Centrus Energy: Stock Overvalued Compared To Bonds

| About: Centrus Energy (LEU)

Summary

LEU’s revenue will fall by 43-46% in 2016 compared to End of Year 2014.

LEU’s common stock still trades as if it was end of year 2014.

Recent bond exchange of PIK notes for preferred stock does not help common stockholders as the net total higher tiered securities does not change.

Common stock rally has gotten ahead of the bond rally and a correction is imminent.

Background

Centrus Energy (NYSEMKT:LEU) is a trusted supplier of enriched uranium fuel for commercial nuclear power plants in the United States & globally. Since 1998, the company has provided utility customers with more than 1,750 reactor years of fuel, which is equivalent to 7 billion tons of coal. They provide value by enriching uranium and selling it to customers.

Right now, the nuclear power industry is in distress. Years of cheap natural gas prices combined with nuclear disasters such as Fukushima have caused many nuclear companies to lose money. While other companies in the nuclear industry, such as First Energy, have survived the tough business environment by relying on a diversified business model, Centrus energy did not diversify and was forced to declare bankruptcy in 2014. The current stock of Centrus Energy is the product of the post-bankruptcy debt conversion to stock.

There are many factors effecting the performance of Centrus Energy debt/equity including but not limited to: macro nuclear economic factors, the bond exchange, and special legal concerns regarding different securities across LEU's capital structure. This article will examine all of the previous factors and how they affect current LEU debt/equity valuations.

Macro Nuclear Environment

Nuclear energy has gone through many ups and downs over the past decade. As can be seen in this link, uranium prices have fluctuated greatly. While uranium prices are currently at historic lows, macro factors including the restart of nuclear power plants in Japan in addition to the construction of new plants in China have convinced many analysts that uranium prices will rise over the next few years. On first sign, rising Uranium prices may sound like good news for Centrus. However, LEU is a uranium enricher not a uranium miner. Rising uranium prices are bad because higher prices means higher supply costs and less profit. At the end of the day, these higher costs will be passed on to the already beleaguered U.S. nuclear power plant industry by increasing their cost of electricity production. This in turn is bad for Centrus since it reduces demand for enriched uranium by accelerating nuclear power plant closures across the country. Right now Centrus Energy's common stock has experienced a massive rally alongside uranium prices since the November 8th election. However this does rally not appear justified as Centrus success depends more on nuclear power plant enriched uranium consumption than uranium prices. Furthermore, while some believe that President Trump will help nuclear power plants via regulations, it is unclear how this can be done since Trump has also promised to help coal plants and to slash regulations.

Bond Exchange

On Jan 5 2017, Centrus Energy announced an exchange offer where the company offered to trade $362 worth of new secured debt, $509 preferred stock, and $128 cash in exchange for every $1000 PIK bond. A picture describing the company's old vs. new capital structure can be seen below:

Old Capital Structure

Millions

Maturity

PIK Notes

234.6

2019/2024

Cash

170

Common Stock

53

New Capital Structure

Millions

Maturity

Senior Secured Notes

74.2

2027

PIK notes

29.7

2019/2024

Preferred Stock

104.3

Cash

143.8

Stock

53

Before the bond exchange, Centrus Energy's only debt came in the form of PIK notes. While the bond exchange has certainly reduced net debt, the new securities (preferred shares & secured debt) still rank higher than common stock within the capital structure so nothing has fundamentally changed. Net higher tiered securities minus cash still stands at 64.5 million dollars before and after the exchange. At the end of the day, Centrus energy bonds are priced for bankruptcy(trading @ ~53% of par) while the common stock is priced not too far from the all time high of $9.45. Should nothing happen, bondholders should double their money within two years due to the bond maturity date, while stockholders are dependent on drastically changing business conditions ex: massive nuclear reactor construction & revenue doubling to 2014 levels, to realize further upside. Both doubling revenue and massive nuclear reactor construction booms in the U.S. seem unlikely.

Concerns/ Bond Issues

Centrus Energy common stock looks pricey, and bonds may not be much better. Centrus Energy PIK notes are set to mature in 2019 or 2024 conditional on certain funding requirements are met for the American centrifuge project or the implementation and deployment of a National Security Train Program utilizing American Centrifuge technology. Both the American centrifuge project and the National Security Train Program are related to centrifuge research. Should the projects be funded, then the 2024 maturity date could cause bond prices to go down due to the longer maturity. In addition to the later maturity date, bond prices are at risk of losing all claims (ex going to 0) should the PBGC government agency involuntarily terminate pension plants, or funding for the united states enrichment program is terminated before project completion. While PBGC pension guarantee failures are unlikely due to the backing by the federal government, project cancellation is still possible. That being said, "The PIK Toggle Notes rank equally in right of payment with all existing and future unsubordinated indebtedness of the Company (other than the Issuer Senior Debt as defined below) and are senior in right of payment to all existing and future subordinated indebtedness of the Company". Equity is considered an existing unsubordinated indebtedness of the company so should bondholders go to 0 due to project cancellation stockholders should go to 0 as well. This allows potential bond investors to hedge risk by going long the bonds while simultaneously shorting the common stock.

Conclusion

Centrus Energy PIK notes do not pay interest and are a dangerous investment by themselves due to risk of project cancellation and potential increased maturity date due to funding requirements. That being said, they are still considered debt and thus are senior to equity. Despite the fact that Centrus Energy revenue has declined 42-46% (management guidance $275-300Million) since year end 2014, the common stock trades as if revenue is still 500 million dollars per year.

In macro news, the restart of Japanese nuclear reactors could offer support for uranium prices, but Centrus Energy's business is based on uranium enrichment not uranium mining and most revenue comes from the United States. In the United States, natural gas prices are still relatively low and many nuclear power plants are on the verge of closure. For those with an appetite for risk, a straight up short LEU position may be a good option. For those who like to hedge, a long bond short common arbitrage trade may be better.

Disclosure: I am/we are short LEU.

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.

Additional disclosure: Long: Centrus Energy 2019/2024 PIK bonds

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

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