Fool on the Street: AES Has the Right Stuff

Now, you shouldn't trust everything you read, especially when the information comes in the form of a press release or a presentation. (Yeah, that goes for this article, too.) Always read with a critical eye and decide if the information being presented is the information you need.

Warren Buffett reminds his shareholders that he tries to give the information he would want when evaluating a business. So kudos to the management team at merchant energy company AES (NYSE:AES) for giving potential investors the right information (at a Bank of America conference) to make an informed decision about whether the company is a worthwhile investment.

Everyone needs energy and electricity. It's hard to imagine functioning without them. And now that the Enron fallout has settled, allowing investors to determine which energy companies will continue to function well, it's no surprise that investors have been purchasing shares of electricity generators like Reliant Energy (NYSE:RRI), NRG Energy (NYSE:NRG), Mirant (NYSE:MIR), Dynegy (NYSE:DYN), and TXU (NYSE:TXU). Where does AES stack up against the rest of the crowd? First we'll critique the presentation; then we'll use the information to compare AES to its rivals.

First things first
What did I like about the presentation? Well, I could care less about the color choices for the slides. But I was glad I didn't see any earnings forecasts. Instead, I saw strategic information about growth opportunities, cash flow information, and return on invested capital. Yes, Fools -- apparently management at AES focuses on the right stuff to evaluate its business. Very Foolish indeed.

Growth opportunities
Developing countries have the greatest need for energy. That's because industrialized economies have trouble developing and growing without a solid energy infrastructure. So it shouldn't be surprising to see AES focusing on investing in Africa, South America, Eastern Europe, and Asia.

However, there are very real risks in setting up shop in those areas. Some of these economies are unstable and currency values can fluctuate. And there can be battles over what prices the plants can charge. So it takes local knowledge and experience to keep plants and cash flows running smoothly. Fortunately, AES has plenty of both.

From an environmental perspective, it's good to see AES developing wind energy projects. I think the jury is still out because the technology is relatively young and expensive. But with more experience, increased reliability, and increased scale, generating costs should continue to fall.

Cash flow information
I like strategy as much as the next guy. But can AES make any money off of these investments? Well, it does have a track record of creating cash flow from previous investments. Since 2002, when the market wrongly thought the company was going to implode along with Enron, AES has generated more than $5 billion in free cash flow (FCF), which it has used to reduce its debt load to shore up its balance sheet.

I also like that management breaks out maintenance capital expenditures ($800 million to $900 million expected for 2006). That gives investors a better idea of how much FCF the company is making (FCF is operating cash flow minus maintenance capital expenditures). AES is a capital-intensive business, so it helps to understand how much of its capital expenditures goes to maintenance and how much goes to growth. Look for more to go to growth in the future as its balance sheet gets stronger.

Return information
If I expect more capital to be invested in growth projects, then it's important to know what returns AES is generating. I've said it before and I'll say it again: If you're not calculating the return on invested capital (ROIC) at each company you analyze, you're missing a very important metric. It's your capital that the management is investing; make sure they are generating good returns from it.

According to the company's calculations, ROIC is up from about 8% in 2004 to more than 13% in 2005. Returns are moving in the right direction and are greater than its cost of capital. To me, that means AES is creating value from its capital allocations. And if you're not familiar with how to calculate ROIC, AES shows you how they do it in the appendix. That's good stuff.

The best merchant energy company
Again, I was happy that management gave me the information I need to evaluate the business against its peers. And I think the appropriate measure to use is:

Enterprise Value/(EBITDA - Maintenance capital expenditures)

I use this measure because all of these companies have capital structures consisting of debt and equity. So we want to use enterprise value (market capitalization plus debt, minus cash) to evaluate the total value of the company. While EBITDA can be a dangerous measure by itself, when we subtract maintenance capital expenditures, we can get an idea of how much "cash" is going to both debt and equity investors.

So, pulling together all of this information, here's a table comparing these electricity generators.

Fool's final word
I don't think it's fair to say that Dynegy and Reliant are bad companies based on the figures above. It's clear they still have some work to do to get the most out of their assets, and that they require a different analysis to evaluate them (a private transaction model would be more appropriate, but that's beyond the scope of this article).

Using the figures in the table, NRG looks expensive relative to its peers, and AES looks to be the least expensive. And from the presentation, we have a reasonable idea of where AES is looking to construct new generation facilities. We also know it generates both cash from its investments and value-creating returns.

Energy is a basic necessity for the growing global economy and it will always be in demand. I'll be the first to say that AES is risky because of its global focus. But at the same time, having a global focus is what should generate increasing returns in the future. And while a relative comparison doesn't necessarily mean a company is a bargain, it sure is a great place to start looking for one.

Bank of America and TXU are Motley Fool Income Investor recommendations.

Philip Durell and the Inside Value team love a good bargain. In fact, they're looking for them all the time. Want to see the ones that pass the Inside Value test for margin of safety?Click hereto take a free trial.

Retail editor and Inside Value team memberDavid Meierused to design gas turbines for power generation before wising up and doing what he really loves. He owns shares of AES but does not own shares in any of the other companies mentioned. You can view his profile here. The Fool takes its disclosure policy very seriously.