April 19, 2010 - 11:57pm EST by
2010 2011
Price: 37.50 EPS N/A N/A
Shares Out. (in M): 304 P/E N/A N/A
Market Cap (in $M): 11,443 P/FCF N/A N/A
Net Debt (in $M): 14,100 EBIT 0 0
TEV ($): 25,500 TEV/EBIT N/A N/A

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At 37.50 per share, First Energy (FE) is trading at a deep discount to intrinsic value and will benefit from several near term structural changes in the market that will drive the earnings power of the company higher.  The stock currently offers a greater than 5% dividend yield, and per share value of ~$48 (25% upside) in today's abysmal power market with a value of ~$60 (55% upside) if you can stick around for 12-18 months. 

FE is a generation and distribution company. Their generation portion of the business is unregulated, the seven utilities serve load in OH, PA, and NJ.  The company currently operates ~14 TW of generation with 46% of the base load capacity being low cost nuclear. 

FE is a long today because:

1.       FE is highly levered to industrial demand in OH - our calls indicate that many of the steel rollers and the GM plants supplied by FE are ramping up over the summer (more shifts) general load is recovering and other industrial glass foundries in the area have kicked back on - after a 15% declines in 2009 volumes, it is not unreasonable to think much of that demand will come back in 2009, generation and distribution earnings will both benefit allowing them to achieve or beat their 3.60 guidance (guidance expects a 10%+ recovery in demand).

2.       In 2011 the company gets to re-price their POLR in PA.  For simplicity, POLR load is electricity you have to sell to utilities from your generation facilities at a rate set by regulators.  In PA this goes away in 2011.  Prices are currently $41.50/MWH as set by the regulators - the flat power price a couple of years out as of today is ~$44.50.  The bump in power prices assumes no further recovery and if they sell volume at current levels it will provide about 0.20 cents of earnings.  If market prices are higher the upside is better - each $1/MWH in PA is about 0.05 in earnings, nice to have but you don't need it.

3.       The stock is off in the last 3 months because of (i) proposed merger with AYE (more on this below) and (ii) the Davis Besse Nuclear facility is currently shut down for repairs and will likely be down longer than the originally planned 50 or so days.  The market has underestimated the benefits of the AYE merger and is over-penalizing the company for the repairs needed at Davis Besse. 

AYE Merger.  The company is currently offering to acquire AYE in an all stock deal; 0.667 shares of FE for every share of AYE.  AYE is utility/generation group similar to FE and serves adjacent markets (both companies' utilities are adjacent throughout PA.  AYE has some fantastic high efficiency coal plants in PA that are to the east of the Ohio load FE serves - the plants have recently been upgraded with new environmental controls.  FE is looking to do the merger for several reasons (i) the company can save on administration and billing etc. at the utility (ii) there is opportunity for improvement in the operations at AYE's plants given FE's expertise in investing small amounts of capital to yield big improvements in efficiency (turbine adjustments, coal mix optimization, etc.) (iii) AYE has some transmission projects in the works that will augment FE's fixed return assets and (iv) the company has generation synergies. 

Focusing on the generation synergies for a minute...they think that they can get about $250MM of improvements due to (i) shaping (how you run your plants for various demand scenarios on the grid), (ii) better fuel purchasing, (iii) the fact that they can sell their power using a very sophisticated sales force, and (iv) some clever retail marketing that pushes long duration contracts at a discount, this capturing the price sensitive buyers who normally shop the power away from the utility.  If you check out the presentation related to the merger there is a very colorful slide (pg. 20) with lots of graphs detailing all of the great savings and synergies...the consultants and bankers did a nice job laying it out. 

The synergies they are NOT telling you about are the ones that we need to discuss to better understand the hidden option in the merger.  The simple reason they don't talk about all the benefits of the merger is that they would have to give more of them away to the regulators.  In utility mergers everybody has a say...everybody.  In the case of this merger there are politically appointed folks from VA, PA, MD, WV, OH and the feds all putting their hand out to collect a vigorish on the transaction.  Some of the anticipated synergies will have to go back to the states and ratepayers (the synergies at the utilities will certainly be less than those on the pretty slide) in the form of minor rate cuts, capital improvements, minimal job elimination commitments etc.  The conversations are taking place over the summer so be assured that the politicians plan to run around in November pretending to be Robin Hood, and it's going to come out of FE's synergy purse. 

Should the merger be approved, what will actually happen over the next couple of years is that the company will materially rationalize their portfolio.  They will lower utilization on their higher cost plants (or eliminate them altogether) and redirect power across the OH and PA region.  The load that AYE serves to the west of their plants can be served by the FE plants.  Given the abundant supply of power in OH and MISO there is positive basis that comes to selling power into more constrained regions. 

