| 2008 | 2009 | ||||||
| Price: | 94.70 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 18,142 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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Despite falling natural gas prices, concerns about demand growth and technical pressures, I am recommending the purchase of Entergy (ETR) shares. Entergy is an electric power company consisting of regulated and unregulated assets. The utility provides regulated electric and natural gas services to customers in
Entergy’s proposed spin-off of its non-utility nuclear assets (“Enexus”) should occur in late 4Q 2008 or early 1Q 2009. If successful, Enexus will be the only pure play publicly-traded nuclear generating company in the
*This multiple declines to <9x if the NPV of estimated CO2 legislation is subtracted.
Due to expected investor interest in “clean” power and since management will be on the road conducting both debt and equity roadshows, in addition to speaking at the Merrill Lynch and EEI power conferences, I do not believe normal spin-off dynamics will apply to this situation. If anything, I would expect Enexus to appreciate upon being spun-off and the Entergy stub to trade flat, or even lower. As such, the time to purchase the shares is pre-spin. To synthetically create the nuclear stub, one could short a basket of pure utility stocks, or merely a comparable utility.
As with most power companies, the price of natural gas is a key determinant of value. For the purpose of this analysis, I take the futures curve (2009-2012) as fact. The recent downward trend in natural gas prices has caused power stocks to trade off substantially. Even though natural gas could decline further, the opportunity to own nuclear power plants at these levels is too compelling to ignore.
Reason for Spin
“Entergy believes that the separation of the non-utility nuclear business is the best way to unlock the full value of Entergy’s businesses in both the short- and long-term and provides each of Entergy and us with certain opportunities and benefits that would not otherwise be available to Entergy and us.”
“We expect to return cash flows that are greater than needed for investment to shareholders in a timely manner. We anticipate that our primary manner of returning capital to shareholders will be through share repurchase programs.”
EEI Conference in November 2007
“With this type of structure they’re in position to either be part of consolidation or be a part of filling out their own portfolio in a very efficient way but in any event, it’s an upside option for all of you as owners of the company.”
“We will listen to all offers anybody has as we go through this process if it monetizes this value on the front end to the benefit of all of you that are shareholders.”
Timetable
Approvals required:
Status: Approval received, which signifies financial stability, technical qualifications and maintenance of decommissioning funds.
Status: Approval received.
Status: Pending – Entergy expects to hear in the near-term if the transaction qualifies for tax-free treatment. This approval is required for Entergy to issue pre-spin debt. A bank meeting was scheduled for the first week of September, but the Hurricane Gustav pushed it back a week.
Status: Pending. On January 28th, 2008, Entergy filed its request. The review consists of a determination if there is potential harm to ratepayers. The ALJs completed a limited discovery process. Initial comments are due September 15th. Reply briefs are due September 29th. After this, a ruling will be made on whether an evidentiary hearing is needed. A hearing would only take a couple of days, although initial commission commentary suggests a hearing will not be necessary. The biggest outstanding issue was the potential termination of the value-sharing agreements. This was recently settled as Entergy agreed to continue making these payments post-spin, although in the event of a change of control (i.e. takeover), the company could discontinue these disbursements. Approval expected in November.
Status: Pending. On January 28th, 2008, Entergy filed its request. The approval requires a finding that actions promote the general good of the state, a more challenging hurdle than
Company Overview
Entergy’s regulated assets consist of transmission, distribution and generation assets in a four-state territory that comprises portions of
Utilities are dependent on economic growth and reasonable regulatory environments. Compared to other utilities, Entergy Classic operates in more difficult regulatory environments with sales growth expected to be in line or slightly higher than the national average (1.5%). Despite lower per capita incomes and higher electricity costs as a percentage of median household income, the company’s territories should be more insulated than other parts of the country from economic difficulties.
Housing prices* in the East South Central and West South Central territories have held up better than the rest of the US. For 2007 and the last 12 months ended June 30, 2008, these regions showed year-over-year gains of 2.3% and 3.0% compared to declines of 1.2% and 1.7% for the broader US market. Furthermore, exports (agriculture, manufacturing and chemicals) from Entergy’s service territory comprise a greater percentage of its economy as compared to the rest of the country (~2x higher). Entergy’s utilities also benefit from infrastructure development and rising commodity prices. The regional economy is the #1
*Existing home prices per Federal Housing Enterprise Oversight.
A summary of the Enexus nuclear plants is below:
Capacity License Expected
Plants MW Region Factor Expiration Renewal
FitzPatrick 838 NYISO-A 93% Oct-34 NA
Pilgrim 688 ISO-NE 91% Jun-12 Oct-08
Indian Point 2 1,028 NYISO-G 95% Sep-13 Apr-10
Indian Point 3 1,041 NYISO-G 92% Dec-15 Apr-10
Total 4,998
*The NRC’s license approval process is expected to take 22-30 months. FitzPatrick approval received September 9th.
