The Stock Market Values Of Usec Finance Essay
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The report values the existing operations and future projects of USEC and analyses whether the stock market is significantly over or undervaluing the business. USEC is the world's leading provider of enriched uranium to the commercial power plants with a 50% market share in the North America.
The current share price fairly reflects the existing operations and future growth of those operations. However, there are two important valuation issues. Firstly, the company has initiated the American Centrifugal Project (ACP) which will use new technology. It would reduce costs and double the current capacity. The total capital investment is expected to be $1.7 billion and the plant is expected to start production in 2011. The NPV of the ACP is -$220 million implying that the share is overvalued significantly.
Secondly, the company has a very high amount of uranium inventory and if its market value is included then the market is significantly undervaluing the liquidation value. However, the liquidation value is likely to be lower than the market value of inventory because it will be difficult to sell all inventories without resulting in sharp drop in uranium prices.
Overall, considering the high risks involved in the ACP, the market price is higher than the true worth of the company and hence the trading strategy would be to short USEC.
USEC is the world's leading supplier of enriched uranium fuel for commercial nuclear power plants. This report analyses whether the company is over or undervalued and suggests an appropriate trading strategy.
The USEC's share price of $10.80 fairly reflects the expectations of the cash-flow potential of company's existing operations. However, there are two main issues that can result in USEC's valuation being significantly different from its market valuation. Firstly, the company was in the initial stages of implementing the American Centrifuge Project (ACP) which will not only double the scale of the company but also significantly improve its competitive position. The usage of a new technology in the ACP will reduce electricity costs substantially, a major cost contributor in enriching Uranium.
Secondly, as a result of USEC's contract with the US government and the Department of Energy (DoE), the company has a high inventory of uranium acquired at a cost which is less than 50% of the current market price. This could give a potential valuation boost.
The above-mentioned two points are analysed in detail to understand their potential impact on the valuation of the company. Finally, a trading recommendation is made on the basis of the above analysis.
USEC operates the only uranium-enrichment facility in the US, a diffusion plant in Paducah, Kentucky. Uranium fuel for nuclear power plant is sold as Separate Work Unit (SWU) and USEC uses, on average, one pound of uranium to produce one SWU. The capacity of the Paducah plant is 3.5 million SWU. USEC has another plant which is placed in cold standby under a contract with the DoE.
USEC also provides contract and consulting services to the DoE. The company supplied 50% of enriched uranium fuel to commercial nuclear power plants in the North America. Its global market share was 30%. Its main competitors are AREVA/Eurodif, Tenex and Urenco. USEC's revenues and net profit for the year ended 31 December 2005 were $1,559 million and $22 million respectively.
Rationale for investing in the ACP
The company has recently initiated the American Centrifuge Project (ACP). ACP is a major investment and will cost $1.7 billion. The company is pursuing the ACP due to the following factors.
USEC's operating costs are significantly high due to its usage of a technology that consumes more electricity for enriching uranium into SWU. The electricity costs of the company have risen recently because a long-term contract with a power supplier has expired. The operating profit margin declined from 5.2% in 2004 to 4.3% in 2005.
The new technology at the ACP will reduce enrichment-process energy consumption costs by 95% and overall enrichment costs would be cut by 50%, relative to the existing process. This would allow the company to target higher profit margins and/or higher market share by positioning itself as a low-cost producer.
US government has entered into the Megatons to Megawatts contract with the Russian government under which USEC is bound to purchase 5 million pounds of uranium each year from Russia. The Paducah plant can process only 3.5 million pounds of uranium per annum. The higher purchase than consumption over the years has resulted in an inventory of 29 million pounds of uranium.
The capacity of the ACP is 6.5 million SWU per annum. The high capacity will reduce the existing inventory over time.
One of company's competitors, URENCO, is planning a new plant in New Mexico. The ACP may deter URENCO from opening the new plant.
USEC will also save $8m and $30m in lease and capital expenditure costs respectively annually by putting Paducah plant in cold standby once the ACP starts production.
NPV of the ACP currently implied by the stock market
The stock market implied NPV of the ACP can be deduced from the difference between the market value of USEC and the NPV of its existing business. The current share price of $10.80 fairly reflects the discounted cash flows of the existing operations as well as the future growth of those operations. This implies that the stock market is assigning no NPV to the ACP.
In spite of the new technology reducing costs and inventory, and increasing sales, the stock market doesn't seem to think that the ACP will change the value of the company. This could be due to a number of reasons. Firstly, USEC already has a very high market share and it would be difficult for the company to significantly increase its market share with the near doubling of production capacity.
Secondly, ACP will be the first commercialisation of a new technology and actual benefits in terms of energy savings may not meet the projected figures. Flyvbjerg et al. (2009, p. 172) state that projects underperform due to 'numerous uncertainties such as project complexity, technological uncertainty'. This would reduce the NPV of the project.
Thirdly, the plant is expected to cost $1.7 billion and take 4 years to build. 'Large-scale projects typically cost much higher than the initial estimates' (Touran and Lopez, 2006, p. 853). The time required to complete the project may also exceed initial estimates and could end up further increasing the cost. This could have a severe impact on USEC's financials as the company will have to pay interest on high borrowings.
Finally, 'the company may not be able to recoup a large part of its investment if the things did not go to plan' because of the specialist nature of ACP's assets (McLaney and Atrill, 2007, p. 510).
The WACC formula is given below.
WACC = Cost of debt*(1-Tax rate)*(Debt/(Debt+Equity)) + Expected return on equity*(Equity/(Debt+Equity))
The expected return on equity is calculated according to the Capital Asset Pricing Model (Pagano and Stout, 2004, p. 14).
