Case-USEC INC.
Jaspereric
F-1546.pdf
UVA-F-1546 Nov. 5, 2008
This case was written by Ben Mackovjak (MBA ’07) and Lucas Doe (MBA/ME ’04) under the supervision of
Professor Kenneth Eades, as a basis for class discussion rather than to illustrate effective or ineffective handling of
an administrative situation. Copyright 2007 by the University of Virginia Darden School Foundation,
Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected].
No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in
any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission
of the Darden School Foundation.
USEC INC.
When the loudspeaker in Concourse A of the Richmond International Airport announced
that his 4:00 p.m. flight to Boston was delayed until 7:00 p.m., Ben Mackovjak realized that his
hope of seeing any of the 7:00 p.m. Red Sox game at Fenway Park was gone. Mackovjak worked
as an analyst for Rivanna Capital (Rivanna), a long/short equity hedge fund based in
Charlottesville, Virginia that focused on publicly traded small and midcap companies. As a
hedge fund company, Rivanna followed a simple investment rule to buy stocks (a long position)
that were undervalued by 10% or more and short sell stocks (a short position) that were
overvalued by 15% or more. Since its inception a few years earlier, Rivanna’s investors had
become accustomed to earning superior risk-adjusted returns. The key to Rivanna’s success up to
now had been to conduct careful analyses of the fundamental value drivers of companies to
identify the right stocks for a portfolio.
Mackovjak had been offered the analyst position for the summer of 2006, after
completing his first year of the MBA program at the University of Virginia’s Darden School. If
the Rivanna partners were pleased with his work, Mackovjak could receive a permanent offer
that would be effective immediately after his graduation the following May. It was now July, and
Mackovjak had participated in the analysis of many interesting companies; however, none had
been as interesting as USEC Inc., and none was more important to his aspiration of securing a
permanent job offer from Rivanna. USEC was the first company for which Mackovjak had the
responsibility of recommending the stock as either short or long to the senior partners. With only
one more month before classes started, it was unlikely that he would have another such
opportunity to display his capabilities.
Mackovjak had been pouring over USEC’s financials, listening to past conference calls
with equity analysts, and reading various research reports. The results of his discounted cash-
flow analysis showed him that USEC’s stock price of $10.80 fairly reflected the expectations of
the cash-flow potential of USEC’s existing operations as well as the future growth of those
operations. But Mackovjak also recognized that USEC was in the beginning stage of a massive
capital-expenditure project known as the American Centrifuge Project (ACP) that would almost
double the scale of the company and dramatically improve its competitive position. Given the
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size and importance of the ACP, it seemed almost certain that including the project in his
analysis would ultimately be the key to Mackovjak’s recommendation about the stock. If he
found ACP to be a value-creating investment, it would imply that the USEC stock was
undervalued, and Rivanna should take a long position. Conversely, if ACP was a value-
destroying investment, Rivanna should short the stock to take advantage of it being overvalued
by the market. More importantly, if Mackovjak improperly assessed the value of ACP, then his
recommendation about USEC would almost certainly prove to be wrong, which would not play
well for his career aspirations at Rivanna.
Now that he had several hours to kill waiting for his flight, Mackovjak decided to pick up
where he had left off at the office a few hours ago, evaluating USEC. It was true that he had been
working long hours all summer and deserved a weekend in New England with friends, but it was
also true that the founding partner of the firm wanted his recommendation on USEC by Monday
morning.
USEC Background
Headquartered in Bethesda, Maryland, USEC was the world’s leading supplier of
enriched uranium fuel for commercial nuclear power plants. In addition to the enrichment
business, USEC also performed related contract and consulting services for the Department of
Energy (DOE) (Exhibits 1 and 2). USEC was a publicly traded company that leased its
technology and facilities from the DOE. USEC’s unique business model carried with it
significant influence from the U.S. government through its contractual obligations with the DOE
and through other government agencies who had security concerns with uranium enrichment.
The company competed in a global market with only three major competitors: AREVA/Eurodif
(France), Tenex (Russia), and Urenco (Germany) and held a 50% share of the North American
market and 30% share of the global market.
In the early 1990s, USEC was created as a government corporation to restructure the
government’s uranium-enrichment operation. In 1998, USEC was privatized, and by 2006, it
operated the only uranium-enrichment facility in the United States, a gaseous-diffusion plant in
Paducah, Kentucky. USEC also had another plant in Portsmouth, Ohio, which it had placed in
cold standby1 under a contract with the DOE. Urenco was planning to expand its operations by
building a competing uranium-enrichment facility in New Mexico but had not yet begun
construction of the facility, nor had it announced a precise time frame for the undertaking.
