On January 15, 2013 we wrote a letter to the Board of Directors of EnergySolutions (NYSE:ES-OLD) expressing our belief that the go-private offer from Energy Capital Partners ("ECP") was inadequate. In that letter, we highlighted many of the business opportunities available to the company, the value of receiving the restricted cash back from the company's Zion Decommissioning Project, and the inadequate valuation offered by the buyer. A copy of the letter can be found here.
In light of new information in the merger proxy and recent investor presentation to lenders, we recently sent the Board of Directors a follow up letter. We believe incremental information since our letter only strengthens the case that ES is dramatically undervalued at the offer price of $3.75/share and that shareholders will be much better off if the company operates independently. We believe the company is not getting credit for its solid asset base, restricted cash associated with its Zion project, and that other transaction alternatives provide a better return to shareholders over time. We have detailed this in an analysis attached as an exhibit at the end of our letter. Additionally, we found errors in the analysis performed by the company's financial advisor and are troubled that the Board would rely, at least in part, on faulty financial analysis from its advisor to justify the going-private offer. A copy of our letter, which more fully details our points, is copied below:
February 14, 2013
Attn: Board of Directors
423 West 300 South, Suite 200
Salt Lake City, Utah 84101
Ladies and Gentleman,
As a follow up to our letter dated January 15, 2013, we are writing to express our serious concerns about the Board's decision to accept Energy Capital Partners' ("ECP") offer of $3.75 per share for EnergySolutions (the "company"). Per your instruction to other shareholders who expressed their displeasure with the go-private offer, we waited for the expiration of the go-shop period and the release of the proxy to more fully understand the Board's decision and the background of the process. While it is not surprising to us that the company did not receive a superior proposal from another party given its unusual collection of assets, the question from our initial letter remains: does remaining independent provide more value to shareholders long-term? We believe incremental details from the proxy and the recent investor presentation to lenders serve to strengthen the case that the offer by ECP grossly undervalues the company.
We believe shareholders should reject the offer to go private at $3.75 per share for the following reasons:
No Value Given for Restricted Cash - We continue to be baffled that the company and its advisor, Goldman Sachs ("GS" or "Goldman"), have neglected to include restricted cash from the Zion decommission project in valuing EnergySolutions. In its calculation of enterprise value on page 49 of the proxy statement, Goldman Sachs only adjusts for the amount of projected cash and cash equivalents at 12/31/12 of $125.7mm. While we understand that there is a risk that the company may not get the entire restricted cash balance back from projects such as Zion, in giving current shareholders no value for the restricted cash the Board and Goldman Sachs have already assumed a worst case scenario. If the Board is already assuming the worst case scenario, we see no reason to accept this proposal as there is very little downside from a valuation perspective and shareholders will instead have the "free option" of recouping the restricted cash at a future date. We even expected that the proxy would have some "smoking gun" related to Zion and some reason for excluding restricted cash. However, much to our delight, details from the recent presentation to lenders, the merger proxy, and filings with the Nuclear Regulatory Commission ("NRC") suggest quite the opposite:
- In the proxy on page 53, the company presented its downside "Case 2" which includes a 50% reduction in Zion profitability. We note that even with a 50% reduction in profitability, any profit from the Zion project will result in the full release of $200mm of project restricted cash back to the company.
- In the company's most recent Lender Presentation on February 11, 2013 on Slide 17 the company highlights that it will "continue to pursue strategies to reduce collateral supporting the [Zion] project". Additionally, on Slide 25, the company highlights that the "Project is on schedule, [and] management expects 5-10% profit margins including waste disposal to Clive."
- In the same presentation to lenders, the company evaluates its credit statistics net of restricted cash (Slides 9, 21, 30). Including the restricted cash for credit purposes and excluding it for valuation purposes strikes us as inconsistent.
- The company filed a License Transfer request with the NRC on January 10, 2013 related to the proposed transaction with ECP. We point the Board to page 31 of 49 which shows the projected budget for the Zion project with a detailed cost build-up through the year 2020. This shows that the project will be profitable and the projected NDT trust funds continue to be above projected costs. While the budget is as of January 1, 2012, presumably if things have changed materially the company would be obligated to let the NRC know of this material change prior to filing for its license transfer. As we have pointed out above, management continues to expect a 5-10% profit margin on the project.
