FirstEnergy Solutions Debt - Swan Dive Or Bungee Jump...?

| About: FirstEnergy Corp (FE)

Summary

FirstEnergy Corp announced plans to exit its merchant power business within 12-18 months.

Sale, closure, and bankruptcy are all possible exit paths.

Merchant power-related unsecured notes plunged into the mid 40s after the exit announcement.

Certain FirstEnergy Solutions notes are worth consideration at their repriced levels.

FirstEnergy Solutions Corporation (FES) is a wholly-owned subsidiary of publicly-traded FirstEnergy Corp (NYSE:FE), a holding company for 10 regulated distribution utilities selling electricity to 6 million wholesale and retail customers concentrated in Ohio, Pennsylvania, New Jersey, West Virginia, and Maryland. FE also has an unregulated merchant power business conducted via its Competitive Electrical Services (or CES) segment. CES is managed as a $5.4 billion stand-alone business which generated and sold 58 million MWH of electricity last year from a diverse 13,162 MW power portfolio. The portfolio includes coal, at 48% of net capacity; nuclear, 31%; gas/oil, 12%; and hydro/wind/solar, the 9% balance.

FES, Allegheny Energy Supply (or AE) and FirstEnergy Nuclear Operating Co (or FENOC) are the 3 key entities within CES. FES has two principal subsidiaries, FirstEnergy Generation, LLC (FG) and FirstEnergy Nuclear Generation, LLC (or NG). FES purchases all of the power generated by FG and NG, uncommitted output from AE, output related to leasehold interests in Ohio Edison Co. or Toledo Edison Co. (in facilities subject to sale/leaseback arrangements), and certain full output, cost-of-service Power Supply Agreements. FG and NG own or lease, operate and maintain FE's fossil and hydroelectric generation facilities (excluding those owned by AE and its subsidiary Monongahela Power Co.). NG owns FE's nuclear generation facilities and FENOC operates and maintains them.

Going Regulated. Management has decided to fully exit the CES merchant power business over the next 12-18 months and focus solely on the regulated distribution and transmission of electricity. This decision is part of a continuing trend by U.S. utility companies to divest themselves of merchant power generation units. The logic of combining stable cash flows from a regulated utility with unstable cash flows from merchant power generation has made less and less sense given the increased volatility of natural gas prices (and other commodity input prices). The delayed Clean Power Plan requirements that would mandate state-by-state carbon emission cuts have proven all but unnecessary in removing coal-fired plants. With little growth in demand for electricity, competition from less expensive gas-fired plants, and subsidies making alternative energy more attractive, those mandates have become superfluous. Last, the election this year of a new Republican administration for the White House and Republican control of Congress will likely assist coal producers and relax pollution control restrictions on coal-fired plants. However, that may not increase CES' profits on its coal-generated electricity and could reduce margins at its oil/gas, nuclear, and alternative energy facilities by increasing supply and decreasing capacity prices in the PJM, the nation's biggest competitive electricity market.

The difference between what FE management projects for the regulated utility operations and the unregulated merchant power operations is stark. FE expects its regulated operations to see 4% to 6% compound annual growth over the next 3 years. The distribution business is expected to earn more than $1.81 per share this year and $2.24 per share next year and the transmission business is expected to earn a minimum $0.78 per share this year and $0.81 per share next year. On the other hand, while CES is expected to remain cash flow positive and generate north of $1 billion funds from operations for the next 3 years, management also expects CES' FY'16 EBITDA of $920-950 million to turn into FY'17 EBITDA of $595-660 million. As it removes merchant power capacity, by FY'18, management sees a further reduction in CES Adjusted EBITDA to $275-395 million. On the bottom line, CES FY'16 $0.53 per share this year may go to a possible loss of $0.01 per share in FY'17 (including special items).

On its Q3'16 earnings conference call, FE management said market conditions for CES continue to deteriorate, "punctuated by weak power prices, insufficient results from recent capacity auctions and anemic demand forecasts." That is true for all merchant power sellers and they have responded by shutting down or selling power assets. Since the end of FY'12, CES has itself deactivated 33% of its own merchant power capacity.