The Vermont Yankee and Pilgrim plants are located in
Concerns about license renewal are overblown. Since these plants emit no CO2 and are critical from a reliability standpoint, I expect all licenses to be renewed, despite worries about Indian Point and Vermont Yankee. Indian Point supplies 10% of the
As illustrated below, Enexus is largely hedged in 2008 at below-market prices. As the hedges decline, earnings should rise substantially.
Hedges 2008 2009 2010 2011 2012
Unit-Contingent 48% 48% 31% 29% 17%
Other 45% 35% 28% 14% 7%
Total Energy Hedges 93% 83% 59% 43% 24%
“Open” 7% 17% 41% 57% 76%
Average Contract Price $55 $61 $58 $55 $54
Capacity Hedges 88% 65% 57% 42% 21%
Average Price / kW per Month $2.0 $2.0 $3.4 $3.7 $3.5
Blended Contract Revenue $57 $62 $61 $57 $54
*Unit-contingent contracts are priced at a discount of 3%-10%.
*As the hedge percentage declines, collateral postings will fall.
*Per Analyst Day - Ravenswood sale in NYC implies 2012 capacity pricing equivalent to ~$11-12/kW-mon. Entergy anticipates price of ~$9.50.
Management’s “aspiration” for EBITDA is $2 BN by 2012. This compares to 2008 expectations of $1.2 BN. As below-market hedges roll-off, the company’s operating performance should improve significantly. Additionally, Enexus intends to reduce its percentage of unit contingent power contracts (i.e. contracts to supply power if it is available – no forced outage), which are priced at a discount to non-contingent contracts. Other potential growth vehicles include CO2 legislation, uprates (already increased capacity by 245 MW; 28 MW scheduled for
The EquaGen joint venture should be a source of growth, although not a huge driver. In addition to operating Enexus and Entergy Classic plants, EquaGen will offer nuclear services, including decommissioning, plant re-licensing and plant operations, to third parties. According to management, this unit has the technological expertise to operate any nuclear plant in the country. Since being acquired by Entergy, EquaGen’s nuclear expertise has resulted in an average improvement in capacity factors from 76% to 92%. Forced outage rates declined from 12.5% to 2.7%. Moreover, production costs fell to $20.09/MWh from $27.00/MWh.
Management Compensation
Per the compensation program, the greatest part is intended to be “at risk,” performance-based compensation. Approximately 65% and 60% of the CEO and COO’s annual target compensation is performance-based compensation.
Non-equity incentive plans (cash bonuses) are based on earnings per share and operating cash flow. These targets are aligned with externally-communicated goals. Equity awards are typically granted in the form of stock options with a three-year vesting schedule and performance units with a three-year performance cycle. Upon the exercise of stock options, the officer must retain at least 75% of the after-tax net profit in the form of Entergy stock for at least 60 months. The amount of performance units received is a function of shareholder return as compared to other comparable companies. Upon separation, the CEO will receive 75,000 shares vesting in three annual installments. Historically, Entergy management has held substantially more company stock than executives at other power companies.
Valuation
Utility earnings growth of 3.5% is projected when applying an organic sales growth rate of 1.5% with $300 MM new investment in service and assuming 2.5% growth in operations and maintenance expense. Share buybacks are expected to boost this growth rate closer to 6-8%. The company plans on a 70-75% dividend payout. To further augment growth, the company cites baseload generation investment of $5-$10 BN over the next 5-10 years (gas-fired, coal, pet-coke – Little Gypsy and nuclear units –
The average utility trades for around ~13x 2009E EPS. To be conservative, I applied a 12.5x multiple to 2009 projections. My estimates are pro forma for debt retirements ($1.5 BN from Enexus proceeds) plus share buybacks of $2.5 BN. When adding in some value for the wholesale assets ($2/share), I compute an Entergy Classic valuation in the high $50s / low $60s.
Based on the current price of $94.70, this implies a mid-to-high $30s share price for the nuclear stub. Using roughly 196 MM fully diluted shares (YE 2008) and a net debt balance of $4.1 BN from the Form 10, I calculate an enterprise value of about $12 BN*. Based on 2008E numbers, the EBITDA, EBIT and FCF multiples are 9.5x, 11.9x and 27.5x. However, the roll-off of below-market hedges should lead to far higher earnings. Using 2009 numbers, these multiples fall to 8.2x, 9.9x and 14.2x. While, these multiples include a small benefit from RGGI, federal CO2 legislation represents substantial additional upside.
*Assumes an NPV of $375 MM for NYPA value sharing payments.
*Includes 50% of the impact of closed cycle cooling towers that may be mandated for the Indian Point plants.
