As I noted in my write-up for The Pantry (PTRY), my investing strategy focuses on finding value stocks trading at a Price to Book (P/B) of less than one. From these, I try to find seemingly boring and unsexy companies that I think will keep posting positive free cash flows to equity holders long enough for the market to re-evaluate the company, presumably at a P/B of greater than one.
One company that's held my interest for a while now is Mirant Corporation (MIR). Again some basic information:
- Market Cap : 2.35B
- Enterprise Value: 2.93 B
- P/E : 1.99
- Forward P/E : 10.23
- PEG Ratio : 0.18
- P/S : 0.79
- P/B : 0.53
Yahoo! Finance description:
Mirant Corporation produces and sells electricity in the United States. It generates electricity through coal-fired and oil and gas generating facilities. The company's operations primarily consist of procuring fuel, dispatching electricity, hedging the production and sale of electricity by its generating facilities, managing fuel oil, and providing logistical support for the operation of its facilities. The company was founded in 1982 and is headquartered in Atlanta, Georgia.
The Crux of It
The main sell for Mirant is that even after taking away intangibles, goodwill, and other non-current assets, the stock still maintains a P/B of less than one. Looking at their balance sheet from their most recent Q3 filings, using today's closing stock price and subtracting the value of intangibles, derivative contracts, deferred income taxes, prepaid rent and other, I get a P/B of 0.87.
From that P/B, Mirant is being priced practically like it's going in to bankruptcy. When all of these values are netted from shareholder's equity as reported on the balance sheet, one essentially arrives at a post-bankruptcy value to shareholders because I would consider these netted assets ones that would only remain valuable to the business were it to remain a going concern. Arguably if the derivative contracts were exchange traded they could probably be easily sold off, however since Mirant noted that they dealt quite significantly in OTC derivatives I subtracted this value to be more conservative.
If Mirant was going in to bankruptcy, I wouldn't want any part of it. I'm not a lawyer or a vulture and don't want to speculate whether there's going to be more than the current share price left over once senior stakeholders have been paid. The company's large cash reserves and a question regarding whether or not Mirant actually has excess cash from their recent Q3 earnings call have lead me to believe, however, that this company is not being priced because of bankruptcy risk. In light of this, it's necessary to look at other possibilities.
So Why the Discount?
Typically, if something sounds too good to be true, it probably is. That being said, with Mirant I think the reason for the dramatic under-pricing is a market perception that companies like Mirant, generating electricity from coal and gas, are carrying unstated environmental liabilities and could potentially get thrown under the bus as the United States' economy moves toward "green" energy.
If you look at Mirant's competitors, this story is supported. The AES Corporation (AES) and Calpine Corp. (CPN) are both trading at P/B values of over one (2.01 and 1.19, respectively), and in both companies' business descriptions they note being involved in one or more alternative energy generating activities, including geothermal and wind. RRI Energy, Inc. (RRI), however, is only trading at an unadjusted P/B of 0.47. The distinguishing difference of RRI? They're not involved in alternative energies, much like Mirant.
Is this discount warranted? Looking at Mirant, they've had to spend $1.67 B, of which they still have $341 MM to go, on capital expenditures due to the Maryland Healthy Air act. They estimate further capital expenditures to bring them up to other environmental standards to be $12 MM in 2009 and $20 M in 2010.
While environmental liabilities will affect companies that are more heavily involved in the dirtier forms of electricity production more than those that are producing partially from alternative means, both companies are still retaining environmental liabilities were states and/or countries to become more adamant about reducing pollution. AES for example, while utilizing wind energy, only generated $28 MM of their Q3 $3.8 B in revenue from it. So while they may be better poised with operational expertise in this industry as it takes off, they're still generating the bulk of their revenues the old fashioned way.
Stability of Cash Flows
Mirant posted operating cash flows of $727 MM for Q3, with total net CFs of $198 MM. This included capital expenditures of $508 MM, well above depreciation charges of $37MM.
One of my concerns with Mirant's CFs was the amount coming from proprietary trading. Being familiar with Enron, several red flags went up when I read about this element of their business in their most recent 10-Q. However, upon noting that realized trading revenues only accounted for $32 MM (7% of total) and even after subtracting unrealized trading losses of $24 MM that the figure would still be positive at $8 MM, I was much calmer.
Looking forward to upcoming charges, Mirant notes projected capital expenditures of $225 MM in 2009 and $441 MM in 2010. These comprise expenditures for the Maryland Healthy Air Act (60% of 2009 and 46% of 2010), other environmental (5% and 5%), maintenance (26% and 26%), construction (4% and 18%) and other (5% and 5%).
As I understand it, a large chunk of this construction expenditure is going to come from building Marsh Landing, a "760 [Megawatt] natural gas-fired peaking" plant" near Antioch, CA. From their Q3 earnings call, Mirant notes: "We expect [Marsh Landing] to begin construction next year, and we expect to have construction completed and go into commercial operation in May 2013". For some perspective, Mirant currently produces 10,112 MW of power, so Marsh Landing would expand production by 7.5%.
In terms of upcoming debt, Mirant has $535 in unsecured LT debt coming due in May 2011 and $374 MM in secured LT debt coming due between 2009 and 2013. Based on their positive net cash flows and large cash reserves ($2.0 B), I don't see Mirant having any issues either retiring the debt or rolling it over, especially as credit markets continue to unfreeze.
In terms of looking at operating revenues for 2010 and beyond, Mirant seems to have a very effective hedging program in place to smooth out volatile commodity movements. Mirant is 86% hedged for 2010 for power prices and 78% for fuel. Looking forward, they're 52% hedged for power and 61% hedged for fuel in 2011, with this hedging level continuing to taper off until effectively reaching zero in 2014. In light of this, I don't see a dramatic threat to Mirant's positive net CFs in the near future.
Outlook for U.S. Energy
While the prospect of the power generating assets of Mirant becoming impaired as environmental standards increase or alternative technologies become cheaper increases the risk of this company, I'm of the persuasion that the United States' need for energy will maintain the necessity for more traditional forms of power generation.
In a slide presentation from Mirant that accompanied their Q3 earnings call, the company included a graph looking at current and predicted reserve margins. For those of you unfamiliar, reserve margin is "the capacity of a producer to generate more energy than the system normally requires".
The earnings call noted:
I point as I have before to the orange line toward the bottom of the page, which is PJM East, which is our most important market. This trend remains and takes into account all that's going on demand side management and other efforts, and it is for anyone who is responsible for making sure that there is an adequate electric supply to meet the needs of the American public, a worrisome situation. This is not how a system should operate. This is not a good trend. It is a good trend for incumbents. It is a good trend in our own narrow self-interest for Mirant, but this is not good for the system.
While this is of course using their proprietary research, I think that when it is combined with other research it suggests that the United States and the world will increasingly need more and more energy, of which for the foreseeable future traditional energy generating techniques will remain a large part.
While I don't profess to be an expert on energy generation or utilities, I do feel that Mirant is priced at such a level as to be a very good investment possibility. Especially facing what I perceive to be an improving macro-economic climate, I strongly feel that Mirant possesses potential to be positively revalued by the market.
Too see the spreadsheet I used for my analysis, please check out my blog.
Disclosure: Author holds a long position in MIR