Three Problems. While the logic for FE's decision is clear, CES faces three company-specific threats to achieving Fe's objective. First, a railroad transportation dispute may result in CES owing $770 million in contract liquidation costs. Second, rating agency downgrades will prevent the FG and NG subsidiaries from refinancing $645 million of debt puttable prior to FYE'18. And third, CES may need to post up to $355 million of additional collateral to satisfy financial guarantees.

In August '15, after the EPA implemented its Mercury and Air Toxics Spend rule (a/k/a MATS), FE declared a force majeure to suspend rail transportation contracts for coal to be delivered to deactivated plants. BNSF and CSX (NYSE:CSX) are disputing the force majeure claim via arbitration. The railroads could be owed up to $770 million in contract liquidation payments due by the middle of next year if the arbitration decides by February '17 there was no force majeure. An arbitration award significantly below the $770 million figure is still a major financial risk for FES. A $100 million award - a fraction of the damages sought - would still be enough to trigger a default under the company's credit agreement, which is another reason why Moody's cut the Company's credit rating to Caa1. Management said last week that "a very negative" decision in the railroad case would speed up the 12 to18 month time frame for exiting CES.

That's a bit of wishful thinking. A large arbitration loss would doom CES' ability to refinance $645 million of puttable debt maturing by FYE'18 and also require posting of additional collateral under FE's financial agreements. At its current debt ratings, CES is already required to post $68 million of collateral. A further ratings downgrade adds $10 million to that figure and the triggering of a material adverse change would add another $10 million. Most problematic is the potential for another $265 million of collateral to be required to satisfy surety bond agreements. That would bring the total potential collateral requirement up to $355 million. FES could address the increased collateral requirements through a combination of cash on hand, borrowing under the unregulated money pool or proceeds from asset sales. However, how much collateral is needed at what time is not entirely predictable.

FE's Plan. On the Q3'16 conference call management said it wants to convert competitive generation units to a regulated or regulated-like construct in Ohio, while seeking a solution for nuclear units in Ohio and Pennsylvania that recognizes their environmental benefits. FE intends to dispose of FES' 13 coal, nuclear, hydro, gas and oil power plants. What cannot be sold or placed into regulated or lightly-regulated contracts will be closed. Of the 13 plants, 6 are powered by natural gas, 4 are coal-fired plants and 3 are nuclear plants. FE management underscored its intention to distance itself from merchant generation by announcing its intention to bring on independent board members at FES and by stating its intention not to provide any further equity funding to FES.

In Ohio, management spent a year hoping state regulators would approve Purchase Power Agreements for two unprofitable plants. Management requested an 8-year deal which would provide $558 million per year in payments from utility customers. However, the Ohio regulators decided last week to allow just a 3-year deal with only $204 million in payments per year, a decision management called disappointing. FES' two nuclear plants in Ohio (Davis-Besse and Perry) are also on the block but cheap natural gas prices have made nuclear facilities uncompetitive too despite their otherwise light environmental footprint.

In Pennsylvania, there is no path toward converting plants to regulated or lightly regulated facilities. With that in mind, management is talking to potential buyers of its Pennsylvania natural gas power plants in Springdale and smaller facilities in Chambersburg, Hunlock, and Gans. Jones commented that the Pennsylvania natural gas-fired plants are potentially the most attractive for a new buyer. The other Pennsylvania plants for sale include the Bruce Mansfield coal-fired power station and the Beaver Valley nuclear plant.

AE gas and hydro assets are also for sale and there will be challenges to dispose of those assets too. AE's Mon Power plans to conduct an RFP process by the end of the year for its generation shortfall in West Virginia and management expects AE will likely offer its Pleasants plant into that process. On Friday, Mon Power announced it will review its 487 MW ownership stake in the Bath County Pumped Storage Project located in Warm Springs, Virginia. PJM's new capacity rule reduces the value of pumped storage generation stations because they cannot produce electricity continuously throughout the day. The rule change is expected to split capacity revenues from the Bath County facility in half.

FES Financials. See FES Financial Summary table below. FES revenues come from selling power to individual retail customers, into governmental aggregation programs, and via participations in Provider of Last Resort auctions. Its customers are concentrated in Ohio, Pennsylvania, Illinois, Michigan, New Jersey and Maryland where electricity demand and pricing are determined by competitive power markets, global economic activity, and Midwest and Mid-Atlantic economic activity and weather conditions.

