MMC Energy: Attractive Business Model Requires Acquisitions

MMC Energy (MMCN.OB) had an update conference call for investors late last month, and recently announced a significant bit of stock-related news, so I thought I'd catch up a bit on this company.

Background
MMCN is a small scale power plant acquisition company, with the goal of acquiring small electrical power generating facilities in high demand areas. It came public last summer, just in time to put a couple of its plants online for the Southern California heat wave, and is at this point unprofitable and - it hopes - at a very early stage of its growth.

I wrote a bit about MMCN when I first purchased shares, and the shares I own are still under water. Largely, that's because most investors, myself included, have a hard time putting a value on this company until we know how many acquisitions - and which acquisitions - it'll be able to make. It also had some insider selling, and a delay of its stated goal of listing on the AMEX by the end of 2006, both of which I think depressed the share price.

The interesting thing about MMC, in my opinion, is not so much that it's acquiring power plants - which most people agree are in very short supply, with many high growth areas routinely undersupplied - but the way it makes money from these plants.

Unusual Business Model
It owns only three operating plants right now, but it's shown with these three and indicated for future acquisitions that it's not really aiming to be in the business of selling electricity. Odd, eh? Instead, it essentially uses its power plants to sell insurance. Now don't get me wrong, it does sell the electricity when its plants are operating, and it does make some money from those sales, but the vast majority of its revenue is from "reliability sales."

The company employs what it calls a "Reliability Asset Model," whereby it recognizes that the primary value of its small power plants is the capacity it provides - not necessarily the actual watts generated at any given moment. You see, utilities as part of their regulatory burden are required to show that they have the capacity to handle peak power demand, and that they have a margin of safety of additional demand above and beyond that capacity.

And MEMC sells them the promise of that capacity. So far for 2007, for example, it has agreed to what are called in California "resource adequacy contracts" for all of its generating capacity for the year.

That means, before it even fires up the turbines, it's made $3 million for this year. And this money is its to keep even if the plant never operates, so you can imagine the very high margins these sales represent. In exchange, it agrees to have its plants ready and willing to fire up at ten minutes notice to supply the grid during peak demand times.

So most of the time, its power plants aren't operating. When it is called upon, it still gets paid an additional amount at some kind of market rate for generating whatever electricity is required.

I just love this model.

Dire Need for Acquisitions
Now, the bad news is that although it's executed these forward reliability contracts for several years out for much of its capacity, it still can't make it as a going concern without significantly more acquisitions - its SG&A expenses and the recommissioning expenses for each plant take too much of a bite out of the firm when it's only got three tiny plants in its portfolio, so growth is necessary.

And while it has enough cash to get through the year, it doesn't have enough to make acquisitions - so there will be some significant amount of financing, probably dilutive equity financing, that has to be done as soon as it's ready to make more acquisitions.

Which is why the bit of news it announced this week stands out as significant: shareholders (myself included) voted to approve a reverse split in the shares, and the board has determined that it will be a 10:1 reverse split to get the share price up to the neighborhood of eight or nine dollars.

Looking Towards a Major Listing
Now obviously splits and reverse splits don't usually mean anything - but this one is significant, because it will supply the last key criteria to meeting the listing requirements for the major exchanges. Now, as soon as the board feels like it, it can apply for a listing on the AMEX (or possibly the Nasdaq, I suppose).

And that major exchange listing will be a key financial development, since it will make its shares available to institutional investors and provide a much broader market for it when it does make any secondary offerings required in order to finance its acquisitions. The company believes that there is significant demand for institutional investment in the energy generation space, and hopefully a major exchange listing will help it to bring in those investors in secondary offerings without causing too much damage to the share price.

Though I bought shares at an inopportune price, in retrospect, I do think this model makes a lot of sense going forward and I'm confident that management is at least trying to build the company the right way. If you look at its financials for 2006, the $6 million loss on the year included more than $4 million attributable to one-time items - administrative costs related to its IPO and financing, and recommissioning of its newly acquired plants. If those costs hadn't been there, it would have been profitable for the third quarter last year thanks to the heat wave. So there is some promise that this model works if it can scale up a bit more. I'm not buying any more shares just yet, but I am watching this one with some interest.

Update: About an hour after I finished this post - the shares dropped 20%. At the moment I have no idea why, but it looks like someone might not like the reverse split very much.