EnergySolutions, Inc. (NYSE:ES) is a leading provider of a broad range of nuclear services to government and commercial customers, addressing the needs of their customers throughout the lifecycle of their nuclear operations. The Company's services include engineering, decontamination and decommissioning (D&D), operation of nuclear reactors and logistics, transportation, processing and disposal of low-level radioactive waste primarily through its Clive, Utah disposal site. The Company maintains "life-of-plant" contracts for disposal and processing of nuclear waste with the majority of the nuclear reactors in the country, generating relatively stable revenue with very little capital investment required.
Recently, the Company agreed to be purchased by a private equity firm for $3.75 / share, representing a stated enterprise value of $1.1 billion. However, as we discuss below, we believe the stated enterprise value ignores key assets on the Company's balance sheet and meaningful future improvement in the Company's business. EnergySolutions is currently in a "go-shop" period through February 6th, 2013 and is actively seeking higher proposals. Tappan Street Partners has been a shareholder of EnergySolutions for over a year and we believe the current offer significantly undervalues the Company. We have laid out our case in a letter to the Board of Directors, which is copied below. To be clear, beyond this letter we do not intend to engage in a public dialogue with the Board, nor do we expect a response, although the Board is obviously free to do so. We thought it was important to express our thought process in evaluating the Company, and we trust the Board will consider these and other factors in evaluating the offer and the right path forward for the Company. Our intent in posting this to Seeking Alpha is to generate discussion amongst the Seeking Alpha readership on the points we raise.
January 15, 2013
Attn: Board of Directors
423 West 300 South, Suite 200
Salt Lake City, Utah 84101
Ladies and Gentleman,
We are writing to you in our capacity as representatives of Tappan Street Partners Fund, L.P., a private investment fund and owner of EnergySolutions (the "Company") shares. While we are pleased the Company has engaged in a strategic alternatives process designed to realize value for the Company's shareholders, we believe EnergySolutions shares are worth considerably more than the $3.75 per share offered by Energy Capital Partners ("ECP"). In particular, we are troubled that the offer price does not reflect substantial future improvement in EnergySolutions' cash flow and operations, and ignores hundreds of millions of dollars of restricted cash on the Company's balance sheet.
We believe the offer price of $3.75 per share from Energy Capital Partners is inadequate for the following reasons:
Bid Ignores Restricted Cash - In the press release announcing the buyout proposal, the Company references a total enterprise value of $1.1 billion at the deal price of $3.75 per share. We believe the quoted enterprise value overstates the true bid value by over 25% by incorrectly ignoring $331 million of restricted cash on the Company's balance sheet, $200 million of which relates to a cash collateralized letter of credit used to secure the Company's Zion decommissioning project. Adjusted for $200 million of Zion restricted cash, as well as the rather generous $35 million rounding in the press release, we believe the true enterprise value of the ECP bid is $865 million. Although the Company has thus far been unable to free itself from this inefficient use of capital, substantial time and resources have been dedicated to resolving the issue. Previous management had indicated progress had been made and, upon taking over in June 2012, new management indicated it would continue to be a focal point. By our estimates, even if nothing can be done, simply allowing the restricted cash to be released in six years at the end of the Zion project would yield an IRR to ECP (or EnergySolutions' shareholders should the deal not close) of approximately 8%. To the extent the restricted cash can be released prior to the end of the project, the IRR increases meaningfully. Ignoring the Zion restricted cash effectively allows a buyer to finance a substantial portion of their purchase price with EnergySolutions' own balance sheet. At a bare minimum, we believe any offer price should reflect the value of the Company's restricted cash related to Zion, which could be as much as $2.22/share of incremental value, a meaningful improvement from the currently contemplated $3.75 per share. Ignoring this value implies the Company not only eats through its projected profit on the project, but also an additional $200 million of costs. Given management's comment on EnergySolutions' November 9th earnings call that "the Zion project continues on track and we expect to earn 5% to 10% profit margins over the life of the project" we find it unlikely that this restricted cash has no value. We would also note that the Company's own debt covenants and S&P Ratings provide value for this restricted cash in assessing its leverage.
Historically Low Disposal Volumes at Clive - Current MIMS data suggest waste volumes are at near decade lows. In our discussions with management, they indicated that "very little was going on" by way of major projects at the moment, and the current run-rate volumes in the Company's LP&D segment are largely the "ballast" from the Company's ongoing life-of-plant contracts. Given the high fixed-cost nature of the LP&D Segment and these historically low volumes, we believe EBITDA will improve meaningfully on even small changes in underlying waste volumes. The current $135 million of 2012E EBITDA reflects trough waste volumes, rather than steady-state volumes, and warrants a higher multiple.
Zion Waste Volumes Materially Increase 2014 EBITDA - We believe the Company is 12 months away from meaningful waste volumes from the Zion decommissioning project. As most of the waste comes in years 4 - 6 of a decommissioning project, and disposal can represent up to 30% of the cost of a decommissioning project, we expect EBITDA to improve significantly in 2014. By our estimates, incremental EBITDA from Zion waste disposal could be as much as $30 million beginning in 2014 which will allow the Company to accelerate debt paydown. We do not believe the current offer reflects what should be at least 3 years of meaningfully higher cash flow beginning in 2014.