For FY'16 and beyond, FES expects 65-75 million MWHs in annual contract sales with a projected target portfolio mix of 10-15 million MWHs in governmental aggregation sales, 0-10 million MWHs of Provider of Last Resort auction sales, 0-20 million MWHs in industrial sales,10-20 million MWHs in block wholesale/structured sales, and 10-20 million MWHs of spot wholesale sales. Committed contract sales for FY'16 and FY'17 were 61 million MWHs and 38 million MWHs, respectively.

FES financial statements reflect the volatility and multi-year deterioration of the merchant power business. Through Q3'16 end, FES had $3.1 billion of debt on its books versus LTM EBITDA of $298 million, implying net leverage of 10.4x. Moody's downgraded FES and its subsidiaries' unsecured debt from Ba2 to Caa1 and S&P downgraded their unsecured debt from BB- to single B and placed the ratings on Watch Negative. On the other hand, S&P chose to continue rating the AE debt BB- while placing the issuer on Watch Negative too. FES is certainly not alone among merchant power generators - Moody's has placed the entire sector on Outlook Negative.

FES Financials

FES and AE Debt. At Q3'16 end FES owned a power generation portfolio with $9.3 billion of net plant assets with 10.180 MW capacity. Against the FES assets were liabilities which included roughly $4.1 billion of debt (including off-balance sheet debt). The $3.1 billion total debt on its balance sheet includes $101 million of short term debt. FES has access to an undrawn $1.5 billion guaranteed unsecured L+175 bps revolver which expires March '19. The revolver has a $900 million sublimit for FES and a separate $600 million sublimit for AE. There is still incremental secured debt borrowing capacity of $2.8 billion under the FES/AE revolving credit agreement.

See graph of FES corporate bond price histories below. The outstanding FES public corporate debt includes $696 million principal amount in two senior unsecured note issues and $2.3 billion in 33 municipal revenue bond issues. The two FES parent corporate bond issues - 6.05% Senior Notes due '21 and 6.80% Senior Notes due '39 - are priced at 45 and 40 percent of their par amounts, respectively. With yields of 27.4% and 17.6%, investors are fully anticipating a restructuring of the notes either in or out of bankruptcy court:

There are cross-guarantees between FES and its two main subsidiaries FirstEnergy Generation, LLC (FG) and FirstEnergy Nuclear Generation, LLC . The FG and NG bonds include $612 million of first mortgage debt and $1.7 billion of unsecured debt issued via the municipal revenue bond market. The first mortgage bonds are rated B1/BB- and are priced between 87 and 95 depending on the coupon, maturity and amount outstanding. The unsecured muni bonds carry the same Caa1/B*- ratings as the FES parent senior unsecured corporate notes and are priced between 53 and 62 depending on the coupon, maturity and amount outstanding.

There are no similar cross-guarantees between FES and AE debt, despite their shared interest in the revolver. Separately, AE has another $2.4 billion of net plant assets with 2,982 MW capacity. Against the AE assets are $704 million of outstanding debt. This includes $82 million of short term debt, $406 million of long term unsecured debt, and $216 million long term secured debt. AE's portion of the $1.5 billion undrawn revolver is constrained by a $600 million sub-limit.

FES has another $9 million sale leaseback obligations on its balance sheet. Not included on its balance sheet is debt related to a 93.83% leasehold interest in the Bruce Mansfield Unit 1 plant. The net present value of that leasehold interest is estimated at $1.1 billion.

There are liabilities that FES will thankfully not need to address, namely, its pension obligations. According to management, the $921 million pension obligation to employees of CES will stay as an FE obligation after CES is disposed of.

The timing of scheduled debt repayments and the possibility of a large arbitration loss create a situation in which near term asset sales will be required to avoid a default by FES and its subsidiaries on debt maturing within the next 2 years. FES's FG and NG subsidiaries must refinance re-marketable muni bond issues with put features coming due FY'17 and FY'18.