USEC served as the U.S. government’s exclusive agent for the Megatons to Megawatts
program, a 20-year nuclear-nonproliferation agreement between the United States and Russia.
Through this program, USEC facilitated the conversion of weapons-grade uranium by buying the
1 Cold standby was a condition where the plant could be returned to production of three million SWU within 18
to 24 months if the U.S. government determined that additional domestic enrichment capacity was necessary. Under
this agreement, the government paid USEC to maintain the plant in that state of readiness. Mackovjak’s analysis
suggested that the Portsmouth plant had unfavorable operating economics such that it would only be taken off
standby for a national-defense-related issue.
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uranium from the Russian government and then selling it as fuel to commercial power-
generating companies. The uranium purchase provided the Russian government with a steady
stream of revenue and, at the same time, supported the intention of the United States to keep
uranium out of the wrong hands. With seven years still left in the program, USEC estimated that
the agreement had been responsible for the dismantling of 20,000 Russian warheads.
The Megatons to Megawatts agreement stipulated that USEC would buy the equivalent of
5 million pounds of uranium each year at a fixed price of $20 per pound.2 For many years, USEC
had benefited from the fixed-price agreement as the market price of uranium had risen well
above $20 per pound; however, the requirement of purchasing 5 million pounds regardless of the
demand from USEC’s customers had resulted in a large buildup of uranium inventory. On
occasion, USEC would sell excess uranium from its inventory but as of Q2 2006, it carried 29
million pounds of uranium in inventory, which was reported at a cost of $20 per pound.3
Based on a classic investments book by Benjamin Graham, Mackovjak had computed the
net working capital of USEC on a book-value and a market-value basis (Exhibit 3). According
to Graham, companies that sold for less than their working capital “after deducting all liabilities
ahead of the stock” were truly “bargain issues.”4 Following Graham’s hypothesis, Mackovjak
computed what he termed a “net working-capital liquidation value” and found it to be higher
than USEC’s stock price of $10.80 per share. Although he found this an interesting exercise, he
decided it was not relevant for his analysis, which relied upon future cash flows at both the firm
and the ACP level.
Uranium-Enrichment Process
Uranium fuel was sold as Separative Work Units (SWU), which was a measure of the
energy required to convert natural uranium into a blend of enriched uranium. In order to produce
SWUs for sale, USEC needed to purchase the uranium and then perform the enrichment process
as needed. Uranium, when found in nature, had two principal isotopes: uranium-235 and
uranium-238, but only U235 was fissionable. With U235 constituting only approximately 1% of
raw uranium, uranium typically had to be enriched to bring the concentration of U235 up to a
level approaching 5% to qualify for use by a nuclear power plant.
USEC’s existing enrichment process at the Paducah plant used gas-diffusion technology,
which required large amounts of electricity to operate a series of enormous industrial
compressors. For many years, USEC had managed to keep the cost of electricity stable until its
long-term contract with a power supplier expired. Without the benefit of the power contract,
USEC’s margins had shrunk as its cost of production relative to its competitors had suffered. In
2005, USEC’s enrichment cost for the gas-diffusion process was $42 per SWU and was expected
2 The MTM program allowed USEC to buy either raw uranium or the equivalent of 5 million pounds of
uranium. Either way, USEC paid the equivalent of $20/lb. of raw uranium and recorded it as $20/lb. in its inventory
account. 3 Because uranium was considered a durable material, it was not depreciated for accounting purposes. 4 Benjamin Graham, The Intelligent Investor (New York: Harper & Row, 1986), 14.
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to increase in line with inflation. The capacity of the Paducah plant was 3.5 million SWU per
year. When USEC phased in the ACP, production would be moved to the ACP, causing
Paducah’s production to fall to 1 million SWU in 2011 and zero in 2012, and the plant would be
placed in cold standby.5 USEC paid $8 million annually to the DOE to lease the Paducah plant,
an expense that would disappear once the plant was in cold standby. If USEC continued to run
Paducah at its capacity of 3.5 million SWU, the company expected to spend $30 million on
capital expenditures every year, and depreciation on the plant would approximate capital
expenditures for the near future.
Uranium and the SWU Market
Global energy prices had increased dramatically during the past several years as had the
prices for uranium and SWU (Exhibit 4). USEC management estimated that the price of
uranium in 2006 would be $43 per pound,6 while the price of one SWU would be $127. Like
most commodities, there was substantial volatility of uranium and SWU prices as supply and
demand pressures changed over time. On average, the best guess regarding future prices was that
uranium and SWU would increase with inflation. These market prices were important to USEC
because its customers paid the prevailing price for SWU, which in turn determined USEC’s
revenues.
