas distribution businesses and its Colorado electric utility to BKH for $940 million cash.
 
  1. ILA will merge its Missouri electric utility business with GXP (GXP is a regulated electric utility serving Missouri and Kansas).  For each ILA share, ILA shareholders will receive $1.80 cash plus 0.085 GXP shares.
 
The asset sale and merger are expected to close during 2008. The following table illustrates the economics of the transaction to ILA shareholders:
 
Analysis of ILA / GXP merger per ILA share
GXP share price, 7/6/07
29.18
Gross ILA share price, 7/6/07
 4.00
Cash received per ILA share @ merger
 1.80
Net ILA share price, pre-tax
 2.20
 
 
GXP shares received / ILA share @ merger
 0.0856
Implied ILA share price (net of $1.80), before paying capital gains tax
2.50
Taxable capital gain (ILA implied share price less ILA share price net of $1.80)
0.30
Capital gain tax (assumes 15% rate)
0.04
Net ILA share price, after tax
2.24
 
 
Implied GXP share price (assumes 15% cap gains tax paid upon receipt of $1.80)
 26.22
Implied GXP market cap. using ILA shares (after paying tax on $1.80)
 3,122,425
   New equity issuance to fund capex through 2010
 367,580
Market capitalization using ILA shares after equity issuance
 3,490,005
 
 
GXP discount when purchased using ILA shares, assumes payment of capital gains tax on $1.80 distribution
11.3%
 
 
The table shows ILA shares are trading at about a 11% discount ($2.24 vs. $2.50) to what the terms of the merger imply.  Given that the merger will close sometime in 2008 and that GXP’s shares pay a $1.66 dividend yielding 5.7%, a 6% discount is to be expected since ILA shareholders will forgo about one year’s worth of GXP dividends.
 
The pending merger between ILA and GXP is highly likely because it benefits all stakeholders.  From ILA shareholders’ perspective, it is the catalyst for releasing the value illustrated in the table on page one of this report and explained below.  From GXP shareholders’ perspective, the merger is likely to be accretive within a year or so.  From the customer and regulators’ perspective, the merger is likely to produce cost savings, some of which will be passed on to customers in the form of lower electricity rates.  
 
If the merger does not close, ILA shareholders are not likely to suffer because the value of their company would remain in tact in need of another catalyst.  In fact, ILA’s share price fell from $4.67 on February 6 (the day before the merger was announced) and have generally traded below the implied merger price of $4.54 (based on the share prices of ILA and GXP). 
 
Comments on GXP
After the merger, GXP’s management will run the combined company; given this and the fact the acquisition consideration includes GXP shares, an investment in ILA is a de facto investment in GXP. GXP operates in two segments:
 
  • Strategic Energy, an intermediary between electric generators and consumers, operates in 10 states.  Strategic Energy produced 57% of GXP’s ’06 revenue and lost $10 million.
 
  • Kansas City Power & Light (KCP&L), a regulated electric utility operating in Missouri and Kansas. KCP&L produced 43% of GXP ’06 revenue and $150 million of net income (all of GXP’s earnings).  
 
We are not favorably impressed with Strategic Energy and are skeptical of the value of intermediation in the electricity markets.  Our skepticism is confirmed by Strategic Energy’s low margins and declining returns.  Accordingly, we assign no value to this business and hope that it is either returned to profitability or shuttered.
 
 
GXP’s Strategic Energy: Pertinent Statistics
(000)
2006
2005
2004
Revenue
1,534,900
1,474,000
1,372,400
Net income
(9,900)
28,200
42,500
Assets
459,600
441,800
407,700
Capex
3,900
6,600
2,600
SE President's compensation
1,741
1,212
745
 
 
On the other hand, KCP&L is a valuable business and its managers have done a good job running the company.  Its debt is investment grade and is expected to remain so after the merger.  GXP shares pay an annual dividend of $1.66 and are expected to continue to pay this dividend post merger.  KCP&L generates 97% of the electricity it sells and enjoys a low cost fuel position (weighted mean fuel costs of $12.38 per MWH). KCP&L recently was granted a rate increase with a 11.25% target return on equity, a full percentage point more than ILA’s target return (though without fuel escalation provisions, which KCP&L is unlikely to need given their fuel mix – see below).
 