In FY'17 there are $178 million total principal payments due, the most significant of which relates to the $129 million Beaver County Pennsylvania IDA 2.5% adjustable rate municipal bonds due '41 which have a put at par on 6/1/17. Then, in FY'18, there are another $561 million total principal payments due. Again, there is a single re-marketable muni bond issue which accounts for the bulk of the refinancing risk, the $235 million Ohio State Air Quality Development Authority 3.75% adjustable rate municipal bonds due '23. Those have a put at par on 12/3/18.

Context and Consequences. Management's decision to exit CES should be seen as part of a continuing trend by U.S. utility companies to divest themselves of merchant power generation units. Combining stable cash flows from a regulated utility with unstable cash flows from merchant power generation has made less and less sense given the increased volatility of natural gas prices (and other commodity input prices). The delayed Clean Power Plan requirements that would mandate state-by-state carbon emission cuts have proven all but unnecessary in removing coal-fired plants. With little growth in demand for electricity, competition from less expensive gas-fired plants, and subsidies making alternative energy more attractive, the mandates have become superfluous. The election this year of a new Republican administration for the White House and Republican control of Congress will likely assist coal producers and relax pollution control restrictions on coal-fired plants. However, that may not increase CES' profits on its coal-generated electricity and could reduce margins at its oil/gas, nuclear, and alternative energy facilities by increasing supply and decreasing capacity prices in the PJM, the nation's biggest competitive electricity market.

As FE exits the merchant generation business, it has shut down capacity and taken impairment charges. One consequence of these impairment charges is that they call into question the valuation of the remaining $9.3 billion of net merchant power PP&E on the books. For example, on July 19th, FE and FES announced a decision to exit operations of the Bay Shore Unit 1 generating station (136 MW) by 10/1/20 via sale or deactivation and to deactivate Units 1-4 of the W. H. Sammis generating station (720 MW) by 5/31/20. As a result, in Q2'16 FE recorded a non-cash pre-tax impairment charge of $647 million (of which $517 million applied to FES). The charges didn't end there, however. FE and FES also recorded termination and settlement costs on fuel contracts of $58 million (pre-tax) and recognized a non-cash pre-tax goodwill impairment charge of $800 million (of which $23 million applied to FES). Deactivations are still subject to regulatory review which might add to charges already incurred.

Back of the Envelope. One way to look at the FES situation is to market value the debt versus the expected cash flow for next year. Using the last set of trade prices, the price for all of FES' first mortgage bonds is roughly $562 million, for its unsecured muni revenue bonds, $1.0 billion and for its two senior unsecured notes, $321 million. That tallies to $1.9 billion market value of debt versus a management forecast of $595 million minimum FY'17 adjusted EBITDA, implying 3.2x market value total leverage. That's a simple approach which makes FES debt look reasonably leveraged at market rates and, hence, worth speculating on. A better back of the envelope approach, however, is to estimate the fair value of FES' underlying plant value in an arm's length transaction and then make the comparison versus the claims, ranked by security/seniority.

Assuming a sale of plants rather than a deactivation or bankruptcy scenario, you should assume the purchasers will be private equity investors. Private equity shops are now the main buyers of unloved US power plants - it's been quite a while since you saw any utilities acquiring merchant power plants. For example, in September of this year, a Blackstone (NYSE:BX) / ArcLight Capital Partners joint venture agreed to pay $2.17 billion to American Electric Power (NYSE:AEP) for four plants (or 5,200 MW). Three were gas-fired plants (a 1,186 MW plant in Indiana, an 840 MW plant in Ohio and another 507 MW plant in Ohio). One was a coal-fired plant (the 2,665 MW Gen. James M. Gavin plant in Cheshire, Ohio). Blackstone / Arclight reportedly paid about 8.0x EBITDA for the two natural gas-fired plants in Lawrenceburg, Indiana and Waterford, Ohio versus about 5.0x EBITDA for the coal-fired plant in Cheshire, Ohio.

There are other data points showing that private equity investors as the most likely buyers. In December '15, ArcLight bought 4,800 MW of primarily gas-fired plants in New York, Michigan, Illinois and Ohio from Tenaska Capital Management, another private equity firm. In August '13, Energy Capital Partners paid $472 million to Dominion Resources (NYSE:D) for 2 coal-fired plants and a 50% interest in a third (3,398 MW). In December '12, Riverstone Holdings paid $400 million to Exelon Corp (NYSE:EXC) for 3 coal-fired Maryland plants with 2,648 MW of capacity.

