NRG is a better, more stable business than commonly appreciated that is priced like a horrible business (4x-5x levered FCF a few years out and 5x-6x EBITDA net of NOL value). NRG is cheap now due to a dislocation resulting from TX winter storm Uri and the market being slow to appreciate the pro forma free cash flow profile of the business after the Direct Energy acquisition which closed in January 2021.Valuation
Stock Price of $33 x 245mm shares outstanding = $8bn market cap. Net debt is $8.2bn for a TEV of $16.2bn. Pro Forma for the Direct Energy acquisition that closed in January 2021, EBITDA plus synergies (fully realized in 2023) should be in the range of $2.3bn - $2.7bn. Cash interest expense is ~$420 (this will come down as some high coupon debt is repaid) maintenance capex is ~$230mm, and cash taxes are minimal due to $10bn of NOLs at NRG. That equates to $1.6bn-$2.0bn of levered free cash flow relative to an $8bn market cap today so 4x-5x FCF. EV to PF EBITDA (net of the NOL NPV) is in the 5x-6x range. Given the changes NRG has made to its business model to improve the stability of cash flows, I don’t think it is unreasonable for NRG to trade at 8x-10x levered FCF, especially given leverage will be below 3x EBITDA. NRG has senior unsecured notes that mature in 2031 with a 4.15% YTW, which makes no sense relative to a 20% free cash flow yield to equity.Business Overview
Electricity generation in deregulated markets is a bad business. Retail electricity providers are terrible business that go bankrupt all the time (look at Just Energy or Griddy recently as a result of Winter Storm Uri in TX). When you combine, at significant scale, electricity generation with retail distribution such that all electricity generated is sold to captive retail customers at a markup, the result is actually a decent business with stable cash flows and a few competitive advantages. NRG is an integrated power company that pairs retail electricity brands with generation assets so that retail load is balanced with generation supply in NRG’s deregulated markets. The majority of NRG EBITDA is generated in TX with a smaller amount of EBITDA generated in East Coast PJM markets. In TX, NRG is the largest retail electric provider with over a third of the market, and NRG and Vistra (formerly TXU) control the majority of the retail electric market. They are both over 3x the size of the next largest competitor. Business and household customer count should continue to increase in TX due to population growth, and consumption of energy should also increase longer term as the US attempts to electrify everything possible; both are good for NRG.Why is NRG not a terrible business?
Retail margins in TX have been stable over time. The advantage of the fully integrated model is that NRG is relatively agnostic to power prices / spark spreads / dark spreads in its markets. If power price go up, NRG makes more money on its generation assets and less money on its fixed price retail contracts (most contracts last ~1 year). If power prices go down, NRG makes less money on the generation assets, but more money on the retail contracts because NRG is delivering cheaper electricity at a fixed price. Vistra, unlike NRG, is net long power prices in TX (ie, VST sells less electricity to consumers than it generates at its power plants). Pure play retail electricity providers (like Just Energy or Griddy) don’t have generation assets to back up their retail contracts, so they buy power in the market and hedge against price spikes, which is a very difficult position to be in. Most pure play retail electricity providers are also subscale. NRG and VST’s retail businesses are over 3x the size of the next largest competitor, which is an enormous advantage in marketing, brand recognition, and economies of scale. The recent power price volatility in TX as a result of winter storm Uri actually makes it harder for pure play retail electricity providers to compete and exposed the precariousness of their business models.What is unique about the TX electricity market?
The TX electricity market (ERCOT) is the most deregulated power market in the US, which makes being a pure play retail electricity provider very difficult, and gives NRG and VST a competitive advantage since they are the only two scale players that own generation and retail books. In NY or CA for instance, ConEd, PCG, and EIX are fully regulated utilities that earn a regulated ~10% ROE and own power plants, transmission and distribution wires, and the relationships with the households and business that use electricity. In other markets, like PJM in the East, the generation, T&D and retail businesses might be separated and deregulated, but the grid operator makes capacity payments to power plants to ensure there is always enough electricity generation supply available to meet demand. These capacity payments make power prices more stable generally, which makes it easier for pure retail electric providers to operate because they don’t have to deal with wild swings in the price of electricity they are providing to households and businesses at fixed prices. TX is a unique animal in that it is completely deregulated – there are a bunch of different companies that own power plants, Oncor (formerly owned by TXU, now owned by Sempra) and CenterPoint (CNP) are the two major transmission and distribution providers, and there are a bunch of different companies that own the retail relationships, but NRG and VST control over 50% of the market. The TX grid operator, ERCOT, doesn’t make capacity payments, but instead ERCOT incentivizes power plants by allowing for massive power price increases called scarcity pricing at times of high demand (typically in the hot summers). These scarcity prices hit $9,000/mwh during winter storm Uri vs typical power prices of more like $30/mwh. That price spike bankrupted some retail electric providers, and in general power price volatility in TX makes it very difficult for electricity retailers to operate unless they also own generation.Why is the stock cheap now?
