Description

With the upcoming end of restructuring, delevering and equitization of bank debt create catalysts. Opportunity to cheaply own the equity of the UK’s largest and most efficient coal-fired plants, and one of the only pure play British coal gencos, in an era of elevated electricity and gas prices. Effective floor on value stemming from private equity interest.

Drax Holdings owns Drax, a 4,000 MW coal-fired power plant located in Selby, UK. The company is currently going through a restructuring process that is expected to conclude at the end of 4Q 2005. With no capex overhaul to extend it, Drax’s life is expected to be 25 years. The debt has taken on an odd form in the restructuring, with the A tranches consisting of some bank and some bond debt. The A2 tranche comes with the A3 tranche and the equity stapled to it, so when you buy one, you buy them all.

Name: Drax Holdings, Ltd.

Ticker: NA

Price: 399

# Shares / Float / Short Interest: NA

Market Cap: NA

Yield: NA

Location: Selby, UK

Top Execs and Amount (and type of stock) Owned:

Capital Structure
Amount (UK Pounds) Price Market Value
A1 Tranche 388.3 100% 388.3
A2 Tranche 459.0 399% 1,831.4
A3 Tranche 86.0 0% -
Equity - 0% -
-
B Tranche 38.7 100% 38.7
Net Cash 58.5 100% (58.5)



ARGUMENTS / RISKS

* Attractive valuation: At 399%, you can create Drax at 4.9x EV / 2006E EBITDA, even assuming conservative cuts in today's electricity forward prices. The closest real pure play comp is British Energy, which trades at 7.0x (keep in mind that it’s not a great comp though). If Drax would trade at a 7.0x multiple, it would be worth 655%, a 64% premium to current levels. At a 6.0x multiple, the A2 tranche is worth 546%, or a 37% premium to today’s levels. I believe 6.0x is more realistic.

Amount (UK Pounds) Price Market Value
A1 Tranche 388.3 100% 388.3
A2 Tranche 459.0 310% 1,422.9
A3 Tranche 86.0 0% -
Equity - 0% -

B Tranche 38.7 100% 38.7
Net Cash 58.5 100% (58.5)

Enterprise Value 2199.9
2006E EBITDA 498.8
EV / 2006E EBITDA 4.4

BGY EV / 2006E EBITDA 7.0
Drax at 6x 2,992.6

Implied Value for A2 Tranche 546%
Premium to current levels 37%



Huge cash flow potential in 2006 and 2007: Current UK forward power prices are higher than 50.0 GBP/MWh as gas prices have skyrocketed (declining north sea crude stocks and limited refining capacity have caused gas prices to hit record highs) and older coal plants have gone offline, elevating gas plants’ costs and rendering them the source of marginal power in the UK. For my base case, above, I have taken a 18% discount to those prices in the interest of being conservative. You need to see a 29% fall in prices to reach breakeven with no hedging.

Analysts differ on whether electricity costs are going down but, even using a very conservative GBP 40/MWh (this is 23% lower than current prices and lower than my base case), Drax’s dark spread (difference between electricity prices / MWh and coal prices / MWh) is GBP 28.52 (vs 9.69 for a generic gas plant), and dark green spread (spark spread less CO2 emissions costs / MWh) is GBP 14.81 (vs 3.60 for a generic gas plant). When fixed costs of roughly GBP 150mm/year are added in, Drax puts out EBITDA of about GBP 213.4mm before CO2 emissions rebates. All plants get government-sponsored emissions rebates. Through 2007, Drax has 2/3 of its CO2 emissions costs rebated, or roughly GBP 238.7mm. This translates to EBITDA for 2006 and 2007 (assuming GBP 40/MWh electricity prices - a 23% discount to current prices) of GBP 437.5mm. Less capex, interest and taxes, free cash flow for 2006 and 2007 is GBP 317.5mm.

Post 2007, the government will revalue the rebates - they won’t be taken away - and they’re expected to be roughly 50% of CO2 emissions costs going forward. Using GBP 40/MWh, that would result in EBITDA and free cash flow post 2007 of GBP 381.5mm and GBP 261.4mm, respectively.

Currently, the equity is valued at GBP 1,286.4mm. Electricity prices at GBP 40/MWh would result in total free cash flow to equity of GBP 635.1mm in 2006 and 2007, or approximately half of the equity value.

EV at A2 tranche 399%: 2,199.9
Less A1 tranche: (388.3)
Less A2 tranche: (459.0)
Less A3 tranche: (86.0)
Less B tranche: (38.7)
Plus cash: 58.5
Equity value: 1,286.4


* Additional income possibilities from ancillary sales of SO2 credits and biofuels: The company says that it can make a recurring GBP 50mm from sales of sulphur credits and biofuels. I have assumed zero for those and think of them as gravy.