GXP fuel mix and cost
 
 
Fuel Mix
 
Fuel cost
Fuel
'07 est.
 
$/MWH, '07 est
Coal
74%
74%
$12.80
Nuclear
22%
96%
$4.50
Natural gas & oil
2%
98%
$95.80
Wind
2%
100%
$0.00
 
weighted mean fuel cost
$12.38
 
Earlier in the decade, KCP&L went through a comprehensive planning process which included working with all concerned constituents, e.g., customers, regulators, and environmental groups, to develop a mid-term plan to meet electricity demand in a responsible fashion.  The result of this process is its Comprehensive Energy Plan. The evidence to date is the plan is a success: KCP&L recently was granted a rate increase with a target return on equity of 11.25% and law suits brought by the Sierra Club and other environmental groups have been dropped.    
 
ILA and GXP’s electric utility businesses are geographically adjacent. The close proximity of ILA and GXP is important for realizing some of the cost savings discussed below.  Note that all of ILA’s territory falls within Missouri, as does most of GXP’s. As regulated utilities, both GXP and ILA are dependent on their relationship with the Missouri Public Service Commission (MPSC).  GXP’s excellent relationship with the MPSC is likely to benefit ILA shareholders (see section below entitled cost savings). 
 
The following table summarizes the valuation of the combined company (ILA + GXP).
 
ILA + GXP Valuation pro forma
(000 except share price)
 
GXP diluted shares outstanding, post merger with ILA
 119,073
GXP share price
 29.18
Market capitalization, 7/6/07
 3,474,548
Equity issuance to fund capex 2008 - 2010
 367,580
Market capitalization, after equity issuance for capex 2008 - 2010
 3,842,128
Cash, pro forma 12/31/06
 890,121
Preferred shares, pro forma 12/31/06
 39,000
Debt, pro forma 12/31/06
 2,702,841
Enterprise value, net 7/6/07
 5,326,268
Enterprise value, after equity issuance for capex 2008 - 2010
 5,693,848
 
 
Dividend, annual per share
 1.66
Dividend yield
5.7%
 
The combined company is trading at 8.3x 2008 EBITDA and 5.5x 2011 EBITDA, based on what we think are conservative assumptions.
 
Balance Sheet: $1 billion PP&E, $800 million in NOLs & interest savings
 
ILA will have cash (net of debt) when the asset sale to BKH closes; ILA also has generating assets in Missouri worth at least $1 billion and has net operating losses and tax credits worth about $400 million. In the absence of substantial liabilities, the company’s balance sheet is strong, yet consider the following facts:
 
  • ILA’s long-term debt is not investment grade, nor is it even close to being investment grade (currently rated B2 by Moody’s and B by S&P).
 
  • ILA closed the sale of its Kansas electric utility assets on 4/1/07 for $292 million cash, leaving ILA with net debt of $860 million. 
 
  • The planned sale of ILA’s gas distribution business to BKH is for $940 million cash. BKH is credit worthy and has obtained financing commitments for this acquisition.
 
  • ILA has borrowing capacity of $260 million, none drawn as of 3/31/07.
 
  • ILA’s debt currently trades as if it were investment grade.
 
This set of observations is remarkable in that ILA will have cash net of debt (when it closes the sale to BKH as currently agreed) with substantial un-drawn borrowing capacity yet it’s debt is five notches below investment grade.   This is important because ILA’s debt is outrageously expensive, but becomes substantially less expensive when ILA is upgraded to investment grade, (which happens when merged with GXP).  The following table summarizes ILA’s long-term debt:
 
 
ILA’s Long-term Debt
 
 
 