Per the Form 10, the cost (in 2003 dollars) is at least $740 MM and an additional $630 MM in lost generation.
Any spending would not occur for several years due to appeals and litigation.
*Starting in 2018,
Again, management’s aspiration 2012 EBITDA is $2.0 BN. Based on my model, this number is in the ballpark, although it has come down due to falling natgas prices. Using my 2012 estimates, the multiples are 6.6x, 7.6x and 8.9x, respectively. From 2009 to 2013, I calculate an EBITDA and FCF CAGR of ~10% and over 20%, respectively. The company intends to buy back substantial amounts of stock with FCF and Congress should pass CO2 legislation.
Pro forma for CO2 ($15/ton), I calculate around $5.25/share of FCF in 2012. Assuming a multiple of 12x, I estimate price target in the low $60s, which amounts to a mid-teens return over the next several years. Even a 10x multiple results in a healthy return (11%+). If I assume a $9 gas price in 2012, the FCF/share is near $6.00.
Replacement Cost
Replacement cost can be dangerous, especially in an environment of falling natural gas prices and concerns about declining power demand, but it is still a useful metric in my opinion. At current prices, the implied price per kW is around $2,400. This compares to recent numbers provided by various utilities which estimate new nuclear costs of $5,000-$7,000/kW. Even in the aforementioned difficult environment, there comes a point when you just want to own nuclear assets outright. That point is now for me.
What if Spin Does Not Happen?
Even if the spin-off does not occur, earnings per share growth should drive the shares higher. Assuming typical utility growth plus some share buybacks and using the hedge data provided by management plus the futures market (natural gas and heat rates), a 2009 EPS target of $7.50-$8.00 is reasonable (consensus = $7.89). For these assets and this management team, a ~12x multiple (3.16% dividend yield) seems very reasonable. In the event the spin is not approved, other options the company cited include a tracking stock or issuing debt at the plants.
What if Natural Gas Futures Fall to $7.00?
Figuring out the downside is always challenging considering that multiple compression seems to accompany declining earnings and cash flow. The marginal economics of many emerging shale plays requires gas prices in excess $7.50/mmbtu. However, if natural gas falls (2009-2013 strips) to $7.00, the 2009 numbers are not impacted too much given hedges. The more important calculations are for 2012 and 2013. At $7.00 gas, 2012 and 2013 FCF/share amounts to $2.90 and $3.75, based on my estimates. The 2012 number assumes some impact for RGGI, but not Congressional CO2 legislation, whereas the 2013 figure includes $15/ton of CO2. If I exclude the CO2 benefit, the 2013 is roughly comparable to 2012. Applying a 12x multiple to the average of this range (2012-2013) results in a $40 price. That represents a 4% annual return from my estimated value of where the Enexus stub trades based on the current value trading price of Entergy. While not opportune, this does help frame a downside scenario.
In the event a sub $8 natgas scenario persists, CCGT additions are uneconomic, especially considering escalating new build costs. Since coal is off the table, incremental demand would need to be satisfied via demand-response, wind and transmission build-outs. These “solutions” are easier said than done. If the market functions as it should, I would expect capacity prices to increase to compensate for lower natural gas prices.
Entergy vs. Other Power Names
I believe the entire sector is cheap right now. However, with Entergy, you get a top-notch management team, clean energy (upside to CO2), downside protection from the regulated utility and a catalyst (spin-off). Plus, a post-spin takeover is a real possibility.
Conclusion
I have now posted three power company ideas – one for each fuel type: Calpine (natural gas), NRG (coal) and Enexus (uranium). Despite a challenging environment, I am still a believer in power assets. Over time, these businesses should deliver good results to long term shareholders.
Risks
Indian Point Environmental – Potential Requirement for Cooling Towers
In November 2003, the New York State Department of Environmental Conservation (NYDEC) issued a draft permit indicating that closed cycle cooling would be considered the “best technology available” for minimizing alleged adverse environmental impacts attributable to the intake of cooling water at the Indian Point plants. Entergy notified the NYDEC that retrofitting Indian Point 2 and Indian Point 3 with cooling towers likely would cost, in 2003 dollars, at least $740 million in capital costs and an additional $630 million in lost generation during construction. These estimates do not capture incremental O&M (estimated at 1-3% of construction costs) and reduced output (1%-5%). At their Analyst Day in April, the company claimed they have evidence that the
Entergy and others listed several reasons against installing the cooling towers:
In April 2008, the US Supreme Court agreed to review the decision of the 2nd Circuit on the question of whether the EPA may take into consideration a cost-benefit analysis in developing these regulations, a consideration beneficial to Entergy that the 2nd Circuit Court disallowed.
Given various appeals and litigation, any cash will not be spent for at least four years.
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