AES

www.aes.com

Presentation to AAII-SIG Central NJ Chapter

January 15, 2005

 

 

 

 

This presentation is not a form of solicitation, nor is it intended to be a recommendation to purchase or sell any investments.  This presentation is merely intended as a form of sharing of research to the AAII-SIG.  I do personally own AES and most of my managed portfolios also own AES.  Most of our purchases were made at prices under $9.00 per share.  Please see disclaimer on last page of this report.  Although there are conclusions at the end of this report, they need to be taken in context and read with the understanding of the attached disclaimer.  Please understand that much of this report is hypothetical, and that the conclusions are there not as a recommendation, but as a sharing of thoughts and information.  Again, the ultimate purpose of this report was to share information with a group of investors that get  together and look to share ideas.  The intent of this report is merely as a learning tool.  It very well might have material errors.

 

PLEASE DO NOT MAKE AES INVESTMENT DECISIONS BASED ON THIS REPORT.  PLEASE DO YOUR OWN DUE-DILIGENCE

 

Company Description

 

 

Global power company with 35,320 megawatts of total net owned generation capacity, with another 1,037 under construction.

 

 

 

Breakdown of Operating Capacity (Gross MW) in operation

 

 

 

Breakdown by Region of Capacity (not all AES owned) (Gross MW) in operation

 

 

 

Operating Capacity (MW) by Fuel Mix

 

 

 

 

 

 

 

 

 

AES has over 30,000 employees

 

Annual Revenues of almost $9.0 Billion.

 

111 Plants and 17 distribution Companies

 

Businesses in 27 Countries

 

 

 

 2003 Sales By Business Segment :

 

 

 

The following is a blurb from the AES website, “AES was added to the S&P 500 in 1998, and in 2000 the stock price exceeded $70 per share. The period was characterized by unprecedented growth, including the acquisition of Electricidad de Caracas in Venezuela and Gener in Chile, and assuming control of two regional electricity distribution companies in Kazakhstan.

 

2001 and 2002 brought numerous challenges, including the global markets downturn and the collapse of many in the sector. AES responded by launching a turnaround program, and by 2003, was on sound financial footing and looking toward the future.

 

AES today still seeks to be the world's best power company, now generating and distributing electric power to 11 million people, with generation facilities in 27 countries around the globe.”

 

 

This is how AES describes their business operations:

 

“Every electric power plant turns some form of energy into electricity. Our power plants run on diverse fuels -- from natural gas and coal to biomass (agricultural and wood waste) and water. We choose the method that makes the most sense for a particular situation, based on prevailing regulations, fuel availability and other factors.

 

 

 

In some circumstances we sell power as a wholesaler, producing energy that other companies deliver; in other cases we act as the retailer and distribute the power directly to the consumer. We divide our businesses into four categories – Contract Generation, Competitive Supply, Large Utilities and Growth Distribution – based on the scope, customer base, delivery mechanisms or market dynamics involved.”

 

 

 

 

 

Business Segments

 

Sales by Business Segment

 

 

 

 

 

 

 

 

 

 

 

Contract Generation -          This segment is essentially "generation for hire" in which AES creates electricity and sell the majority of it to a customer who then distributes it.  Contract Generation (37% of F2003 Sales) and Competitive Supply Segments (10% of F2003 Sales) accounted for 47% of F2003 Sales.  80% of these revenues are Long-Term contracts.  20% of the revenue is Merchant / Short Term Contracts.  Generally these are sales to Local Utilities or Wholesale customers.  Typically the cash flows are stable, the customer takes the fuel cost and demand risks.  The plants are capital intensive and require debt.  AES has been prioritizing the debt as non-recourse.  Non-recourse debt possibilities increase with the projects credit quality. 

 

AES owns and operates contract generation plants that sell electricity to utilities or other customers under long-term contracts (minimum five years and more typically 15 to 30 years). Fuel supply is usually hedged consistent with the power sales contract.

 

New projects are on line in Asia, Caribbean and USA.

 

2003 Fleet additions created $500M in new revenues.

 

72% of generation capacity are in emerging markets.

 

Competitive Supply: are Sales to local utilities or wholesale customers under short term (spot) contracts.  There is higher return potential here, because AES absorbs the demand and fuel risks.  Sales and cash flow are variable and less predictable than other segments.