Outstanding
 
 
I rate
term
3/31/07
% total debt
First mortgage bonds
9.44%
amort. through 2021
16,900
1%
Senior notes
7.63%
11/15/09
68,500
5%
Senior notes
9.95%
2/1/11
137,300
10%
Senior notes
7.75%
6/15/11
197,000
14%
Senior notes
14.88%
7/1/12
500,000
36%
Senior notes
8.27%
11/15/21
80,900
6%
Senior notes
9.00%
11/15/21
5
0%
Senior notes
8.00%
3/1/23
51,500
4%
Senior notes
7.88%
3/1/32
287,500
21%
Medium term notes
7.19%
2013 - 2023
17,000
1%
Mandatorily convertible notes
6.75%
9/15/07
2,600
0%
Convertible subordinated debentures
6.63%
7/1/11
2,000
0%
Other
5.16%
2007  - 2028
24,800
2%
weighted mean interest rate
10.56%
total
1,386,005
 
 
Note that 36% of ILA’s debt ($500 million which represents 20% of the company’s net enterprise value) bears interest at 14.88%. The company’s mean borrowing costs are 10.46%, which is higher than its allowed return on equity (10.25%). For perspective, consider that GXP’s borrowing costs average 5.45%. 
 
Missouri’s Public Service Commission has wisely not burdened Missouri’s consumers with higher electricity costs to compensate for the onerous terms of ILA’s debts. After all, this debt is the legacy of ILA’s international expansion and diworsification into merchant energy and telecom which brought ILA to the brink of collapse earlier in the decade. 
 
Fortunately, several tranches of ILA’s debt reset (11.88% in the case of the $500 million senior notes) when ILA becomes investment grade post GXP merger. This saves $37.6 million per year in interest immediately. To estimate the terminal value of this savings, we assume a 35% tax rate on cash flow and apply a PE of 16 (typical of regulated utilities) to arrive at $390 million. Eventually, all of ILA’s debt with be refinanced at “regulated utility” market prices, e.g., GXP’s debt cost 5.45% (see GXP’s debt summary in appendix), reducing interest costs from $146 million to $76 million.  Using the above methodology, this savings is worth $728 million (70 x 0.65 x 16= $728).  Regardless of how one counts it, annual savings of $70 million is substantial to a business with a market capitalization of $1.6 billion.
 
ILA’s balance sheet also includes Missouri-based electrical generating assets which, by our estimate, have a replacement value of at least $1 billion (see table in appendix for details).
 
Finally, a valuable collection of assets which are not featured on ILA’s balance sheet are yet another legacy of the company’s storied past: tax credits and operating losses, which are estimated to be worth $399 million. 
 
ILA Tax Sheltering Assets
 
Projected Benefit to GXP
ILA's Alternative Minimum Tax Credits
78,000
Net value of ILA's U.S. NOLs
360,000
Other deferred tax assets from ILA
56,000
ILA Reserves
(95,000)
Total tax sheltering assets
399,000
 
ILA’s net operating losses expire in 2023 – 2025, so there is ample time to make use of them. The merger with GXP is designed to preserve the value of these assets and GXP management estimates that they will be consumed within five years.
 
Additional cost savings: $53 million per year 
 
The planned merger between ILA and GXP is expected to save the combined company $90 million per year.  This is substantial when one considers ILA’s mean EBITDA for the last three years was $148 million. It is also conservative when one considers that GXP’s management is banking on only $37 million of interest rate savings, while, in the medium term (~ 5 years), GXP will be able to refinance most of ILA’s debt resulting in approximately $70 million annual savings. 
Other sources of savings are anticipated from supply chain, operations and shared services.  These anticipated savings seem reasonable given the geographic proximity of the two businesses and the fact both companies are regulated electric utilities.  Finally, GXP management will be running the show after the merger and, unlike ILA’s management, they have historically proven to be solid stewards. 
 
