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Summary We are adding the AES Corporation to our “buy” list. Both the fundamental and technical analyses indicate a potential for a 35% gain over the next few years. The key risk is our assumption that cash flows do not materially deviate from their long-term uptrend. Introduction The AES Corporation (NYSE: AES ) has been exposed to a number of headwinds recently, most notably falling energy prices across the globe, rapidly appreciating U.S. Dollar and weak demand coming from the emerging markets, particularly Brazil, Argentina and Colombia. The most recent negative surprise was the Q3 revenue miss of as much as $1.5bn, which prompted the management to revise down their 2016 earnings guidance below analyst estimates. Cost cutting measures have been put forward to offset the macroeconomic headwinds by 2018 and we see them as a necessary adjustment. It is difficult to judge whether they work out as planned, but it is encouraging to see that the leadership is taking the appropriate steps to keep the business viable. Furthermore, Andres Gluski (the CEO) emphasized their focus on free cash flow as a source of shareholder value, and we believe that this is an appropriate measure for estimation of AES Corporation’s long-term investment value. Valuation Our valuation model for AES is based on the company’s ability to generate cash. The key measure of cash flows that we use is free cash flow, which is the total cash inflow from operations minus the dividends and capital expenditure outlays. This is effectively the amount of “excess” cash that the company is making and therefore accruing to its lenders and shareholders. While we do look at historic cash flows, cash flows projections are of crucial importance because markets are forward looking. Our estimated cash flows for the next 10 years are simply based on the previous trend, as we do not have access to analyst estimates for AES. After 10 years, we assume that the growth rate of cash flows falls back to its previous trend and remains on it for the next 10 years, after which it normalizes towards the sustainable rate of 3.9% per annum, based on the average real GDP growth over the last 15 years and the average inflation rate of 2%. The chart below shows the historic (blue line) and projected free cash flows (red line). (click to enlarge) To calculate the total value of the firm, we discount the projected cash flows and the company’s terminal value by its weighted average cost of capital ( OTC:WACC ). Our estimate of AES’s cost of debt is 7.28%, based on their interest expense and amount of debt outstanding in the last fiscal year. The cost of equity is calculated using the 10 year treasury yield as the “risk-free” proxy plus the implied equity risk premium of 9.13% times the historic beta of 1.1675 for the stock. Some of the other key metrics summarized below: •Beta = 1.17 •ERP = 5.98% •Cost of Debt = 7.28% •Cost of equity = 9.13% •Debt to Assets = 54.45% •WACC = 7.73% •Current Price = $9.9 •Fair Price = $26.52 (167.9% return) After discounting the projected free cash flows and the company’s terminal value in 10 years’ time, we subtract the current value of debt and arrive at the total equity value of 17,887,985, which equates to $26.52 per share. With today’s share price at $9.9, re-pricing towards the estimated fair value would require a return of 167.9%. The green line in the below chart represents the estimated “fair value” per share, with the dashed lines showing the upper and lower bounds of the confidence interval based on stock’s volatility. (click to enlarge) Relative Valuation American Electric Power Company (NYSE: AEP ), Pinnacle West Cap. (NYSE: PNW ), Firstenergy (NYSE: FE ), Nrg Energy (NYSE: NRG ), Consolidated Edison (NYSE: ED ), Cms Energy (NYSE: CMS ), Dte Energy (NYSE: DTE ), Entergy (NYSE: ETR ), Nextera Energy (NYSE: NEE ), Dominion Resources (NYSE: D ), Xcel Energy (NYSE: XEL ), Exelon (NYSE: EXC ), Ppl (PP and), Pg&E (NYSE: PCG ), Pub.ser.enter.gp. (NYSE: PEG ), Edison Intl. (NYSE: EIX ), Southern (NYSE: SO ), Teco Energy (NYSE: TE ), Pepco Holdings (NYSE: POM ), Eversource Energy (NU) are AES’s closest peers within the S&P 500. The table below can help us understand AES’s valuation in relative terms. Table 1: Relative Valuation Table, S&P 500 peers AES AEP PNW … Median Lower Quartile Upper Quartile PE 11.60 15.10 17.20 … 16.90 13.23 20.50 PC 2.48 6.31 6.33 … 6.31 4.81 6.83 PB 1.63 1.58 1.57 … 1.61 1.56 1.75 ROE 17.02 10.13 9.46 … 10.13 9.08 11.51 EPS Growth (5 year) -1.03 2.39 39.79 … 1.03 -1.73 6.80 Beta 1.17 0.58 0.72 … 0.59 0.55 0.69 AES Corporation benefits from very low price multiples, which indicates that the bad news are already in the price. price to earnings ratio of 11.6x is below the lower quartile for the group (13.2x). The same is the case for the price to cash flow and price to book multiples, currently standing at 2.5x and 1.6x, respectively. (click to enlarge) Even more importantly, the price to book ratio of 1.6x looks very attractive in the context of the return on equity of 17.0%. The chart above shows that this makes the company look significantly undervalued relative to peers, given the current industry relationship between this price multiple and underlying profitability. The stock looks attractive from the technical perspective as well. While in the short term the price could fall to as low as 8.6%, a failure to break below this level would confirm the wedge-like formation in play, targeting roughly 35% upside, depending on the timeframe. While a potential break below the support would imply further short term weakness, we see current price as an opportunity to buy due to the 2.5 times greater upside. Of course, if rate hikes in the U.S. push the U.S. dollar higher, investors will need to exercise more patience until the target is reached. (click to enlarge) Conclusion In summary, the company leadership has already taken action to counter the unfavorable impact of macroeconomic developments across the globe. The cost cutting measures that are aiming to support the free cash flow generation through 2018 may or may not work as planned, but investors should focus on risk management and diversification rather than crystal ball gazing. Our discounted cash flow model indicates roughly 35% upside (the lower end of the fair value range, the conservative target), which is also supported by long-term technicals. AES Corporation looks significantly undervalued relative to peers as well, thereby ticking all our boxes. As a result, we are adding this stock to our “buy” list today. Scalper1 News
Scalper1 News