I believe that the current valuation of USEC (USU) offers investors a highly favorably skewed risk/reward profile. While shareholders do have to worry about a more than minute chance of bankruptcy or heavy dilution, the far more probable outcomes have return potentials of 2-10x.
USEC is a leading supplier of low enriched uranium ("LEU") for commercial nuclear power plants. Nuclear power plants generate approximately 20% of U.S. electricity and 14% of the world's electricity. The percentage of electricity usage expected to come from nuclear power is anticipated to increase in the future due to its lower relative cost and smaller impact on the environment relative to competing energy sources such as fossil fuels.
The company currently produces about half of its supply of LEU at the Paducah gaseous diffusion plant (GDP) and acquires the other portion under a contract with Russia under the Megatons to Megawatts program, whereby it purchases the SWU component of LEU derived from dismantled nuclear weapons from the former Soviet Union for use as fuel in commercial nuclear power plants.
In 2013, the company will be phasing out both of these primary revenue streams: USEC plans to shutter its outdated and obsolete gaseous diffusion plant and the Megatons to Megawatts (M2M) program is completing its 20-year life.
In lieu of these two programs, the company is in the process of building a new centrifuge technology to replace its GDP, and has already signed an SWU purchase agreement with Russia to replace the SWU the company was purchasing under the M2M program.
Its principal objective now is to secure a $2 billion financing from the U.S. government under the DOE loan guarantee program in order to complete building the American Centrifuge Plant, which it began building in 2007.
Let's look at each program transition separately:
GDP to ACP:
The Paducah gas diffusion plant, which USEC currently leases from the DOE and operates, has been in operation since 1952 and is considered to be an obsolete technology, as it requires significantly more power to enrich uranium than other technologies available today. The company plans to cease operations at the facility this year and return the lease to the DOE. Most of the cleanup cost will be borne by the DOE, and most of the liability that USEC will incur has should already be included as a liability on the balance sheet.
The company believes that the best next step is to transition to centrifuge technology, on which some of their competitors are already operating.
Since 2007, the company has invested over $2.3 billion building the American Centrifuge Plant (ACP) in Ohio, which is expected to utilize 95% less electricity to produce low enriched uranium on a per SWU unit basis than USEC's existing gaseous diffusion technology. Electricity currently makes up approximately 70% of the production cost using the GDP. While revenues would essentially stay the same, the ACP would cut costs and increase gross margins materially.
The company still requires at least another $2 to $3 billion in order to complete the ACP. The company has applied for a $2 billion loan guarantee from the U.S. government under the DOE loan guarantee program, but as of now, has not received the green light. Instead, Congress requested that the company continue further research through December 2013 to reduce the risks and improve the future prospects of deployment of the American Centrifuge technology. The additional research is estimated to cost $350 million, and the government will pick up 80% of the bill.
If the company does manage to receive funding and build the facility, it would be a tremendous boon for shareholders. It is difficult to estimate exactly what the future valuation of the company could be, but assuming that revenues stay in the $1.5 billion range and electricity costs drop by 95%, unlevered free cash flow could be in the range of $500-$750 million per year. (The company does not break out the difference in cost between the M2M and the GDP, so it is difficult to estimate the exact cost savings, but I used a rough assumption based on electricity usage.)
At a range of 10x to 15x unlevered free cash flow multiple (which seems fair considering it would be a relatively low beta company), this would give the company a $5 to $11.25 billion enterprise value. The equity value after deducting the $2.5 billion of debt would be around $2.5 billion to $8.75 billion.
Assuming that the company also issues an additional $1 billion of equity to finance the facility, original equity value would be worth ~$1.1 billion, which means that shareholders could conceivably earn over 8x on their money over the next few years.
What are the chances that the company completes the ACP? I believe the chances are higher than the market is implying (I would peg the chances between 50-75%), based on the following reasons:
- The U.S. government is already very committed to the project -- most recently shown by investing $280 million to fund continued research for the facility.
- The ACP has bi-partisan support, including from President Obama, who wrote during the elections: "Under my administration, energy programs that promote safe and environmentally-sound technologies and are domestically produced, such as the enrichment facility in Ohio, will have my full support. I will work with the Department of Energy to help make loan guarantees available for this and other advanced energy programs that reduce carbon emissions and break the tie to high cost, foreign energy sources."
- The DOE loan guarantee program has made significantly worse investments in less proven technologies.