 
Rate base growth: up 62% by 2011, new equity issuance ~ 10%
 
ILA and GXP rely on public utility commissions, e.g., the Missouri Public Service Commission (MPSC), to allow them to set electricity prices high enough to earn an acceptable return on capital.  The capital that the utility commission considers for this calculation is called rate base and consists of the depreciated property, plant and equipment of the businesses plus allowances for working capital requirements.  As a result, there are two ways in which regulated utilities can increase earnings:
 
  • Increase the allowed return on rate base
  • Grow the rate base 
 
In the case of ILA and GXP, the MPSC is likely to keep the allowed returns on the equity portion of rate base between 10.5% and 11.5%; we use 11% in our projections. On the other hand, Missouri is currently short on electric generating capacity. According to data published by GXP, Missouri is current short  200 MW of power; this gap is expected to grow 500 MW by 2010 unless additional capacity is built. GXP figures they will need to increase their generating capacity from 4155 to 4700 MWs to stay ahead of demand (utilities generally need at least 12% more generating capacity than peak summer demand to provide reliable service).  ILA is in worse shape: during the last several years the company purchased nearly half of the electricity it sold, much of it generated using natural gas as a fuel. As a result, ILA and GXP are implementing capital expansions which are likely to increase their rate bases by 62% by 2011.
 
 
ILA + GXP Rate Base Growth
 
 
ILA
GXP
Combined
Cap. Structure
Target equity
Implied
Implied
Year
Rate base
Rate base
Rate base
Equity / total cap.
Return
Earnings
Appreciation  
2007
 1,068,000
 2,400,000
 3,468,000
53.0%
11.00%
 202,184
 
2008
 1,224,000
 2,700,000
 3,924,000
53.0%
11.00%
 228,769
 
2009
 1,339,000
 2,700,000
 4,039,000
53.0%
11.00%
 235,474
-3%
2010
 1,841,000
 3,700,000
 5,541,000
53.0%
11.00%
 323,040
33%
2011
 1,918,000
 3,700,000
 5,618,000
53.0%
11.00%
 327,529
35%
 
The table shows that the earnings of the combined ILA + GXP are likely to increase by 60% by 2011 driven by the increase in rate base.  What is striking about this is that most of the costs of the capital spending projects will be financed with debt and cash flow, requiring little equity issuance (see capital spending exhibit in appendix).   The following table summarizes the sources of financing for ILA and GXP’s capital spending plans:
 
 
Financing for ILA + GXP Capital Expenditures through 2010
Capital Source
Amount (000)
New debt financing (based on maintaining 53% equity, 47% debt capital structure)
1,591,420
ILA tax assets
399,000
Cash from ILA's sale to BKH, net of cash distribution to ILA shareholders
263,000
Anticipated contribution from rate increases
370,000
Internal funds & other
100,000
Savings from merger (interest rate, supply chain, operations & shared services)
295,000
Estimated new equity issuance (share sale) required
367,580
total capital spending through 2010
3,386,000
 
Less than $400 million of new equity is likely to issued to fund these projects. The net result is that earnings are likely to increase by 60% supported by a 10% increase of shares outstanding: a very good scenario for shareholders.
 

Catalyst

Catalysts
1. Merger with GXP / debt upgrades.
2. Rate base growth / execution of ILA/GXP capital expansion plan.
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    Description

    Thesis
    Aquila, Inc. (ILA) is a regulated electric and gas utility serving customers in the Midwest. ILA’s shares trade at a substantial discount and have for some time. The company’s pending merger with Great Plains Energy Inc. (GXP), however, is likely to unleash ILA’s value.  Interestingly, the combined company’s rate base is expected to grow by 60% over the next three years but, by our calculation, they will need to dilute their current equity base by about 10% to support this growth.
     
    Introduction
    There are three aspects of ILA which need to be considered in order to understand the value currently being overlooked by the market:
     
     
    First we outline the basic parameters of ILA’s pending asset sale to Black Hills Corp. (BKH) and subsequent merger with GXP.  We will offer some comments on GXP then discuss the three elements of value (balance sheet, cost savings, rate base growth).
     
    The following table summarizes ILA’s balance sheet as of 4/1/07 and adds-back our estimate of the value of their Net Operating Losses and savings from lower interest rates as their debt re-sets when they become investment grade and, eventually, as their debt is refinanced at more normal utility company rates.
     
