International utility AES Corporation (AES) is not your typical utility stock: there is no dividend, growth is a primary objective, and financial leverage has at times been questionable. This company is of interest to the aggressive or speculative value investor because the downside risk appears manageable from Friday's close of 14.04 while the upside reward is indistinct and may be underestimated by the market.
The company describes itself as follows:
We are a global power company. We own a portfolio of electricity generation and distribution businesses on five continents in 29 countries, with generation capacity totaling approximately 43,000 Megawatts ("MW") and distribution networks serving over 11 million people as of December 31, 2008. In addition, we have more than 3,000 MW under construction in ten countries. Our global workforce of 25,000 people provides electricity to people in diverse markets ranging from urban centers in the United States to remote villages in India. We were incorporated in Delaware in 1981 and for almost three decades we have been committed to providing safe and reliable energy.
We own and operate two primary types of businesses. The first is our Generation business, where we own and/or operate power plants to generate and sell power to wholesale customers such as utilities and other intermediaries. The second is our Utilities business, where we own and/or operate utilities to distribute, transmit and sell electricity to end-user customers in the residential, commercial, industrial and governmental sectors in a defined service area
International/Emerging Markets Strategy
Many analysts question the amount of growth that will arise in the US during what may prove to be a sluggish economic recovery. Because AES is actively growing its presence in international and emerging markets, it naturally fits into investment strategies aimed in that direction.
Obviously the company has assets that are exposed to misappropriation by regimes that make a policy of nationalization or seizure of productive resources. From the 10-K:
...in the second quarter of 2007, we sold our stake in EDC to Petróleos de Venezuela, S.A. ("PDVSA"), the state owned energy company in Venezuela after Venezuelan President Hugo Chavez threatened to expropriate the electricity business in Venezuela. In connection with the sale, we recognized an impairment charge of approximately $680 million. In addition, our Latin American operations experience volatility in revenues and gross margin which have caused and are expected to cause significant volatility in our results of operations and cash flows. The volatility is caused by regulatory and economic difficulties, political instability and currency devaluations being experienced in many of these countries. This volatility reduces the predictability and enhances the uncertainty associated with cash flows from these businesses.
Diversification across 29 countries on 5 continents should maintain this risk at a manageable level.
Utilities tend to carry large amounts of debt. AES has more than usual, although in recent years that situation has been improving. The 10-K is accompanied by an exhibit 12.1, which sets forth the ratio of earnings to fixed charges. From 2005-2008 the ratio progressed as follows: 1.23, 1.54, and 1.97. Clearly, this situation has been improving.
The financial set-up is a holding company, with much of the debt in the subsidiaries being non-recourse to the parent. As of the 3rd quarter 2009, non-recourse debt totaled 14,014 million, compared to 5,656 million of recourse debt. Moody's rates the AES Corporation's senior unsecured debt at B1. A recent presentation features a information about recourse vs. non-recourse, liquidity, etc.
Accounting errors in the 2006 10-K necessitated restatements, always cause for concern.
On November 6, 2009, AES announced an agreement with a subsidiary of CIC (China Investment Corp). CIC will buy 125.5 million shares for 12.60 per share, increasing equity capital by 1.581 billion. This will be mildly dilutive of existing shareholders. The deal is expected to close during the first half of this year, subject to regulatory approvals.
This agreement, when implemented, is a positive, as the increased equity should improve financial strength and flexibility going forward. The CIC investment returns about 7% based on existing earnings, substantially more if the capital acquired is deployed effectively. It appears fair and beneficial to all parties concerned.
Cash Flow and Capex
The most recent presentation asserts a 22% CAGR rate for proportional free cash flow, a nonGAAP metric. As a general rule, Mr. Market prefers cash flow to capex. AES, if performing according to plan, will generate increasing EPS and free cash flows from its construction program, which is fully financed and 96% contracted under long term contracts. Increasing free cash flow is normally a tell for increasing share prices.
AES is active in wind and solar, recently announcing commercial operation of its wind farm in Armenia Mountain, PA.
5 year average EPS is a good metric for a utility where earnings are expected to be relatively steady of time. Using 3 ¾ actual plus guidance for Q4 09 and a generic estimate for 2010, I project 5 year average EPS at 1.03 as of the end of 2010. Applying a historical midpoint multiple of 17 to this metric, I arrive at a target of 18. A similar exercise on P/S ratios yields a target of 22. I am investing on the basis that this stock will hit 18 within one year.
Assuming the CIC investment occurs as agreed, these valuations would need to be revised. AES has managed some excellent if irregular ROEs, well in excess of the implied cost of this equity capital. As such, revisions would be a judgment item, reflecting an opinion as to management's skills in deploying capital. I think they can do 20% ROE with these funds going forward.
Revenue growth for the past 5 years annualizes to 9%. At today's prices the investor is getting GARP.
A review of past price history suggests that this stock is worth what someone will pay for it. The 52 week high/low is 15.44 - 4.80. From 2006-2008 high prices were over 20 every year. Five year average EPS is a fairly stable metric, but AES has traded at multiples ranging from 5 to 38 on that basis, with multiples in excess of 25 occurring every year from 2005-2008.
An investor might take up a starter position, accumulating on the dips, and selling if and when the growth/emerging markets story for this company becomes popular. Entry point would depend on the investor's estimate of current market level and credit trends, as this stock can be expected to under-perform if credit markets experience renewed difficulties. The attraction is, it will likewise outperform if global recovery moves on to a new era.
For options players, the following spread makes sense to me:
Buy to open 10 VNUAU, AES Jan2011 7.5 calls @ 7.01
Sell to open 10 AESEC, AES May2010 15 calls @ .91
A Philosophical Digression
The other day I was doing some self-examination on my success as an investor and came to the somewhat sorrowful conclusion that my low conviction picks seriously out-perform my high conviction picks. How can that be?
On a typical high-conviction case, I study the industry and company in some detail, do detailed projections, delve into supply/demand, write copious notes on my findings, etc. The problem is, with so much support for an opinion, and such a large investment of time and energy, it's hard to just let go and move on to the next thing when I'm wrong. Probably I would do better to leave high conviction to Warren Buffett or others better qualified to practice that art and science.
Furthermore, it is difficult to develop high conviction without a credible amount of factual support - belt, brace and suspenders. Everyone else has the same information and there just isn't a lot of pop in these type cases. The reason Buffett does so well on them is he always has the ability to write a check and he has a very long time frame, only buys when the best companies can be had at a discount, everyone else is in a state of panic.
Don't get me wrong: I always do my homework – look at 10 years financials, visit the website, check out presentations, fill out a 5 page spreadsheet, browse professional analyst opinion, etc.
The difference is, on a low conviction case, I see something value-wise that looks attractive, together with some sort of reservation - a blemish, a worm in the apple, a rose among thorns, a diamond in the rough. Rather than try to talk myself past the reservation, I just accept it, factor it in as part of risk and reward, and take it from there.
If a low conviction pick does poorly, it is easy enough to do the right thing, close the position, and go on to something more promising. Similarly, if it does unexpectedly well, it is a pleasure to take profits, none the worse for being quick and easy. Rather than trying to research or rationalize the risk out of existence, it is more effective to accept it and deal with it.
AES is not a high conviction pick, given the geo-political and financial risk. But it could have some pop. I like it at the price.
Disclosure: Author holds a long position in the AES options position mentioned