Should FE escape a large railroad dispute arbitration loss, let's use AEP's transaction as a guide and apply a low-ball 5.0x multiple for all of FES' FY'17 $595 million minimum EBITDA - including the half that is not generated by coal-fired plants. The result implies a total valuation for FES of nearly $3.0 billion versus its $3.1 billion face amount of debt. Subtracting the full face value of its $613 million secured first mortgage bonds leaves $2.4 billion of assets to cover $2.5 billion of unsecured notes. Again, the unsecured notes look largely covered.

But what if FE loses its arbitration case…? Management expects to have a liability decision from the arbitration board no later than February '17. Should FES incur a full $770 million of related costs payable in May, there would be only $1.6 billion left to cover the unsecured notes, implying about a 65 cent recovery on unsecured notes trading at 40-45 cents on the dollar. A 47% one-year potential return upside certainly sounds appealing but, with repayment dependent on asset sales, the financial risk of refinancing near-term maturities could easily stretch that time period to two years, cutting the upside in half. Moreover, should FES be required to post $355 million of collateral after an arbitration loss, there would be only $1.3 billion left to cover $2.5 billion of unsecured notes, or 51 cents on the dollar. Now you're down to 19% upside over a one-year time frame.

Do you feel lucky…? The crux of the matter is that there are $739 million of total principal payments coming due between now and FY'18. These include payments on notes rated Caa1 which go to D on any significant arbitration loss announcement next year. At either of those ratings, the notes can't be refinanced without asset sales to cover the required principal payments. Management might convince note holders by closing some significant asset sales prior to June '17 - say, by selling an initial package of gas-fired plants at 7.5x. But that's asking for a lot of private equity cooperation in a short time frame. Moreover, private equity investors looking at buying FES merchant generation plants are certainly aware of FE's timing and will seek to take advantage of it.

My own view is that management dislikes the idea of throwing CES into bankruptcy because it wants to avoid any blowback from state authorities evaluating expansion of its profitable, regulated distribution and transmission businesses. On balance, I doubt bankruptcy is avoidable if management sticks to its time schedule for exiting CES, if the arbitration ruling drops a bomb on the balance sheet, and if the collateral postings eat up available cash.

If you're more convinced than I am that FES will avoid a big railroad transportation arbitration loss and absolutely must speculate in its debt, at least pick your position/poison carefully. For example, there are potential opportunities within the $328 million first mortgage bonds issued by FG. The FG bonds that looks most interesting are the $141 million Ohio State Air Quality Development Authority 5.625% due 6/1/18 which have FG as the ultimate first mortgage borrower and are also guaranteed by FES. These last traded at 91.875 where they yield 11.52%. Those bonds are still rated B1/BB-.

If you want to bungee jump with unsecured bonds, at least try jumping off the right structure. For example, the Bruce Mansfield Unit 1-07 6.85% Pass Through Notes due '34 could be worth a look. Unit 1 of the Mansfield Plant is a three-unit, fully scrubbed, coal-fired generating facility whose three units have 2,460 MW of net capacity. The plant is located on a 473-acre site in Shippingport, Pennsylvania on the Ohio River, about 25 miles northwest of Pittsburgh. Commissioned in '76, FES sold and leased back a 93.825% undivided interest in Unit 1 in '07. The notes are secured by an assignment and pledge of collateral which includes FES's interest in Unit 1, the ground Interest and rights under the lease to receive basic rent payments. That's not much of a security interest or collateral if the plant is deactivated / bankrupted within the next 18 months. In that case, say goodbye to those rent payments which is why the 6.85% Pass-Through Notes are rated Caa1 and trade at 45. But at least they are at a subsidiary level and some enterprising attorney could argue they are closer to an underlying asset. Also, ownership of the 6.85% notes is concentrated - the top institutional holder owns 23.4% of the issue. That might help tag along holders in any future debt restructuring discussion.

FE Solutions Bond Specs

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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