     
    (000)
    Current assets (sans cash) minus current liabilities (sans debt)
    87,600
    Non-current tangible assets (sans utility PP&E) minus non-current liabilities (sans debt)
    131,300
    Cash, 4/1/07
    563,400
    Debt, 4/1/07
    (1,423,000)
    Replacement cost of Missouri generating assets
    1,076,928
    Tax assets
    399,000
    Cash to be received from assets being sold to BKH
    940,000
    Immediate value of interest rate savings when ILA becomes investment grade
    391,040
    Additional value of interest rate savings when ILA debt is refinanced @ GXP's rates
    336,960
    Theoretical tangible book value / replacement cost
    2,503,228
     
     
    Actual tangible book value, 4/1/07
    1,201,200
    Actual market capitalization, 7/6/07
    1,534,232
    Implied appreciation: tangible BV to achieve parity  w/ theoretical BV
    108%
    Implied appreciation: market cap. to achieve parity w/ theoretical BV
    63%
     
    Pending asset sale and merger
     
    On February 7, 2007 ILA, GXP and BKH announced an asset sale and subsequent merger as follows:
     
    1. ILA will sell its gas distribution businesses and its Colorado electric utility to BKH for $940 million cash.
     
    1. ILA will merge its Missouri electric utility business with GXP (GXP is a regulated electric utility serving Missouri and Kansas).  For each ILA share, ILA shareholders will receive $1.80 cash plus 0.085 GXP shares.
     
    The asset sale and merger are expected to close during 2008. The following table illustrates the economics of the transaction to ILA shareholders:
     
    Analysis of ILA / GXP merger per ILA share
    GXP share price, 7/6/07
    29.18
    Gross ILA share price, 7/6/07
     4.00
    Cash received per ILA share @ merger
     1.80
    Net ILA share price, pre-tax
     2.20
     
     
    GXP shares received / ILA share @ merger
     0.0856
    Implied ILA share price (net of $1.80), before paying capital gains tax
    2.50
    Taxable capital gain (ILA implied share price less ILA share price net of $1.80)
    0.30
    Capital gain tax (assumes 15% rate)
    0.04
    Net ILA share price, after tax
    2.24
     
     
    Implied GXP share price (assumes 15% cap gains tax paid upon receipt of $1.80)
     26.22
    Implied GXP market cap. using ILA shares (after paying tax on $1.80)
     3,122,425
       New equity issuance to fund capex through 2010
     367,580
    Market capitalization using ILA shares after equity issuance
     3,490,005
     
     
    GXP discount when purchased using ILA shares, assumes payment of capital gains tax on $1.80 distribution
    11.3%
     
     
    The table shows ILA shares are trading at about a 11% discount ($2.24 vs. $2.50) to what the terms of the merger imply.  Given that the merger will close sometime in 2008 and that GXP’s shares pay a $1.66 dividend yielding 5.7%, a 6% discount is to be expected since ILA shareholders will forgo about one year’s worth of GXP dividends.
     
    The pending merger between ILA and GXP is highly likely because it benefits all stakeholders.  From ILA shareholders’ perspective, it is the catalyst for releasing the value illustrated in the table on page one of this report and explained below.  From GXP shareholders’ perspective, the merger is likely to be accretive within a year or so.  From the customer and regulators’ perspective, the merger is likely to produce cost savings, some of which will be passed on to customers in the form of lower electricity rates.  
     
    If the merger does not close, ILA shareholders are not likely to suffer because the value of their company would remain in tact in need of another catalyst.  In fact, ILA’s share price fell from $4.67 on February 6 (the day before the merger was announced) and have generally traded below the implied merger price of $4.54 (based on the share prices of ILA and GXP). 
     
    Comments on GXP
    After the merger, GXP’s management will run the combined company; given this and the fact the acquisition consideration includes GXP shares, an investment in ILA is a de facto investment in GXP. GXP operates in two segments:
     
     
     
    We are not favorably impressed with Strategic Energy and are skeptical of the value of intermediation in the electricity markets.  Our skepticism is confirmed by Strategic Energy’s low margins and declining returns.  Accordingly, we assign no value to this business and hope that it is either returned to profitability or shuttered.
     