The American Centrifuge Project
The ACP was an attempt by USEC to leapfrog over the technology of its competitors.
USEC expected the cost efficiencies of the new technology to position it as a low-cost producer
in the enrichment industry; however, the cost advantage would come at a high cost as the
massive scale of the undertaking was expected to cost $1.7 billion during the next five years. To
date, USEC had spent only $100 million on the ACP. If USEC could contain the cost of the
project, the remaining balance of $1.6 billion could be spent during the next five years as shown
in Table 1.
Table 1. Projected five-year USEC spending ($ millions).
2006 2007 2008 2009 2010
$185 $300 $350 $350 $415
5 When the centrifuge plant was in full operation and the Paducah plant was in cold standby, the Portsmouth
plant would be shut down. 6 Raw uranium was quoted and traded per pound, whereas an SWU depended upon the degree of enrichment of
the uranium, as well as the amount of raw uranium in the process. On average, however, it was estimated that USEC
used approximately one pound of uranium to produce one SWU.
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If construction remained on schedule, the facility would be ready in late 2010, and the
plant fully operational by early 2011, at which time the Paducah plant would begin to be scaled
down. The ACP would be depreciated starting in 2011, using the straight-line method during its
expected useful life of 15 years, at which time the plant would have zero salvage value. USEC
expected the plant to produce 2.5 million SWU in 2011, increase production by 2 million SWU
during the next two years, and reach its maximum capacity at 6.5 million SWU in 2013.
Management was confident that enrichment demand would ensure that USEC would be able to
produce at full capacity. Selling, general, and administrative expenses were expected to rise
according to the increased revenues produced by the ACP. USEC estimated that the electricity
required for enrichment would be reduced by 95%, so that the overall enrichment costs would be
cut by 50%, relative to the existing gas-diffusion process. For the longer term, management
expected the enrichment costs for the ACP would increase with inflation. The company expected
to pay a royalty of 1% of gross revenue to the DOE as compensation for its initial research and
development of the centrifuge technology. After completion, the ACP would require a minimal
level of maintenance investment.
The Decision
Mackovjak had most of the information he needed to value the ACP, although he still
thought he needed a few important assumptions to complete the analysis. In particular, he wanted
to determine a market-risk premium, a long-term inflation rate, and the net working-capital
requirements of the ACP. During his first year in the Darden MBA program, Mackovjak had
made these types of assumptions repeatedly, so he was confident that a market-risk premium in
the range of 5% to 6% was a reasonable estimate. Picking an inflation rate and estimating
working capital, however, were not as familiar to him.
Estimating the long-term inflation rate was troublesome because inflation rates were
often volatile and using an incorrect inflation forecast could lead to a significant valuation error.
Mackovjak knew that he needed to consult someone knowledgeable about inflation and decided
to contact his Darden professor, Dr. Peter Rodriguez. Rodriguez had studied at Princeton under
Dr. Ben Bernanke, currently serving as the chairman of the Federal Reserve. Mackovjak thought
that Rodriguez would know what Bernanke considered a reasonable inflation rate, and he was
certain that the dedicated professor would still be in his office on a Friday evening. Sure enough,
Mackovjak reached Rodriguez and, after a 45-minute conversation, learned that a reasonable
long-term inflation assumption was 3%, which was consistent with current Treasury yields.
To determine the net working-capital requirements of the ACP, Mackovjak needed
another highly qualified person, so he turned to Darden alum Craig Weise, who was a senior
analyst at Rivanna Capital and had assisted on parts of the USEC research. Weise judged that the
ACP would require net working capital equal to 5% of sales. This surprised Mackovjak who had
initially thought that a number twice as large was appropriate; however, now he understood why
Weise had been named a Shermet Scholar, an award given only to the best Darden MBA
students. Because Shermets were well known for their net working-capital estimates and because
he wanted to stay in Weise’s good graces, Mackovjak decided to defer to him and use 5% of
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sales for his working-capital assumption. For information on capital-market conditions, see
Exhibit 5.
It was now midnight and Concourse A was almost completely deserted. The Red Sox had
won in the 10th inning. His flight had been rescheduled for the following morning. The last place
to buy food had closed, rendering Mackovjak’s $5 food voucher essentially worthless. As he left
the airport for his comped hotel room, feeling tired and defeated, Mackovjak wondered if there
was more to the USEC story than just a discounted cash-flow valuation of the ACP.
