Description

Business Description

·        Dynegy (DYN) is an independent power producer (IPP) that provides wholesale power, capacity and ancillary services to utilities, cooperatives, municipalities and other energy companies in 15 states.

·        DYN's power generation portfolio consists of approximately 20,000 megawatts of baseload, intermediate and peaking power plants fueled by a mix of coal, fuel oil and natural gas.

• Midwest - 9,495 megawatts of generation capacity; active in NERC SERC and MISO regions in NI Hub/Com Ed, Cin Hub/Cinergy
• West - 6,740 megawatts of generation capacity; active in NERC Region CAISO, Meade, Palo Verde and ERCOT
• Northeast - 3,809 megawatts of generation capacity, active in NERC Region NPCC in New York Zone G, Zone A
• Dynegy was formed in 1996 when Chevron combined its natural gas and natural gas liquids businesses with NGC Corp.

Recent Corporate Events

DYN acquired 11 power plants from private equity shop LS Power.  Nine of the eleven power plants were plants LS Power had acquired from Duke Energy.  In exchange for the plants and a 50% interest in a development JV, LS received 340 mil. shares (40% ownership in DYN) $100 million in cash and a $275 million Dynegy note.

In May 2007, Chevron sold its entire stake of  96,891,014 shares in Dynegy at $9.70 via Goldman Sachs. 

Recent Trading Events

Between 7/19/2007 and 7/27/2007 Dynegy stock traded down nearly 18% from $10.60 to $8.77.  The recent flight to quality from leverage loans and high yield has taken down the whole IPP sector – MIR, NRG, DYN.  In my opinion this presents a good buying opportunity for value investors with a 12-18 month time horizon.  The underlying fundamentals of supply and demand for power generation are strong, replacement costs having significantly increased and DYN will be a FCF generating company from 2007 onwards. 

The market is pricing some kind of refinance risk for DYN.  Dynegy capital structure is levered but there are no short term refinance issues. The main issue for DYN is getting covenant relief from its creditors to use its FCF to repurchase stock.  Given the recent volatility in credit markets it is unlikely DYN will seek this covenant relief.  The recent flight to quality in credit provides a good opportunity to buy DYN equity the market is throwing the baby out with the bath water. 

Valuation

DYN Valuation Metrics

Equity               $7219.88 mil.

Net Debt          $5900 mil.  approx

EV                   $13,100mil. approx

2007 EBTIDA            $1100 mil.       

2008 EBITDA             $1300 mil.

EV/EBITDA 2007       12x

EV/EBITDA 2008       10x

I have used conservative assumptions for 2007 and 2008 EBTIDA.  DYN becomes cash flow positive in 2007. 

Replacement Cost $11.50 per share (conservative)

12-18 month upside 33-40%

No liquidity Events

DYN has no significant debt maturities till 2011-2012 when approximately $580 mil. and $870 mil. come due. 

Replacement Cost

The costs of building new power plants has increase by 30%.  There is an interesting New York Times article on July 10, 2007 about rising constructions costs for power plants.

IPP profitability in the long term is driven by supply demand for power.  The demand for power is relatively stable.  Historically power demand has grown at 70% of GDP growth.  As the economy grows the demand for power grows.  There have only been 3 years since WWII when power demand has declined year over year – 1974, 1982 and 2001.

As China and India develop, their demand for new power construction is increasing significantly.  There is also significant global demand for engineering & construction services and raw material used in constructing power plants.  Power plants construction also competes with refining and petrochemicals for engineering & construction services and raw materials.  Overall the replacement cost of IPP assets has increase significantly in the last couple of years.

Using conservative replacement cost metrics of $1800 k/w for coal, $700 k/w for natural gas in California and New York and $525 k/w for natural gas in other regions the replacement cost for DYN assets is over $11.50 per share.   The true replacement costs for its assets taking into account recent construction cost escalation is significantly more. 

Value Drivers

Valuation and Replacement cost realization by the market.

DYN has been selling assets in non-core regions.  DYN sold its 534mw Texas based CoGen Lyondell Power generation facility for $470 mil. at $880 kw and 11.8x EBITDA to a JV between PNM Resources and Cascade Investments.  DYN is also in the process of selling 576 MW natural gas plant called Bluegrass in Kentucky and 566 MW natural gas plant called Herad Power station in Georgia.  The sale of the plants should give the market additional insights and validity of DYN portfolio. 

If natural gas power plant sells for $880 kw in Texas, the California portfolio of Dynegy should be worth significantly more.  The California assets acquired via LS Power are a hidden jewel for Dynegy.  The California Energy Commission on May 3, 2007 passed rules barring municipal utilities from signing new contracts with coal fired plants.  A similar set of rules were passed in January for investor owned utilities.  California Energy Commission has basically mandated that natural gas fired plants along with alternative energy (wind, solar) will basically provide all of California’s future power needs. 

LS Power Green Field development JV

LS Power and Dynegy have a JV for developing new power plants.  The JV is primarily focused on coal powered plants.  Basically by buying DYN one gets access to a development and strategic growth policy operated by LS Power.  LS Power is the premier private equity player in the IPP space.  They have shown excellent judgment and returns in investing in the merchant power space.  The JV’s focus on building coal fired plants will primarily be in the mid-west.  Expect there to be a lot of political opposition but the basic strategy of DYN will be to build new coal fired plants only in regions where it does not have significant natural gas plants (West, Northeast). 

Re-generation of Existing Facilities

There is also implicit optionality in re-energizing DYN portfolio.  Basically over time DYN can build extension or new brownfield facilities at its exiting power station in capacity constraint regions – California.  Replace peakers with combined cycle plants.

LS Ownership

LS Power owns 40% of DYN.  By investing in DYN one can get to free ride on LS Power expertise without having to pay private equity fees and locking up ones capital for 7 years.  LS Power has a majority of their fund and significant gains on assets sales tied into DYN stock.  LS Power cannot sell their stock till 2009 and owning 40% of the shares outstanding it is unlikely they will sell their stock in the public market. 

LS Power with their capital tied in DYN are going to try and maximize value for shareholders in DYN.  I expect them to make very sound investment decisions in developing new power plants – don’t expect them to speculatively build new capacity, do ego building acquisitions or lever up the firm.  LS Power ownership is the primary reason I like DYN over other IPPs.  In DYN, I have the best investor in merchant power, LS Power, and my equity ownership having aligned interest – maximize the value of DYN stock price over the long term. 

Risk

 Near Term Commodity Risk

Short term natural gas price fluctuations can affect earnings and cash flows quarter by quarter.  DYN historically has been un-hedged on commodity risk.  When DYN acquired the LS Power assets it also acquired LS hedges.  I expect DYN under LS ownership to be more conservative with its hedging program

New Power Plant Construction

Unlikely in the short term as most IPP are trading below their replacement value. 

Decline in Power Demand

Significant recession

Catalysts

Asset sales, replacement costs, FCF generation, new coal fired plant development, LS Power ownership

Catalyst