     
    GXP’s Strategic Energy: Pertinent Statistics
    (000)
    2006
    2005
    2004
    Revenue
    1,534,900
    1,474,000
    1,372,400
    Net income
    (9,900)
    28,200
    42,500
    Assets
    459,600
    441,800
    407,700
    Capex
    3,900
    6,600
    2,600
    SE President's compensation
    1,741
    1,212
    745
     
     
    On the other hand, KCP&L is a valuable business and its managers have done a good job running the company.  Its debt is investment grade and is expected to remain so after the merger.  GXP shares pay an annual dividend of $1.66 and are expected to continue to pay this dividend post merger.  KCP&L generates 97% of the electricity it sells and enjoys a low cost fuel position (weighted mean fuel costs of $12.38 per MWH). KCP&L recently was granted a rate increase with a 11.25% target return on equity, a full percentage point more than ILA’s target return (though without fuel escalation provisions, which KCP&L is unlikely to need given their fuel mix – see below).
     
    GXP fuel mix and cost
     
     
    Fuel Mix
     
    Fuel cost
    Fuel
    '07 est.
     
    $/MWH, '07 est
    Coal
    74%
    74%
    $12.80
    Nuclear
    22%
    96%
    $4.50
    Natural gas & oil
    2%
    98%
    $95.80
    Wind
    2%
    100%
    $0.00
     
    weighted mean fuel cost
    $12.38
     
    Earlier in the decade, KCP&L went through a comprehensive planning process which included working with all concerned constituents, e.g., customers, regulators, and environmental groups, to develop a mid-term plan to meet electricity demand in a responsible fashion.  The result of this process is its Comprehensive Energy Plan. The evidence to date is the plan is a success: KCP&L recently was granted a rate increase with a target return on equity of 11.25% and law suits brought by the Sierra Club and other environmental groups have been dropped.    
     
    ILA and GXP’s electric utility businesses are geographically adjacent. The close proximity of ILA and GXP is important for realizing some of the cost savings discussed below.  Note that all of ILA’s territory falls within Missouri, as does most of GXP’s. As regulated utilities, both GXP and ILA are dependent on their relationship with the Missouri Public Service Commission (MPSC).  GXP’s excellent relationship with the MPSC is likely to benefit ILA shareholders (see section below entitled cost savings). 
     
    The following table summarizes the valuation of the combined company (ILA + GXP).
     
    ILA + GXP Valuation pro forma
    (000 except share price)
     
    GXP diluted shares outstanding, post merger with ILA
     119,073
    GXP share price
     29.18
    Market capitalization, 7/6/07
     3,474,548
    Equity issuance to fund capex 2008 - 2010
     367,580
    Market capitalization, after equity issuance for capex 2008 - 2010
     3,842,128
    Cash, pro forma 12/31/06
     890,121
    Preferred shares, pro forma 12/31/06
     39,000
    Debt, pro forma 12/31/06
     2,702,841
    Enterprise value, net 7/6/07
     5,326,268
    Enterprise value, after equity issuance for capex 2008 - 2010
     5,693,848
     
     
    Dividend, annual per share
     1.66
    Dividend yield
    5.7%
     
    The combined company is trading at 8.3x 2008 EBITDA and 5.5x 2011 EBITDA, based on what we think are conservative assumptions.
     