 

AES highlights that sales growth has been driven by Argentina demand and favorable pricing.  Yet, I recently read that there are gas shortages in Argentina, and AES is being forced to buy electricity on the spot market.  Supposedly the spot prices are above AES’ marginal costs.  Certainly something to monitor.  Perhaps this could create an earnings shortfall, which in turn, could perhaps create a buying opportunity, if share prices were to drop.

 

Most of Competitive supply is coal generated.  It is certainly affected by commodity prices.

 

Large Utilities - Large Utilities are their "heavy hitters" in the electric power arena: Indianapolis Power & Light (IPL) in the U.S., Eletropaulo Metropolitana Electricidad de Sao Paulo S.A. (Eletropaulo) in Brazil, and La Electricidad de Caracas (EDC) in Venezuela. In most cases large utilities combine generation, transmission and distribution - covering the entire supply chain. These giant utilities, of which AES is majority owners, maintain monopolies with defined service areas selling electricity under regulated tariff agreements. They each have transmission and distribution capabilities (IPL and EDC also have generation plants).

 

  Large Utilities (40% of F2003 Sales) and Growth Distribution (13% of F2003 Sales) accounted for 53% of F2003 Sales.   The business driver for Large Utilities is monopoly positions, regulated prices; demand is determined by local economy.  AES has 17 Utilities in 8 different countries.

 

The following are 3 of AES utilities:

 

 

a.               IPALCO is holding company for Indianapolis Power and Light (IPL).

 

 

b.                They generate and sell electricity to 450,000 customers. 3,300 of capacity, of which 99% is coal fired. IPL has $690M in cumulative net operating income deficiencies, hence must inform utility commission if dividends are planned.

 

 

c.              EDC has 1M customers.  2600 MW of capacity. 

 

 

d.               Eletropaulo has 5m customers.  30-year concession contract with National Electric Energy Agency (ANEEL).  Tariffs are increased to reflect ROE.  Negotiated every 4 years. Next pricing negotiations are 2007.

 

 

 

Growth Distribution - distributes power in developing countries or regions where the demand for electricity is expected to grow faster than in more developed parts of the world. They are smaller businesses than the integrated utilities businesses, serve a smaller service area, and generally need substantial infrastructure improvements. However, they also have the opportunity to benefit from operating improvements that may stimulate above average growth in earnings and cash flow performance. Electricity sales are made under regulated tariff agreements or under existing regulatory laws and provisions. Distribution facilities in this line of business may include integrated generation, transmission, distribution or related services companies.

 

The following are some tables I constructed which highlights some financial data.

 

2004 Projected ebitda breakdown :

 

 

 

2003 Sales By Business Segment :

 

 

 

 

 

 

2003 Operating Capacity (MW) Fuel Mix :

 

 

 

 

 

 

Notes and Observations:

 

1.            AES has non-fired gas capacity, they will benefit most from increased electricity demand.  As prices increase, their costs are not as associated with fuel price increases.

 

 

2.            AES had an action plan going into 2004.  This plan was aimed at debt reduction, strengthening the balance sheet, improve their credit quality and begin the process of improving margins.

 

 

3.            During F2004 recourse debt was reduced by $800M.  Both S&P and Moody’s raised their credit quality.  S&P rates debt at B+ and Moody’s rates debt as B1 (highly speculative).  Both agencies have AES on positive outlook.  Management goal is BB level (low grade speculative).

 

 

4.            86% of cash flows from regulated utilities and contract generation.

 

 

5.            18.1B in total debt.  $13B of that is non-recourse. 

 

 

6.            Potential debt to equity level of 76% by 2007.  Current debt to equity of 86%.

 

 

7.            Interest Coverage ratio is 1.9X (I like to see that at 4 or greater, maybe one day for AES).

 

 

8.            Morningstar calls Duke Energy, Calpine and Reliant Energy as its peers.

 

 

9.            Sales growth dropped in 2002 and 2003 because of asset sales to restore finances.  2004 growth is coming from tariff increases, higher wholesale prices and increased energy demand.

10.       Interest expense consumed 25% of revenue in 2003.  This should drop with debt pay-downs in 2004.

 

 

11.       In 2001 AES reached 50,700MW.  In 2002 the US merchant industry melted down and devaluation of Argentina peso caused a severe crisis for AES.  Two years of divestitures left AES with 34,500 MW.

 

 

What I see as potential positives:

 

1.            Possible refinancing in emerging debt market.  AES was shut out of debt markets for a number of years.  Refinancing would be done at more favorable terms.