Expected return on equity = Risk-free rate + Beta*(Market risk premium)
The risk-free rate is 5.04%, yield on the 10-year US Treasury bonds. USEC's beta is 1.3 and the market risk premium is expected to be 5.5%. Substituting values in the above equation,
Return on equity = 5.04% + 1.3*5.5% = 12.19%
The current yield on the company's debt is 9.04% and this will be the cost of debt. The tax rate (tax / profit before tax) in 2005 was 40%.
The amount of debt was $475 million on 31 December 2005. It is assumed that the amount of debt has not changed in July 2006. The share price is $10.80. The number of shares was 86.1 million which gives the company a market capitalisation of $930 million.
Substituting values in the WACC equation, the WACC of USEC is 9.90%.
This WACC will be used for discounting APC. However, there are key issues in doing this. It assumes that the APC will be funded with same gearing as the existing business. This would require a large amount of equity funding which is unlikely. The APC will most likely have a different gearing and hence, its WACC will be different.
Using same WACC also assumes similar risk profile. However, this ignores two important points. Firstly, the company will be using a 'completely different and new technology and additional risk should be reflected in higher WACC or risk-adjusted cash flows' (Genus and Coles, 2006, p. 116). Secondly, the risks associated with long construction period should also be taken into account.
Additionally, Lobe (2009, p. 45) states that 'a constant WACC rate must fail if the implied leverage ratio is time varying'. It would be difficult to maintain a constant leverage ratio as the operating profits will change the gearing in the later years. This implies that constant WACC based on current gearing is incorrect. In light of the above points, the WACC of the ACP is likely to be different than that of USEC.
NPV of the ACP
The NPV calculations are based on the following assumptions:
Same capital structure as the existing operations. The debt required to fund the ACP will be $817 million based on the current gearing and remaining investment of $1.6 billion.
SWU price in 2006 of $127 per unit.
Uranium cost in 2006 of $43 per pound.
2006 enrichment cost of the ACP of $21 per SWU.
Annual increases in SWU and enrichment cost at long-term inflation rate of 3%.
Selling and general expenses at 4% of revenues, in line with 2005 figures.
1% of revenue paid as royalty to the DoE.
Tax rate of 40%.
Appendix I shows the sales and cost data used in projecting profit and loss of the ACP. Appendix II shows the profit and loss projections over the useful life of the ACP.
Appendix III shows the NPV calculations of the ACP. The NPV is $597 million. After deducting debt of $817 million, the net value addition to equity holders will be -$220 million. The negative NPV to equity implies that the company's equity will be destroyed by the ACP and hence, the current market price is significantly overvalued.
The NPV is based on a number of key factors including sales volume projections, sales price and cost per unit. The sensitivity of the NPV to key factors is analysed below.
The table below shows the sensitivity of the NPV to changes in sales units, expressed as percents of the base case.
Table 1 - Sensitivity to change in sales volume of SWU
NPV decreases with reduction in sales volume. The highest NPV is -$220 million because the plant cannot produce more than 6.5 million SWU.
The sales price of SWU, the cost of uranium and enrichment are assumed to grow at the inflation rate. The table below shows the sensitivity of the NPV to changes in the inflation rate. The NPV is positive at inflation rate of 4.5% or higher.
Table 2 - Sensitivity to change in the inflation rate
The WACC is based on a number of assumptions and the actual WACC is likely to be higher because of additional risks in this projects. The table below shows the sensitivity of the NPV to changes in the WACC.
Table 3 - Sensitivity to change in the WACC
The negative NPV means that the project is value destroying. However, higher production will help the company release a large amount of its working capital and reduce debt early. That could be the reason behind market's implied nil value of the ACP.
USEC has a large amount of uranium inventory. The balance sheet values inventory at its cost price of $20 per pound. The current market price of uranium is $43 per pound. The more than double market price can have a significant impact on the value of the company if its business is liquidated immediately. The assets liquidation value per share based on the book value of uranium inventory is $5.1, which is 51% lower than the current market price. The assets liquidation value per share on the basis of market value of uranium is $13.1, which is 22% more than the market value.
There are two important issues associated with the liquidation valuation if market value of uranium is used. Firstly, the amount of uranium held by the company is much more than the global annual requirement from the commercial nuclear power plants and it would be a major struggle to even sell a significant amount of uranium immediately.
Secondly, the oversupply due to 29 million pounds will result in significant fall in the price of uranium. It is more likely that the company will realise a lot less than the market value if uranium stock is liquidated immediately and hence, market value of uranium should not be taken into account for the liquidation analysis.
The current share price fairly reflects the existing operations and future growth of those operations. However, there are two important and contrasting valuation issues. Firstly, the company has initiated the American Centrifugal Project (ACP) which will use new technology. The NPV of the ACP is -$220 million which implies that the share is overvalued significantly. Also, there are additional risks due to new technology and higher amount of funding.
Secondly, the company has a very high amount of uranium inventory and if its market value is included then the stock market is significantly undervaluing USEC if the business is liquidated immediately. However, it is unlikely that the market price of uranium will be achieved if the firm is liquidated because the high inventory will result in a sharp drop in uranium prices.
Overall, the company is facing higher operational costs and its reliance on the ACP to increase value is risky with a negative NPV. Costs and time overruns in implementing the project could severely impact the financial health of USEC. The investment strategy would be to short USEC as negatives of the ACP overweigh its positives, at least until the time the ACP becomes operational.
Exhibit I - Sales and cost data of the ACP
Exhibit II - Profit and loss of the ACP
Exhibit III - NPV of the ACP
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