“Differing views on the valuation of Oncor, on one hand, and TCEH, on the other hand, dominated negotiations of a ‘consolidated’ restructuring scenario that involved various creditor constituencies receiving equity in EFH Corp.” – Paul Keglevic, CFO, Energy Future Holdings – First Day Declaration
By Don Erickson and Bryce Erickson – (July 10) – When Energy Future Holdings (“EFH”) and certain of its subsidiaries entered into a pre-arranged reorganization under Chapter 11 of the U.S. Bankruptcy Code on April 29, there were (and remain) a myriad of issues that require resolution for the largest generator, distributor and retail electricity provider in Texas. How should debtor-in-possession (“DIP”) financing be allocated? How and when will restructuring priority be given to various creditors? Is a “tax-free” spin of Texas Consolidated Energy Holdings (“TCEH”) a viable option? What is to be done about Oncor? The list goes on. At the heart of those questions, and of the bankruptcy, are valuation issues that have and likely will continue to permeate throughout the process.
A few of the critical existing and potentially emerging valuation issues in EFH’s Chapter 11 process include things like (i) premises of value, (ii) regulatory issues as they pertain to pricing and rate setting, (iii) consolidated vs. non-consolidated restructuring scenarios and (iv) development of projections and cash flows. All of these issues have interplay with each other and they are certainly not exclusive when it comes to valuation considerations for as complex an organization as EFH. In addition we will look to instructive prior electric company bankruptcies, such as Mirant and Dynegy, to help navigate these waters as well.
PREMISE OF VALUE: REORGANIZATION VALUE VS. FAIR MARKET VALUE
“Being in bankruptcy is like being in a fishbowl,” said Sander “Sandy” Esserman, a partner at Stutzman, Bromberg, Esserman & Plifka who was involved in the Mirant Corporation bankruptcy. One of the most meaningful and thematic aspects stakeholders and observers will be viewing in that fishbowl will be the standard of value lens that one peers through. Standard of value considerations will be front and center at EFH’s division Texas Competitive Electric Holdings (“TCEH”), where creditors are disputing EFH’s restructuring strategy that could wipe out billions of dollars of debt.
There are two premises of value to consider: fair market value and reorganization value. The fair market value standard is more of an as-is where-is proposition, which posits that the value of a company is a reflection of what the current marketplace will pay for it.
This standard is used (often successfully) in reorganization plans and liquidation scenarios where a sale of assets or companies is a viable and appropriate solution to the parties. This could be unlikely in EFH’s situation.
According to EFH management, under certain scenarios, a Section 363 sale could trigger tax liabilities of over $6 billion. However, in the midst of Chapter 11 reorganizations, fair market value has been criticized as overemphasizing the “stigma” of bankruptcy, and thus undervaluing a debtor. Esserman concurred that undervaluation can happen, citing American Airlines and Lyondell as examples of companies that emerged out of Chapter 11 and quickly saw stock prices (and thus enterprise values) increase.
The other key standard is reorganization value, which can be defined as the enterprise value of the reorganized debtor. This more futuristic premise takes into account the effects of the bankruptcy process and its benefits to the value of the debtor(s). The difficulty of this can be in its proper application and timing. The Mirant bankruptcy, whereby the court issued an exhaustive memorandum opinion on the valuation efforts, put significant weight on the reorganization value standard and, as such, utilized exit financing and non-distressed equity returns as assumptions in its valuation opinion. This is almost certainly the posture that unsecured creditors will be taking in regard to EFH.
REGULATORY & CONSOLIDATION ISSUES – HOW DOES ONCOR FIT IN?
One of the negotiated items pre-bankruptcy was whether or not to consider a “consolidated” bankruptcy for EFH, meaning including Oncor in the plan.
This is an important consideration. Oncor is not a debtor in the Chapter 11 case, but its value is a relevant component to the restructuring. TXU is Oncor’s largest customer, and it is regulated by the Public Utility Commission of Texas (“PUC”). Due to its regulated status, Oncor is restricted from making distributions to EFH under certain conditions.