No Value for Future Decommissioning Projects - The current offer gives shareholders no value for additional decommissioning activity in the coming years. In its latest presentation, the Company highlighted that there are currently 13 nuclear reactors shut down in the United States, with an average of two new reactors shut down annually for the next several years and 38 reactors in total shut down through 2030. Rising equity markets have continued to increase nuclear decommissioning trust funds, strengthening the future opportunity for EnergySolutions. Since the Company will be pursuing these projects in partnership with larger E&C firms going forward, we believe such projects will require little upfront capital. Indeed, we believe the partnerships are essentially a guaranteed pricing mechanism to attract volumes to Clive and motivate both utilities and large E&C firms to begin decommissioning work. Additionally, if done in partnership, multiple projects can run simultaneously, adding meaningfully to free cash flow in the coming years. In fact, it seems as though the Company has already begun working on signing up new decommissioning work. On its August 8th, 2012 quarterly call, CEO David Lockwood said:
We are currently in discussions with several large E&C companies as we speak, and are pursuing a number of decommissioning opportunities with them... Decommissioning is a large and growing market. The funds set aside for decommissioning nuclear power plants are estimated to exceed $4 billion today, and will continue to accumulate in the years ahead... We have done [an] analysis of the balance in the utility funds, some estimates of what it would cost to decommission these plants, and we have come away from that analysis very encouraged that there is sufficient money in a number of funds to go forward.
No Value for Cost Savings - The Company's recently announced restructuring plan should achieve $35 million in cost savings above and beyond the 2012E midpoint EBITDA guidance of $135mm. While we fully expect incremental costs to re-bid the Magnox contract and potentially some impact to revenue in 2013, we believe EBITDA should grow relative to 2012 due to these cost reductions.
Working Capital Improvements - In addition to ignoring restricted cash, we do not believe the current bid provides any value for improvements in the Company's working capital management and instead helps ECP finance the proposed deal. Since taking over in June, the new management team has focused on reducing working capital and using that capital to pay down debt. On its August 8th, 2012 conference call, the Company stated that "we have a lot of cash tied up in working capital and that is a key point of emphasis for us going forward." On the latest quarterly conference call, CFO Greg Wood stated: "we continue to work on working capital and reducing our accounts receivable…we reduced our accounts receivable and unbilled by $20mm during the quarter compared to Q2 and by more than $40mm compared to Q3 a year ago." With a September 30, 2012 accounts receivable and unbilled balance of approximately $373mm, or 75 days sales outstanding, we believe significant opportunity for the release of working capital continues to exist and current shareholders should benefit as this capital is released over time.
Improved Pricing - Prior to its IPO, EnergySolutions entered into "life of plant" contracts for waste disposal covering 84 of the 104 active nuclear power plants in the country. As these contracts are renegotiated or are up for ordinary price adjustments, we believe there is an opportunity to increase pricing, as these contracts were likely priced below-market to lock in recurring revenue in an effort to make the IPO in 2007 more attractive. In the 2007 IPO Prospectus, the Company notes that "life-of-plant contracts typically contain a standardized set of purchasing terms and pre-negotiated pricing provisions and often provide for periodic price adjustments."
Inadequate Multiple for a Business of EnergySolutions' Quality - While E&C companies that are considered to be peers of EnergySolutions trade at approximately 6.9x LTM EBITDA and 8.3x LTM EBITDA - Capex, we note that over time, management has indicated to us that they believe EnergySolutions should trade more in line with low capital requirement, recurring cash flow businesses such as Stericyle, which trade near 20x LTM EBITDA - CapEx. Adjusted for the $200mm in Zion restricted cash, we believe the current proposal is approximately 7.5x the Company's expected EBITDA - CapEx for FY 2012. The Company's LP&D segment-particularly the Clive, Utah facility-should command a materially higher multiple than a traditional E&C business given its recurring revenue, low ongoing capital needs, and near monopolistic positioning in the market. Waste management peers, which are much more similar to EnergySolutions' LP&D segment, trade at LTM EBITDA - CapEx multiples in the mid-teens. Because LP&D represents over 60% of the Company's pre-corporate run-rate EBITDA through the first nine months of 2012, we believe a higher multiple for the Company's consolidated EBITDA - CapEx is warranted. We understand that a 20% premium to the trailing 30 day price may be in-line with the typical merger or acquisition; however, having been shareholders both pre and post the substantial decline in EnergySolutions' stock on June 11th, 2012, and having recently added to our position at prices above $3.00 per share, we are much more concerned with realizing value closer to our estimate of intrinsic value than we are receiving a visually pleasing premium based on an arbitrary point in time.
While we acknowledge the possibility of an improved offer from either ECP or a strategic party and appreciate the process currently underway, in the absence of such an offer we believe shareholders are better served by EnergySolutions continuing to operate independently. We believe the Company's current valuation is depressed due to a leveraged balance sheet and the uncertainty created by recent management changes. Based on our cash flow estimates, however, we believe significant deleveraging will occur over the next several years, significantly improving the Company's balance sheet and, with it, the market value of EnergySolutions' common stock. We believe investors are much better off continuing to hold shares of EnergySolutions and allowing the Company to execute on many of the initiatives the new management team has articulated over the last several months. We strongly urge the Board to reconsider the ECP proposal, as we believe much more value is likely to be obtained through the continued operation of the Company as an independent entity.
Prasad Phatak and Chris Koranda
Tappan Street Partners LLC