The quick and dirty way to think about this is:

(i)                  AYE (located in western PA)currently sells towards the Dayton Hub (west of their plants) at a discount to the PJM West Hub (east of plants) round numbers call it ~$5 discount.

(ii)                FE dispatches towards PA and competes at the DQE hub (which had a ~$7 differential to the PJM west hub even in the recent year of low demand)

(iii)               Sales force in PA and the completion of TRAIL (AYE transmission project in the works) will assure that the new mix of plants will be able to dispatch and capture basis differential between the markets

(iv)              Rough numbers if they take 30% basis risk it works out to about $250MM/ year pre tax in extra generation synergies on top of the basis differential they have already modeled in - at higher prices it will be even better

Davis Besse: This is a single nuke plant that has had some historical issues - it is scheduled for a complete turbine/reactor overhaul in 2014. They are on good terms with the NRC and are currently in the process of servicing the nozzles in the reactor.  The found some issues during servicing and it looks like the reactor will be down for 120 days or so instead of the 50 they originally forecast take 15 cents off of earnings because of this in the current year.  Don't think they will fix it in less than 1 year for whatever reason, take 55 cents off of earnings. 

Gas costs more to make electricity with gas than with coal and way more than with nuclear.  As an example, for FE at current gas prices it is about $46/MWH, for coal it is $27/MWH, and for Nuke it is $7/MWH.  Assuming that you can't make enough electricity with the existing nuke/coal plants in the area, you run gas plants and charge the cost plus a margin...since that is the going rate for electricity you get to charge the same amount for the energy you generate at the lower cost plants.  It is for this reason that you always hear analysts say stuff like "buying utilities is a call on gas prices" at any given cocktail party.  Rough numbers, gas forwards are at $5 a year out...the market thinks they are going lower.  The flat forward electricity prices in the region imply a gas price of about $3.80 with a 9500 heat rate.  If it goes perpetually lower, there is price risk but I am less concerned given that the electricity forwards are already adjusting for weaker gas prices. 

How do you lose?

1.       Carbon/Environmental legislation: The never ending saga regarding carbon legislation has two impacts (i) it is forcing power companies to keep old, inefficient coal plants operating even if on skeleton coal capacity, no carbon credits when/if they are allocated with an environmental bill to apply across your other plants (politics distorting markets) - this is relevant to #2 below and (ii) rough PJM and MISO (the areas FE and AYE sell) coal sets the price of power about 50% of the time (you can pass through the cost of carbon) the other 50% of the time it is gas.  The way credits are planned right now about 50% of that production is protected...shut down the extra coal plants you have hanging around to capture credits and you can cover more because you will be running only your high efficiency coal facilities, oh and power prices go up for everybody with limited impact for the producers.  At worse this caps some of the earnings growth in the near term.

2.       Too many watts chasing too few light bulbs: Long story short, there is too much power in the OH region and MISO which will continue to be oversupplied, especially with extra plants online.  This makes it harder to sell into the region if you sell exclusively to that area.  AYE merger and their associated transmission projects help this as does the shutdown of old plants and some competitor's plants that require massive capex for environmental. 

3.       Demand aggregators: Companies will pay industrial folks to shut down consumption at peak times and resell that capacity, over the next decade years, these companies will likely take 5% of the demand out of the market, with flat demand growth after normalization of industrial demand over the next couple of years.  There is less impact if prices don't spike and none of my projections include any credit for rising capacity payments for the utilities (the amount the grid pays utilities to assure they will have generators spinning for spikes where the power isn't already sold).

4.       Ohio Legislation: OH has been a bit of a rough state for the utilities even with their army lobbyists.  They were originally scheduled to go to market rates, then power prices spiked and the state legislators panicked, so they basically decided to wait to go to market rates.  When they changed things they put a provision in that says once they go market rate they can't go back.  This was a mess when power rates were high.  Power rates fell due to the demand deterioration but the OH generators got a little big for their britches and ran an auction...power prices came in lower than expected.  They went back to the regulators and negotiated a sweet deal allowing them to use cost based rates and getting riders for storms, transmission assessments, etc.  The ESP will come into place soon and likely go for 3 years, at which point they get the free call option to go to market based.  This is a heads you win, tails you win outcome but you do need to have some patience. 


Here's what I think the outcomes look like in terms of earnings including the upside synergies I think will materialize as people look forward at the end of the year - giving enough time for people to have an opinion on the merger outcome - there is a 5%+ dividend in the interim - the stock is at 37.50 and there is signifigant skew to the upside::


AYE Merger

FE Standalone

Good Demand/PX



Flat Demand/PX



Bad Demand/PX






A descision regarding the outcome of the AYE/FE merger

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