 

 

2.            Debt upgrades important. One reason I see is the capital intensity of the business requires financing. Nature of the business. Hence, demands and costs are much less with higher debt grades.  AES if upgraded can further refinance existing debt on more favorable terms.

 

 

3.            Management appears focused and competent in their mission.  They realize that AES is a “show me” company.  They are focused on debt reduction, credit quality enhancement, margin expansion, strategic acquisitions and increased Return on Capital (ROC).

 

 

4.            Worldwide demand in power, there is a growing demand for electricity.

 

 

5.            World bank has supposedly been favoring AES in lending and in influencing potential customers to partner with AES.  AES appears to be a proven and respected force.

 

 

6.            Competition has been reduced as several companies have exited the industry.

 

 

7.            Bonds are showing pricing strength.  This signifies that Wall Street believes in AES. 

 

 

8.            Grants Interest Rate Observer on March 15, 2002, mentions that there is potentially $10 - $12B in assets on the books.  I spoke with a researcher yesterday and he remembered $13B.

 

 

9.            3 subsidiaries have publicly exchange-traded shares. I have not verified this, nor have I looked at them.  EDC in Venezuela, Eletropaulo in Brazil and Gener in Chile.  These 3 subsidiaries are valued at approx $1.5B or $2.40 per share.  S&P expects these 3 subs to pay dividends of $160M to AES in 2004.  All subs are expected to pay in area of $800M.  Eletropaulo is expected to pay down debt and not dividends.

 

 

10.       Subsidiary distributions are in the annual $1B range.  This is expected to stay the same or improve over the next 5 years.

 

 

11.       AES is a holding company.  Because there are such a great amount of subsidiaries, it is important to look at operating cash flow.  It is very important to recognize the dividend contribution from the subsidiaries.  This is currently in the $1billion annual range.

 

 

12.       AES announced on January 11, 2005, an agreement to acquire SeaWest Holdings.  SeaWest is a wind power operator and developer.  This is the first major growth project fro AES, since problems of 2001.  I recently read an analyst report, whereas a material financial event is not expected over the near term. Cost is $60M in cash.  Currently SeaWest is producing revenues of $20M.  This will give AES production of 500 MW of capacity.  Supposedly one of the largest US providers of wind power.

 

 

13.       Morningstar indicated that more than 80% of energy in its competitive supply business is generated through low cost coal and hydro, giving cost advantage over gas fired competitors.

 

 

14.       AES looks to curb currency fluctuations by employing more debt in local currencies, rather than in USD.

 

 

15.       Management expects growth in Eastern Europe, Middle East, India, China and California.  No plans to expand in Latin America in near term.  Growth expected in contract generation.  Southern California is supposedly the most generation-constrained region in US.

 

 

16.       Legg Mason owns over 11% of AES.

 

 

17.       Recent guidance reaffirmed Goal of $500 – 600M debt reduction in 2005.

18.       Return on Equity is greater than 25%.  Part of the reason is because of the leverage on the company.

 

 

 

 

 

 

 

What I see as potential negatives:

 

1.            Insider selling - Not necessarily bad, and Wall Street is defending the selling.  Founder of company, Roger Sant, is doing most of the selling.  He founded the company in 1981.  He currently owns 11,339,005 shares.  He seems to be selling off small portions systematically.

 

 

2.            Restatements have occurred.  Makes comps more difficult. General rule of thumb is that restatements are always bad.  In this case it is a bit more difficult to determine, as restatements are for discontinued operations.  My gut (which certainly should not be relied upon) is that this is not a typical restatement, and hence not a negative.  Nevertheless, it will be something I will be watching.

 

 

3.            Slowdown in privatization of Plants.

 

 

4.            Emerging Market politics and regulations.

 

 

5.            Currency exposure in Central America.

 

 

6.            execution of margin improvements and deregulation.

 

 

7.            Rising worldwide interest rates.

 

 

8.            Watch the debt levels.  Some debt has been pushed out several years.  Some of the debt has deferred payment obligations until 2007.  This needs to be watched.

 

 

9.            22% of AES debt is at variable rates.  Need to watch this if interest rates rise.

 

 

10.       Legg Mason owns over 11% of AES.

 

 

11.       Debt levels are high and will remain high. 

 

 

Some Financial Data:

 

1.              Cash flow is strong. I constructed this quick table. I took a lot of liberties and really didn’t construct guided estimates. Borrowed estimates from several reports, etc.  Cash flow will be stronger from option exercising.  Generally I don’t like this, but here cash generation is crucial. 