    Balance Sheet: $1 billion PP&E, $800 million in NOLs & interest savings
     
    ILA will have cash (net of debt) when the asset sale to BKH closes; ILA also has generating assets in Missouri worth at least $1 billion and has net operating losses and tax credits worth about $400 million. In the absence of substantial liabilities, the company’s balance sheet is strong, yet consider the following facts:
     
     
     
     
     
     
    This set of observations is remarkable in that ILA will have cash net of debt (when it closes the sale to BKH as currently agreed) with substantial un-drawn borrowing capacity yet it’s debt is five notches below investment grade.   This is important because ILA’s debt is outrageously expensive, but becomes substantially less expensive when ILA is upgraded to investment grade, (which happens when merged with GXP).  The following table summarizes ILA’s long-term debt:
     
     
    ILA’s Long-term Debt
     
     
     
    Outstanding
     
     
    I rate
    term
    3/31/07
    % total debt
    First mortgage bonds
    9.44%
    amort. through 2021
    16,900
    1%
    Senior notes
    7.63%
    11/15/09
    68,500
    5%
    Senior notes
    9.95%
    2/1/11
    137,300
    10%
    Senior notes
    7.75%
    6/15/11
    197,000
    14%
    Senior notes
    14.88%
    7/1/12
    500,000
    36%
    Senior notes
    8.27%
    11/15/21
    80,900
    6%
    Senior notes
    9.00%
    11/15/21
    5
    0%
    Senior notes
    8.00%
    3/1/23
    51,500
    4%
    Senior notes
    7.88%
    3/1/32
    287,500
    21%
    Medium term notes
    7.19%
    2013 - 2023
    17,000
    1%
    Mandatorily convertible notes
    6.75%
    9/15/07
    2,600
    0%
    Convertible subordinated debentures
    6.63%
    7/1/11
    2,000
    0%
    Other
    5.16%
    2007  - 2028
    24,800
    2%
    weighted mean interest rate
    10.56%
    total
    1,386,005
     
     
    Note that 36% of ILA’s debt ($500 million which represents 20% of the company’s net enterprise value) bears interest at 14.88%. The company’s mean borrowing costs are 10.46%, which is higher than its allowed return on equity (10.25%). For perspective, consider that GXP’s borrowing costs average 5.45%. 
     
    Missouri’s Public Service Commission has wisely not burdened Missouri’s consumers with higher electricity costs to compensate for the onerous terms of ILA’s debts. After all, this debt is the legacy of ILA’s international expansion and diworsification into merchant energy and telecom which brought ILA to the brink of collapse earlier in the decade. 
     
    Fortunately, several tranches of ILA’s debt reset (11.88% in the case of the $500 million senior notes) when ILA becomes investment grade post GXP merger. This saves $37.6 million per year in interest immediately. To estimate the terminal value of this savings, we assume a 35% tax rate on cash flow and apply a PE of 16 (typical of regulated utilities) to arrive at $390 million. Eventually, all of ILA’s debt with be refinanced at “regulated utility” market prices, e.g., GXP’s debt cost 5.45% (see GXP’s debt summary in appendix), reducing interest costs from $146 million to $76 million.  Using the above methodology, this savings is worth $728 million (70 x 0.65 x 16= $728).  Regardless of how one counts it, annual savings of $70 million is substantial to a business with a market capitalization of $1.6 billion.
     
    ILA’s balance sheet also includes Missouri-based electrical generating assets which, by our estimate, have a replacement value of at least $1 billion (see table in appendix for details).
     
    Finally, a valuable collection of assets which are not featured on ILA’s balance sheet are yet another legacy of the company’s storied past: tax credits and operating losses, which are estimated to be worth $399 million. 
     
    ILA Tax Sheltering Assets
     
    Projected Benefit to GXP
    ILA's Alternative Minimum Tax Credits
    78,000
    Net value of ILA's U.S. NOLs
    360,000
    Other deferred tax assets from ILA
    56,000
    ILA Reserves
    (95,000)
    Total tax sheltering assets
    399,000
     
    ILA’s net operating losses expire in 2023 – 2025, so there is ample time to make use of them. The merger with GXP is designed to preserve the value of these assets and GXP management estimates that they will be consumed within five years.
     