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Exhibit 1
USEC INC.
Income Statement as of December 31
(in millions of dollars)
2005 2004 2003 2002
Total revenue $1,559.3 $1,417.2 $1,436.7 $1,380.2
Cost of goods sold* 1,430.6 1,279.9 1,319.1 1,305.6
Selling, general and administrative 61.9 64.1 69.4 54.1
Operating profit 66.8 73.2 48.2 20.5
Interest expense (40.0) (40.5) (38.4) (36.5)
Other, net 10.5 3.9 5.4 7.0
Net income before taxes 37.3 36.6 15.2 (9.0)
Provision for income taxes 15.0 13.1 6.2 (5.0)
Net income after taxes 22.3 23.5 9.0 (4.0)
Net income per share** $0.26 $0.28 $0.11 ($0.05)
Dividends per share $0.55 $0.55 $0.55 $0.55
* Includes depreciation expense as: $35.0 $31.8 $29.3 $23.9
** Using weighted average shares outstanding as: 86.1 84.1 82.2 81.4
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Exhibit 2
USEC INC.
Balance Sheet as of December 31
(in millions of dollars)
2005 2004 2003 2002
Cash and short-term investments 276.9 174.8 249.1 171.1
Accounts receivable—trade, net 256.7 238.5 254.5 225.4
Inventories 961.6 992.2 860.9 839.6
Deferred income tax and other 120.5 83.4 100.3 51.6
Total current assets 1,615.7 1,488.9 1,464.8 1,287.7
Net property/plant/equipment 171.2 178.0 185.1 190.9
Goodwill, net 11.1 4.3 -- --
Other long-term assets 282.8 332.2 484.9 570.9
Total assets 2,080.8 2,003.4 2,134.8 2,049.5
Accounts payable 217.4 202.3 189.4 218.5
Customer advances 99.0 73.3 68.3 45.0
Other payables 111.6 89.7 197.5 106.6
Total current liabilities 428.0 365.3 455.2 370.1
Long-term debt 475.0 475.0 500.0 500.0
Pension benefits—underfunded 153.9 145.2 138.1 137.8
Deferred income tax and other 116.3 99.2 117.9 127.2
Total liabilities 1,173.2 1,084.7 1,211.2 1,135.1
Common stock, total 10.0 10.0 10.0 10.0
Additional paid-in-capital 970.6 963.9 1,009.0 1,054.8
Treasury stock (99.5) (109.2) (127.7) (133.5)
Retained earnings (accumulated deficit) 26.5 54.0 32.3 (16.9)
Total equity 907.6 918.7 923.6 914.4
Total liabilities and shareholders’ equity 2,080.8 2,003.4 2,134.8 2,049.5
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Exhibit 3
USEC INC.
Net Working-Capital Liquidation Value
(in millions of dollars)
Book Market
Cash and short-term investments 276.9 276.9
Accounts receivable—trade, net 256.7 256.7
Megatons to megawatts inventory* 580.0 1,247.0
Other inventory (SWU, uranium, etc.) 381.6 381.6
Total current assets $1,495.2 $2,162.2
Accounts payable 217.4 217.4
Customer advances 99.0 99.0
Other payables 111.6 111.6
Total current liabilities $428.0 $428.0
Net working capital $1,067.2 $1,734.2
Less debt ($475.0) ($437.8)
Less pension underfunding ($153.9) ($153.9)
Liquidation value $438.3 $1,142.5
Liquidation value/share $5.1 $13.1
Premium over current stock price ($10.8) −53% 22%
*Book value of uranium computed as 29 million equivalent pounds × $20/lb. = $580 million.
Market value of uranium computed as 29 million equivalent pounds × $43/lb. = $1,247 million.
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Exhibit 4
USEC INC.
Uranium and SWU Market Prices
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Exhibit 5
USEC INC.
Capital-Market Conditions (July 21, 2006)
U.S. Treasury Bonds Rates
Maturity Yield
Last
Week
Last
Month
6-month 5.02 5.03 5.20
3-year 5.02 5.05 5.17
5-year 4.98 5.02 5.13
10-year 5.04 5.06 5.15
30-year 5.09 5.11 5.19
USEC Public Debt
Amount S&P
Issue ($ millions) Rating YTM
7.75 % due 2015 475 B− 9.04%
USEC Beta
Five years of monthly data 1.30
Stock Price Performance
Recent share price $10.80
USEC Inc. Stock Price
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