 

 

 

 

Projected Cash Flow Table:

 

 

 

2.              I constructed the following table on expected interest expense going forward.  This is merely a roadmap, and the use of numbers was performed quickly.  This can be refined as time goes on.

 

Estimated Interest Expense:

 

2004	1585
2005	1460
2006	1430
2007	1350

 

3.              Five – Year Growth Metrics (2004 – 2008) Company Guidance on December 7, 2004

 

 

 

 

4.              Some guesstimates of Subsidiary Distributions.  I used collection of reports and threw together quickly.  This could be materially incorrect, yet this might start my road map for future.

 

Subsidiary Distribution Guesstimates ($millions)

 

 

 

5.              Some eps estimates I am using.  Again, these are not scientific.  I would venture to guess that these eps estimates are on the conservative side.  Once again, merely a road map for the future.

 

 

Eps estimates:

 

 

6.              Calculation of estimated Interest Coverage Ratio

 

 

7.              Return on Shareholder Equity.

 

Estimates for F2004

 

 

ROE = NI/Sales *  Sales/Total Assets * Assets/ Equity

 

ROE = (374/9,400) * (9,400/30,000) * (30000/1,450)

 

ROE = .0398 * .3133 * 20.6897

ROE =  25.77% 

 

 

 

Items to Look for as Time Goes on :

 

1.       Profit margin improvement.

 

 

2.       Acquisitions – AES recently entered into an agreement to purchase a Wind

 

 

3.       Watch the political and economic climate in Central America.

 

 

4.       Watch the debt levels.  Watch the debt payment intentions, especially going forward to 2007.  That is the year that some debt repayments were deferred to.

 

 

5.       Get better understanding of “maintenance capex”.

 

 

6.       Monitor acquisitions and their future cash flow effect.  SeaWest acquisition was the first acquisition since 2001.

 

 

7.       Monitor the loan covenants.

 

 

8.       Look at pension funding.  I believe that AES has a partially employee contributory plan.  I’m not certain of this, and need to look at in future (perhaps when 10K) is released.  How much has pension been funded? I read $970M needed over next 5 years.

 

 

9.       Watch the dilution.  Watch especially for any dilution caused by converts, renegotiations or covenants.

 

 

10.   Earnings are sensitive to international regulatory actions.  Earnings can be impacted by rate change delays.

 

 

11.    22% of AES debt is at variable rates.  Need to watch this if interest rates rise.

 

 

12.   Look for increased eps via lower interest expense and growth of MW’s.

 

 

Valuation Scenarios and Calculations :

 

1.              Projected F2004e ebitda

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2.              Valuation Metrics – This is a spreadsheet used for AAII-SIG

 

 

AAII-SIG Valuation Metrics

 

 

 

 

 

 

3.              This is a valuation metric I often use as part of my analysis.  It is based on expected eps growth rates.  In this situation, one needs to consider the enterprise value.  The debt would certainly reduce intrinsic value. I really need to examine this further to determine the usefulness of this model.  This is intended as a future earnings model, and not designed for enterprise value.

 

 

Using the above example, we can extrapolate a bit. If we look at year 2 (2005), we actually have no current investment value.

 

 

If we look  further at year 5 (2008), we come up with the following.  For this example I will use the same shares outstanding (poor assumption) and I will decrease enterprise value by $1B for future debt reductions.  Keep in mind, this is merely an illustration and could certainly be filled with errors (It is also getting a touch late on a Friday night, so, please understand this is merely being presented for discussion purposes only).  The Net Intrinsic Value using this methodology would still be only $12.00 per share.  This is less than today’s price of $13.45.

 

 

 

As I construct the above model, I certainly see that when using enterprise value for AES, one would not be rushing to invest.

 

This is certainly where investment decisions become difficult.  Of course if you look at nearly any utility company, you will see that enterprise value is not a concept you would be basing your investment decisions on. 

 

 

 

 

 

Conclusions

 

1.              Let me start by saying that this is a work in progress.  If you were to use this in helping you make an investment decision, you would only want to use it as a source for your own due diligence.  Secondly, information and business fundamentals change quickly.  Hence, if one were to invest in AES or any situation for that matter, they need to be able to competently track developments, sort through data, and understand that reasons for investing can change quickly. With that said, I will proceed.  Please understand that I am in no shape or fashion suggesting that anyone buy AES.  Nor am I hinting that AES should be bought either.  I never feel comfortable giving advice of buys or sells.  I manage portfolios based on specific needs, and all portfolios have different needs and tolerances.