If it is true that neither ECP nor the Board believe the restricted cash has any value, then we urge the Board to distribute contingent value rights (CVRs) to existing holders so that any future recoupment of restricted cash can go exclusively to existing holders. This should be a "free" offering from ECP, since they do not appear to be ascribing value to the restricted cash.
- Strong Interest in Core EnergySolutions Assets - While we acknowledge that no party ultimately provided the company with a superior proposal, we were pleasantly surprised by the amount of unsolicited interest the company has received over the past several years. The company received preliminary proposals and discussed transaction structures for the entire company, UK assets, the Government Group and the Zion decommissioning project. The common thread was that many buyers balked due to the Zion project and concerns regarding bringing the project and its complex accounting onto their own balance sheets. We believe the remedy for this problem is time. While Zion is a 10 year project, much of the heavy lifting is completed in the first seven years. Once the Zion project is more mature and the balance sheet burden diminishes, we believe EnergySolutions will fetch a far better price in the market, should the Board choose to pursue a transaction at that time. However, we see no reason why the company should sell its strong and "non-replicable asset base" (Lender Presentation slide 16) for what we believe to be a steep discount to its intrinsic value simply because other buyers were unwilling to take Zion.
Attractive alternatives are available - The merger proxy filed on February 8, 2013 provides a long and detailed list of interactions with over 20 parties over a period of two years. Initial non-binding proposals received were as high as $9.00 per share, although as we noted above, many bidders were uncomfortable with the Zion project. The initial non-binding offer from ECP in November 2011 was for a minimum of $5.10 per share. However, two things in particular stand out:
- After receiving an offer from ECP of $3.75 per share, the Board in early January 2013 asked ECP to increase the offer to $4.00 per share. After being told no, the Board simply accepted the $3.75 per share offer. We are puzzled by the Board's immediate back down.
- In December 2011, one party (Party H) offered to invest $50mm in equity at a premium to the market price on that date, as well as $50mm in warrants struck at $7.00 per share. The combination of the purchased shares and exercised warrants, if the stock price were to rise to $7.00 per share, would have given Party H an ownership stake in the company of roughly 51%. In January of 2012, the Board rejected Party H's proposal because they were concerned with "significant dilution to our stockholders."
Many capital raising transactions have the potential to be dilutive. The question is at what price? We are dumbfounded the Board would be concerned with dilution at $7.00 per share, but is willingly allowing for 100% dilution of current stockholders at a price of $3.75 per share. If the Board was so concerned with the company's leverage or dilution, why was the option of a rights offering, where current holders could choose to invest more to offset potential dilution, never considered? Given this miss, we question why we should accept the Board's assertion that the current offer is the most compelling alternative or why this offer is better than EnergySolutions operating independently.
Serious Concerns with Fairness Opinion - We are very concerned that the company's advisor, Goldman Sachs, may not be the most objective party to conduct a valuation opinion for the Board. In particular, we are troubled by the following facts:
- Four of the five Partners of Energy Capital Partners are all former employees of Goldman Sachs. Collectively they have approximately 49 years working in the Goldman Sachs Investment Banking Division (IBD).
- During the two year period ended January 7, 2013, the Goldman Sachs IBD has received approximately $4.8mm from Energy Capital Partners and its affiliates.
- From page 52 of the proxy, "Affiliates of Goldman Sachs also may have co-invested with Energy Capital Partners and its affiliates from time to time and may have invested in limited partnership units of affiliates of ECP from time to time and may do so in the future."
- The company's current CEO, David Lockwood, who will be remaining with the company, is a former employee of Goldman Sachs. While the Board has prevented him from negotiating with ECP regarding rolling over equity in the deal, we believe it is fair to assume that he will not be working for free going forward and based on our knowledge of similar deals we believe it is very likely he will receive a substantial portion of his compensation in stock of the new entity.
- Goldman Sachs will receive a transaction fee of $10.7mm from the company, contingent upon successful consummation of the merger agreement.