* Pending legislation in the UK to require coal plants to be fitted for flue gas desulphurization equipment: Drax is already fitted for this equipment. It’s ridiculously expensive and is one of the (many) excessive expenditures that caused it to be so highly leveraged and to go bankrupt to begin with. If the legislation passes, it could be prohibitively expensive for some older coal plants and simply force them to go offline earlier rather than to spend for the upgrade only a few years before retirement. This would further increase Drax’s leadership.

* Restructuring is on track and should provide a catalyst: Drax is currently getting consents for its restructuring. My understanding is that most everyone is on board. The restructuring is a “scheme of arrangement,” not a “restructuring,” meaning that it’s court-sanctioned, not court-administrated, and that it needs only 75% of holders to consent to it before it would go through. Once they officially get 75%, they need to make court filings to confirm it, and that takes a couple of weeks. This is expected to be completed sometime early fall, according to the company.

Concurrently, Drax is working on the IPO prospectus with Deutsche Bank, which is gearing up to market the company as a cheap, low-leverage way to access a pure play coal-fired UK power plant, which is a rare commodity. The only other one is British Energy, and they’re less efficient and need more capex. The date for listing of the stock is currently set at 12/16, with a prospectus due in late September. Drax already has audited financials, so nothing too contentious is expected in terms of getting regulatory approvals.

* Acquisition interest provides a floor: Several private equity firms and strategic buyers have expressed an interest in Drax. Constellation Energy / Perry Capital / Blackstone Group / Hellman & Friedman; Apollo Management / TPG / TowerBrook; and International Power / Mitsui have all put in bids (although IP / Mitsui later dropped out). Drax recently announced that it was focusing on the Perry Group bid. Each bid is below where the A2 tranche is trading (it’s unclear exactly where, but Perry recently raised its bid from GBP 1.9bn and did not disclose the amount of the new bid. A 5% increased offer would put the bid at around 377% for the A2 tranche, and a 7.5% raised offer would put the bid around 390% for the A2 tranche). This interest would conceivably serve as a floor for the entity’s value. Drax plans to negotiate with the Perry Group and entertain new bids while concurrently proceeding with its IPO. Whichever brings more value to the company will be the winner.

* Scant sell-side coverage: Currently only Lehman and Merrill cover Drax. No equity analysts do. The company will be marketing itself to investors and analysts as the IPO comes nearer. As they pick up coverage and focus on the name, people will possibly pick up on the low valuation.

RISKS


* Potential new gas plant construction: Currently gas-fired plants have positive spark green spreads (see above), but not nearly high enough to justify new construction. Normally spark green spreads would need to be in the low double digits to justify new construction; with current spark green spreads at around 3.1 GBP / MWh, gas prices would have to fall considerably before any new build would start in earnest. Currently talk has new gas construction coming on line in 2010. Given Drax’s near-term cash flow potential, 2010 is nice and far away.

* Imports of LNG could increase gas supply and lower prices: There has been a lot of talk about LNG imports, but as of now nobody has contracted to build any terminals to receive it or stations to deliquify it. There are significant regulatory and environmental hurdles to surpass in the UK for such an endeavor, and any new construction would likely not be on line for the foreseeable future.

* Any cratering in UK electricity prices would hurt Drax cash flow: Very true. Market fundamentals, though, seem to point to continuing high gas prices and high electricity prices. These prices and the corresponding spreads are easy to track on Bloomberg, so, much like with refiners, it should be possible to stay on top of everything. Again, you have pretty good cushion: a 29% discount from today’s winter (peak) forward rates keep you at from losing money without any hedges.

* Illiquid security that could take a while to close: Because it’s a rather complex piece of paper, it doesn’t trade very often (usually only GBP 1mm/day), so it’s fairly illiquid. Also, it’s a complex trade to close, and that may even require counsel. That also means that we likely won’t collect interest on the any purchases we make (it yields a couple of %), but that’s an insignificant yield anyway since you’re effectively paying 399% for the A3 tranche. The restructuring process is supposed to conclude by 12/17, and that would likely speed up any issues anyway.

* Delays in the restructuring and/or the listing of the equity: Almost all holders seem to be on board with the restructuring plan. Plus, as mentioned above, the presence of audited financials makes it unlikely that getting regulatory approvals will be particularly difficult.



POTENTIAL HEDGES
* Short a portion of BGY LN stock: British Energy’s stock is highly correlated with UK forward electricity prices, so a potential hedge to british electricity price risk is to short some BGY LN stock. I would not do a lot of it (to avoid getting in the way of a freight train), but it is an option.

CATALYSTS
* Restructuring and accompanying deleveraging
* Private equity interest / possible auction
* Listing of equity
* Analysts assuming sell-side coverage
* Funds focusing on Drax as the equity is marketed

Catalyst

* Restructuring and accompanying deleveraging
* Private equity interest / possible auction
* Listing of equity
* Analysts assuming sell-side coverage
* Funds focusing on Drax as the equity is marketed