 

 

2.              AES by nature is a high-risk investment.  It was nearly bankrupt during 2002.  It hit the perfect storm and it has not yet recovered from that storm.  You must understand that AES is not your typical sleep at night utility company.

 

 

3.              I was actively buying AES between the area of $7.25 and $9.00.  The price has increased by over 37% within the last 4 months.  Personally, as a shareholder, I would welcome a major correction.  I would not at all be upset if I saw prices reach the mid single digits again.  Of course if that were to happen, I would be monitoring the reasons why, the business climate, the ratings agencies and other resources.  If I found a price retrenchment, with no accompanying material financial explanation, I would probably be an active buyer of shares.  Again, I remind you that I can tolerate risk, and recognize that AES could theoretically become bankrupt.

 

 

 

 

 

 

 

 

 

4.              Keeping all of the above in mind, I will proceed with a few more comments.  I would consider AES as an investment at this level for a portfolio.  Because of the price change in such a short span (and that has happened with many conservative utilities), I am not as cognizant of what I consider to be the perceived intrinsic value.  The following are a few reasons why I would possibly consider AES as a core holding:

 

a.              Diversification of ones portfolio to an international power company.  You would own one of the largest power companies in the world. 

 

 

b.              AES has a major presence in emerging markets as well as developed markets.  You would have diversification away from US dollar based multinationals.

 

 

c.              AES is tiptoeing into alternative energy sources.  SeaWest could be the start of something interesting.  I am clueless if the entry into this market is a smart one, but I do like the thought of a potentially cleaner energy source.

 

 

d.              AES is a holding company.  Much of their possible value is not reflected in the financial statements.  They generate dividends from subsidiaries of nearly $1 billion per year.  They generate cash flow in excess of $1 billion per year.  It looks as though that free cash flow might start approaching the $1 billion per year run rate.

 

 

e.              AES could be a turnaround play.  Their bonds have recovered a great deal.  The bond rating agencies have upgraded AES and have them on credit watch positive.

 

 

f.                Return on Equity is greater than 20%.  AES via their leveraged balance sheet can show excessive ROE’s over time.

 

 

g.              Some analysts believe that an AES growth rate of 20% could prove to be conservative.  Granted, one must look at analysts with skepticism and doubt.

 

 

h.              Please read the disclaimer on the last page. Please also re-read the introductory paragraph. 

 

 

Thank you for reading.

 

Respectfully submitted:

 

Ronald R. Redfield cpa/pfs

rredfield@rbcpa.com

908 276 7226

 

Please read following disclaimer. Please do your own due diligence.  Please understand that this report has not been reviewed and could have many material errors. 

 

Disclaimer

 

 If you are a client of ours, and if you have questions regarding Lucent, please call our office. If you are not a client of Redfield, Blonsky & Co. LLC Investment Management Division and are reading this report, we urge you to do your own research. We will not be responsible for any person making an investment decision based on this report. This report is a "by-product" of our research. We are not responsible for the accuracy of this report. We are not responsible for errors that may occur in this report.  Please do not rely on us to monitor or update this or any other report we may issue. In theory, we could come across some type of data or idea, which causes us to eliminate AES from our portfolios. This report has undergone revisions starting on January 15, 2005. We will not notify readers of future revisions. We are not responsible to keep readers of this report updated for changes or material errors or for any reason whatsoever.  This report is dated January 15, 2005; it is possible that by January 18, 2005, we could have eliminated our entire AES position without giving notice to any reader of this report.  We manage portfolios for clients, and those clients are our greatest concern as it relates to investing. Certain clients of Redfield, Blonsky & Co LLC may not have AES in their portfolios. There could be various reasons for this. Again, if you would like to AES, please contact Ronald R. Redfield, CPA, PFS (partner in charge of investment management division).

 

Information herein is believed to be reliable, but its accuracy and completeness cannot be guaranteed. Opinions, estimates, and projections constitute our judgment and are subject to change without notice. This publication is provided to you for information purposes only and is not intended as an offer or solicitation. Redfield, Blonsky & Co. LLC and Ronald R Redfield, CPA, PFS, may hold a position or act as an advisor on any investments mentioned in a report or discussion.