Oncor also has an independent board of directors, not to mention certain structural and operational aspects used to enhance Oncor’s credit quality – known as “ring-fencing” measures that further isolate it from EFH. That said, Oncor is profitable and distributions represent an all-important cash inflow to EFH as a means to fund creditors, perhaps as adequate protection to secured creditors or as payment to unsecured creditors.
The rates set by the PUC impact those measures. This brings about the question of where will the influence of the bankruptcy court end and the regulatory authorities begin? Actions by one may or may not influence the other. We do not pretend to know or even want to speculate on what will transpire in respect to this, but however those rates and dividends out of Oncor change, it will impact the value to EFH and its creditors.
The competitive side of EFH’s business, TCEH, is in a highly competitive business that buys and sells a commodity product. Its rates are not set and have fluctuating inputs that have significant impact on valuations.
How the marketplace views Luminant and TXU Energy is different than how it views Oncor, so it might make sense to treat each entity individually, with separate cash flow projections, pricing and market assumptions. That said, there are other consolidated, multi-faceted public electric companies that may provide good valuation benchmarks.
It is notable that in the Mirant bankruptcy the court considered and utilized public comparable companies. However, with the specific structural, tax and regulatory issues involved with EFH and its subsidiaries, one has to be careful not to generalize comparative aspects of these companies, which the Mirant court emphasized.
PROJECTIONS: REACHING A CONSENSUS OR A BATTLE OF CONTENDING PLANS?
When private equity investors KKR, TPG and Goldman Sachs bought EFH in 2007 for more than $8 billion in equity, it was widely seen as a bullish take on natural gas prices. Back then, investor projections anticipated rising Henry Hub prices. They were wrong. EFH characterized its misfortune this way in their first day motions: “In October 2007, the main ingredients for EFH’s financial success were robust and steady economic growth…natural gas prices that were not expected to significantly decline over the long term. Since 2007, however, overall economic growth was reduced…and wholesale electricity prices have significantly declined.”
New discoveries, hydraulic fracturing and the 2008 recession all led to a drop in natural gas prices. The challenge that needs to be undertaken now is attempting to project prices in today’s environment as these prices form the baseline for any financial or discounted cash flow analysis. Coal prices play a meaningful role as well.
Opinions vary widely on this and therein it is perhaps the most challenging valuation aspect in this entire case. Where will natural gas prices go? Some parties are more optimistic than others and this optimism could fuel the basis for competing reorganization plans. For EFH’s part, it would not surprise people if management took a conservative view on gas prices, having already been burned on prior projections. The stakes are high. Cash flow sensitivity to even slight variations in assumed prices could mean the difference between an unsecured creditor being made whole or getting very little.
One path the court could take is having industry subject matter experts help key industry variables and form a baseline for a projection. The underlying assumptions in the cash flow projections would be ultimately built upon those assumptions.
Even if agreement is reached there, the bottom line cash flow could still vary widely based on cost structure, rates of return and future tax benefits from prior net operating losses (TCEH reported $3.0 billion of pre-tax losses in 2013). The net operating losses, depending on what reorganization plan the court adopts, could prove to be an enormous swing factor as well. They could possibly be worth billions under one scenario or they could potentially be worthless depending on the tax treatment of the plan.
SUMMARY
Valuation issues are front and center of the EFH bankruptcy. How the ultimate reorganization plan plays out will be critical. Many valuation aspects can be structured in a settlement. However, even in bankruptcy environments, there are economic, financial and market issues that still fuel the undergirding drivers to maximizing value for all stakeholders. No investor wants the short end of a stick. Depending on how the valuation issues play out there might be a chance that EFH has a long enough stick for everyone to grasp. Time will tell.
Don Erickson is the president and managing partner of Erickson Partners, LLC. Erickson, a former senior partner with Ernst & Young LLP’s corporate finance practice, has managed over 1,500 valuation engagements since his entry into the valuation profession in 1972.
Bryce Erickson is managing director and a member of Erickson Partners, LLC. Erickson has conducted hundreds of valuations and related engagements for the purposes of mergers and acquisitions, buyouts, financial reporting, estate and gift taxes, allocation of purchase price, litigation support, financing, and business planning.