- The DOE would receive, over and above interest, a 1-2% royalty on gross revenues of the facility.
- ACP would be the only domestic source of enriched uranium. Letting the ACP fail would be a major security risk considering that the other 3 leading enrichment facilities, which together with USEC produce over 90% of the world's enrichment capacity, are sovereign-owned, including Russia.
- Not funding the facility could lead to an increase in SWU prices as SWU demand outstrips supply, and could lead to higher costs throughout the economy as energy costs increase.
- The Obama administration is very focused on jobs, and the ACP would create an estimated 8,000 new jobs.
What happens if the company cannot successfully secure funding?
Under this scenario, the DOE would likely license out the centrifuge technology developed by USEC, for which USEC would receive an agreed upon royalty rate (which is confidential) and capped at $665 million. It is difficult to know how long it would take the company to receive the full $665 million royalty rate, but that would be a potential $665 million, which would likely go to shareholders (at some point) if the ACP facility is not built. It is very unlikely that no centrifuge enrichment plant will be built in the U.S. over the next 5-10 years, considering the high demand from the nuclear industry.
Clearly, it would be more beneficial for USEC to build the ACP facility, but if the company is unsuccessful, it still has the potential to collect over $6 per share of cash in the future.
M2M to Russian Supply Agreement:
The company signed in 2011 a replacement for the Megatrons to Megawatts program called the Russian Supply Agreement. Under this 10 year agreement, USEC will continue to purchase from Russia approximately half of the amount of LEU that it had under the M2M program. The company "will purchase the SWU component of the LEU and deliver natural uranium to TENEX (Russian entity) for the LEU's uranium component. The pricing terms for SWU under the agreement are based on a mix of market-related price points and other factors. "
That last sentence makes analyzing USEC extremely difficult. The company has released no concrete economic information regarding the Russian Supply Agreement. On the Q3 conference call, there were several questions around this topic, but the company refused to give any further information about it.
In all likelihood, the margins will be similar to the M2M agreement, which are themselves difficult to calculate, as the company (as mentioned previously) does not segregate costs related to M2M and GDP.
Due to this lack of information, it is impossible to project with any degree of accuracy the future cash flows of a company under this contract. One would have to guess, though, that the contract is gross margin positive, or the company would not enter into it. Considering Rosatom/TENEX (the Russian supply company) operates centrifuge technology, its prices would likely be reasonable relative to the market.
Clearly, this lack of information adds to the risks of investing in the company.
Other Investment Considerations:
USEC currently trades at $70 million and has net debt of ~$400 million. The company's book value of equity is $650 million, which comes out to about $5.32 a share. Most of the company's assets are pretty dependable, with inventories being marked to market and accounts receivables related to strong customers. One main point of contention on the asset side is the value of the ACP facility if it does not receive funding, which is currently on the books for $1.1 billion. I find it hard to believe that if the company is unable to secure financing that it will lose the full value of its facility, but how much to discount it is difficult to estimate.
Under a scenario where the company is unsuccessful at building the ACP, it could still be worth at least twice its current value taking into account the royalties it would receive from licensing the technology and continuing to sell SWU with a small mark up through the Russian Supply Agreement.
The company does face the risk of bankruptcy/equity dilution, though, as its debt consisted of a term loan of $85.0 million due May 31, 2013 under a credit facility and $530.0 million in 3.0% convertible senior notes due October 1, 2014. Cash at the end of Q3 2012 was $300 million, and the company expects to end 2012 with $200 million, as its plan to invest in inventories ahead of closing down the GDP. The company is in talks to restructure the capital structure, and what the outcome of these discussions will be is unclear.
In summary, the fate of USEC is currently in limbo, and much of its upside is dependent on receiving funding to complete the American Centrifuge Plant. I believe that the market is currently underestimating the potential of the company attaining the required funding and the potential of the company to continue to operate if it does not.
Considering the significant price appreciation potential if the company does receive funding, I recommend both purchasing the stock, as well as January 2014 call options with a strike price of $1.00, currently trading at 15 cents. If the funding situation is worked out by then, the stock could trade significantly higher while limiting your downside to only 15 cents.
Another potential catalyst is the potential acquisition of Urenco, which could put a more concrete valuation on SWU values.
Disclaimer: This is far from a guaranteed investment, and there are many variables to consider. Please do your own diligence, as I do make errors and may have a different understanding on these issues than you.