Two reasons – winter storm Uri and the large Direct Energy acquisition that closed in January 2021. NRG traded at $44 prior to winter storm Uri (arguably still cheap). Now trading at $33 that means market cap has declined by $2.7bn. Uri had at most a $975mm cash impact on NRG (all realized in Q1 2021) and potentially a $500-$700mm impact if NRG is able to realize a recovery on some of its claims arising as a result of Uri losses. In my opinion, the deep freeze in Texas was truly a one time event, and none of the legislative options currently being discussed to fix the TX power market would impair NRG’s business. Mostly TX has realized they need to improve the supply of natural gas and improve communication among all of the energy market participants.
NRG announced the Direct Energy acquisition in July 2020. Direct Energy is a retail electric provider (the third largest in TX with a 10% market share) that will improve the TX retail business and will give NRG a more balanced generation/retail mix in the East. NRG paid $3.8bn for Direct Energy, all cash, which equates to a multiple of 8.6x EBITDA pre synergies and 5.1x EBITDA post synergies. If you read VST’s September 2020 Analyst Day transcript, the CEO says “In ERCOT, we definitely are interested in continuing to add customers. We're still about 65% across the average in terms of match. But when you get into the peak, we're about 75%. I think we still would like to stay somewhat long in ERCOT, although, again, we believe we could manage a balanced wholesale retail position. But we're more interested in quality of retail, and that is becoming more difficult. And then size in retail is becoming more difficult because you guys know that most of the quality retail businesses have been purchased or they're under purchase consideration, I'll put it that way.
But we definitely are interested in growing our retail business, and we think there are opportunities by the way.” So NRG’s biggest competitor essentially acknowledges that Direct Energy is a quality retail operation.What will management do with the cash flow?
NRG has a 4% dividend yield that is well covered. Beyond that, all 2021 FCF will be used to reduce debt to ~2.75x EBITDA, which NRG believe will allow the company to achieve IG ratings. In 2022, management can use all excess free cash flow for share repurchases, and is open to doing so if the share price remains at current levels. I think the market was hoping for share repurchases in 2021, but the impact of Uri eliminated that chance.Isn’t NRG going to have to retire its coal plants? What happens then?
Yes, coal still accounts for ~50% of the electricity NRG generates in TX. NRG has two coal plants in TX, Limestone and W.A. Parish. Limestone will retire at some point. W.A. Parish sits on a site at which NRG already has a gas plant, so NRG will convert W.A. Parish to gas at some point. Winter storm Uri actually demonstrated the need for TX to have diverse sources of electricity, so may have extended the life of coal plants. However, when these plants do retire, NRG can easily replace the generation with power purchase agreements (“PPAs”), which are long term contracts to buy renewable energy from solar and wind farms. NRG’s scale allows them to sign these PPAs at better than market rates, and it is going to make NRG more asset light and more ESG friendly over time. NRG talks a lot about the advantages of PPAs on its earnings calls.What are the risks?
The main risk is regulation of retail margins in TX. This seems unlikely because TX loves competitive markets generally and because the price of electricity per mwh to retail customers in TX is in line to low relative to the rest of the United States (you can see this in EIA data). So it isn’t like customers in TX are being gouged by NRG and VST. The other risk is that NRG still earns $680mm of capacity payment revenue in the East, which is essentially pure margin that power plants earn just for being available. These capacity payments should continue to fall over time, but that alone could reduce EBITDA from the $2.7bn PF to the $2.3bn PF that I reference above. NRG is cheap whether longer term EBITDA is $2.7bn or $2.3bn.