    Additional cost savings: $53 million per year 
     
    The planned merger between ILA and GXP is expected to save the combined company $90 million per year.  This is substantial when one considers ILA’s mean EBITDA for the last three years was $148 million. It is also conservative when one considers that GXP’s management is banking on only $37 million of interest rate savings, while, in the medium term (~ 5 years), GXP will be able to refinance most of ILA’s debt resulting in approximately $70 million annual savings. 
    Other sources of savings are anticipated from supply chain, operations and shared services.  These anticipated savings seem reasonable given the geographic proximity of the two businesses and the fact both companies are regulated electric utilities.  Finally, GXP management will be running the show after the merger and, unlike ILA’s management, they have historically proven to be solid stewards. 
     
     
    Rate base growth: up 62% by 2011, new equity issuance ~ 10%
     
    ILA and GXP rely on public utility commissions, e.g., the Missouri Public Service Commission (MPSC), to allow them to set electricity prices high enough to earn an acceptable return on capital.  The capital that the utility commission considers for this calculation is called rate base and consists of the depreciated property, plant and equipment of the businesses plus allowances for working capital requirements.  As a result, there are two ways in which regulated utilities can increase earnings:
     
     
    In the case of ILA and GXP, the MPSC is likely to keep the allowed returns on the equity portion of rate base between 10.5% and 11.5%; we use 11% in our projections. On the other hand, Missouri is currently short on electric generating capacity. According to data published by GXP, Missouri is current short  200 MW of power; this gap is expected to grow 500 MW by 2010 unless additional capacity is built. GXP figures they will need to increase their generating capacity from 4155 to 4700 MWs to stay ahead of demand (utilities generally need at least 12% more generating capacity than peak summer demand to provide reliable service).  ILA is in worse shape: during the last several years the company purchased nearly half of the electricity it sold, much of it generated using natural gas as a fuel. As a result, ILA and GXP are implementing capital expansions which are likely to increase their rate bases by 62% by 2011.
     
     
    ILA + GXP Rate Base Growth
     
     
    ILA
    GXP
    Combined
    Cap. Structure
    Target equity
    Implied
    Implied
    Year
    Rate base
    Rate base
    Rate base
    Equity / total cap.
    Return
    Earnings
    Appreciation  
    2007
     1,068,000
     2,400,000
     3,468,000
    53.0%
    11.00%
     202,184
     
    2008
     1,224,000
     2,700,000
     3,924,000
    53.0%
    11.00%
     228,769
     
    2009
     1,339,000
     2,700,000
     4,039,000
    53.0%
    11.00%
     235,474
    -3%
    2010
     1,841,000
     3,700,000
     5,541,000
    53.0%
    11.00%
     323,040
    33%
    2011
     1,918,000
     3,700,000
     5,618,000
    53.0%
    11.00%
     327,529
    35%
     
    The table shows that the earnings of the combined ILA + GXP are likely to increase by 60% by 2011 driven by the increase in rate base.  What is striking about this is that most of the costs of the capital spending projects will be financed with debt and cash flow, requiring little equity issuance (see capital spending exhibit in appendix).   The following table summarizes the sources of financing for ILA and GXP’s capital spending plans:
     
     
    Financing for ILA + GXP Capital Expenditures through 2010
    Capital Source
    Amount (000)
    New debt financing (based on maintaining 53% equity, 47% debt capital structure)
    1,591,420
    ILA tax assets
    399,000
    Cash from ILA's sale to BKH, net of cash distribution to ILA shareholders
    263,000
    Anticipated contribution from rate increases
    370,000
    Internal funds & other
    100,000
    Savings from merger (interest rate, supply chain, operations & shared services)
    295,000
    Estimated new equity issuance (share sale) required
    367,580
    total capital spending through 2010
    3,386,000
     
    Less than $400 million of new equity is likely to issued to fund these projects. The net result is that earnings are likely to increase by 60% supported by a 10% increase of shares outstanding: a very good scenario for shareholders.
     

    Catalyst

    Catalysts
    1. Merger with GXP / debt upgrades.
    2. Rate base growth / execution of ILA/GXP capital expansion plan.

    Messages


    SubjectRe: rate base growth
    Entry07/14/2007 02:14 PM
    Membergearl1818
    What numbers in terms of increases in MW are you using by utiltity? & what cost per MW? Are you assuming that all new built plants are coal?

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