We suspect we are not the only shareholders that have serious concerns with the fact pattern above. While we are not accusing anybody of willful wrongdoing, we believe maintaining true objectivity in light of the facts above is difficult.
- Valuation Methodology Ignores Waste Management Peers -As we highlighted in our initial letter, while the company's management believes the company should trade more in-line with waste management peers such as Stericycle, these peers are noticeably absent from Goldman Sachs' multiple analysis, and they have instead relied on engineering and construction peers that trade at materially lower multiples. This is despite the fact that 60% of EnergySolutions' pre-corporate LTM run-rate EBITDA is generated from the company's LP&D segment, and not its service businesses, which are similar to the engineering and construction comparables chosen.
- EBITDA Multiple Valuation Ignores Capital Requirements - Traditional EBITDA valuations ignore the fact that EnergySolutions' core disposal assets have very "moderate capital expenditure requirements" (Lender Presentation slide 18). Using Goldman's EBITDA multiple based valuation, two businesses of equal EBITDA but vastly different capital requirements would be worth the same enterprise value, a conclusion with which we fundamentally disagree. One of the benefits of the company's disposal assets in particular is the low capital requirement for growth and we believe an EBITDA based valuation misses this fact.
- Goldman Sachs' "Present Value of Future Share Price Analysis" is Nonsensical - While we recognize that valuation is a mix of art and science, we believe GS' analysis on page 50 of the merger proxy is incorrect and internally inconsistent. Goldman calculates a future enterprise value using multiples of projected EBITDA in years 2013 - 2017, but then deducts the December 31, 2012 net debt balance to calculate a "future equity value." It does not take much to realize the obvious mismatch here. By not matching future enterprise value with future net debt balances, Goldman's framework ignores cash flow generated, and thus equity value created, in the interim. A correct analysis would use future enterprise values and deduct future projected net debt balances, which would then be a correct "future equity value." This point is not debatable. We estimate that if Goldman had done their analysis correctly, it would have added more than $1.00 per share to the ranges of the present value of future equity values given. We are troubled that GS would rely on this incorrect valuation framework and that the Board would consider this in evaluating the proposal from ECP. The correct way of doing this analysis is more clearly depicted in our exhibit attached to this letter.
- Substantial Debt Paydown is Possible Through Free Cash Flow Generation - While we agree the company has too much leverage currently, we believe substantial deleveraging is possible simply through using free cash flow generation to pay down debt over the next several years. We have attached our analysis as an exhibit to this letter using the company's "Case 2" downside projections for EBITDA and have conducted a valuation using Goldman Sachs' EBITDA methodology. While we believe the company has plenty of opportunities not captured in the Case 2 projections, many of which we highlighted in our initial letter, we think it is important that the Board see what the company might look like under its own downside scenarios, even using Goldman's inappropriate comparable set. We also believe this exhibit highlights the value of the company's restricted cash. Ignoring the value of the restricted cash, when it can be used to pay down debt in the future, is a massive value transfer from current shareholders to ECP at the current offer price of $3.75 per share. We have also highlighted the IRR to a shareholder paying $3.75 per share today assuming they were able to hold for an additional 4 years.
We believe the current offer of $3.75 per share is not in the best interest of current shareholders. Selling the company at this price represents a very expensive opportunity cost, as even in the company's downside scenario shareholders will be forced to forgo an IRR of 25%. Additionally, in the case where Zion restricted cash is not released, simple free cash flow generation and debt paydown would yield an IRR to current shareholders of 16% in the downside case. If the Board is serious about maximizing shareholder value, they will reject the proposed merger and consider other capital raising transactions if incremental capital is required, such as a rights offering. Alternatively, we encourage the Board to consider transaction structures such as the issuance of CVRs as discussed above so that current shareholders will receive value for the return of the Zion restricted cash, an asset that we believe is not being valued. It is not too late for the Board to maximize value. Ultimately, it will be up to shareholders to decide whether or not to accept the transaction, but as currently contemplated, we cannot vote in favor of the merger.
Prasad Phatak and Chris Koranda
Tappan Street Partners LLC
Disclosure: I am long ES-OLD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.