Description

What follows is market commentary, and is not a recommendation.

To access slides I refer to in this write-up :
http://phx.corporate-ir.net/phoenix.zhtml?c=121544&p=irol-presentations

Summary Thesis

NRG is an independent power producer with a market cap of $3.5b which expects to generate $800mm -$1,000mm of free cash flow (after maintenance & environmental capex, but before growth capex) in 2012  ($874 in 2011) for a roughly 25% FCF to equity yield. The share price of NRG has come under significant pressure as a result of the relentless decline in natural gas prices. This myopic concern related to the current price of natural gas has created an attractive buying opportunity due to the underappreciated steps management has taken to dampen the effects of natural gas volatility – namely its hedging program, retail power generation business and their solar portfolio. With natural gas prices trading at current depressed levels, NRG is trading at a significant discount to what is likely to be trough earnings that should reward investors with a medium-long term time horizon.
Although the company is at or near management’s target leverage ratios, there is a fairly significant amount of debt (net debt of $8.4b). So while the FCF yield is quite high, measured on an ev/ebitda basis it is less flattering at 6.5x . We currently have a medium sized long position in NRG shares, and the leveraged nature of the company is one of most significant factors that hold us back from making it a large position.

Overview
NRG is an independent power producer whose business is predominantly selling electricity generated using coal, nuclear and natural gas (63% 2011 ebitda, $1155mm). The other significant segments of the business are retail power generation (37% 2011 ebtida, $665mm) and a portfolio of solar generation assets (in development. $55mm of ebitda in 2012e, rising to over $300mm in ebitda in 2014/2015).

CEO David Crane is a great operator who has historically been shareholder friendly and allocated capital well. While the conventional power generation is the dominant driver of profitability, David Crane is forward thinking in the ways the business may develop in the future, whether that means touching consumers more directly (retail power segment, electric car charging), distributed solar, or other renewable energy sources. He has also looked to opportunistically add conventional natural gas generation assets in markets where they have an existing presence.

NRG has taken steps over the last few years to have the company’s profitability become less dependent on the volatile swings in natural gas prices. The other significant businesses in NRG help achieve this aim, and they are a portfolio of solar projects and NRG’s retail power operations.

Conventional generation

NRG has a diversified power generation portfolio with approx. 23.5 MW of fossil fuel and nuclear generation capacity and 470mw of renewable generation capacity consisting of wind and solar. Regarding safety, NRG boasts of OSHA recordable rate in the top decile. NRG’s generation assets are split up between the geographic areas of Texas (10.7mw), Northeast (6.9mw), South Central (4.1mw) and the West (2.2mw).

Base load power is typically generated by coal and nuclear, with intermediate and peaking power generated predominantly by natural gas. This is because coal/nuclear have high fixed costs, low marginal costs and are time consuming to power up and down to meet variable power needs. Gas turbines, on the other hand, are low fixed cost, high variable costs and can be powered up to meet variable levels of power demand much more easily.

In the markets where NRG operates natural gas is the marginal fuel source. As such, electricity prices are driven predominantly by the cost of this marginal fuel – natural gas.  The profit NRG earns is essentially the difference between the (typically lower) cost of generation using coal and nuclear and the price of electricity set by the generally less efficient, but more flexible gas generation. Also to the extent that NRG sells natural gas generated power, they seek to operate their plants more efficiently than the market in order to enhance their return. Plant efficiency is measured by its “heat rate” which is the amount of BTUs needed to produce a kilowatt of electricity (obviously lower BTUs/kwh is more efficient).

While the long thesis does not require optimism regarding the markets in which NRG operates, the company’s outlook is optimistic regarding the markets where it most highly exposed. Despite a generally languishing economy nationally, NRG is optimistic that they will benefit from being well positioned in the NY, California and Texas from tightening capacity (see NRG q1, 2012 earnings presentation, slide 13).  

NRG is the 2nd largest player in the Texas/ERCOT market. Compared to the U.S. as a whole, Texas has demonstrated much stronger electricity demand due to its stronger economy. Given capacity concerns in Texas, and resulting increased price caps, NRG feels they are well positioned to benefit from what they believe is the best power market in the U.S. (see NRG presentation “winning in Texas”, March 2012, slide 4, 5).

Hedging program

Since natural gas is one of the most volatile commodities in the world, in an attempt to smooth its profits and lock in returns, NRG generally hedges natural gas as a proxy for electricity prices. So as natural gas prices fall, the price of electricity falls. By shorting an appropriate amount of natural gas NRG can essentially hedge their resulting margin contraction. NRG is currently natural gas hedged 103% for 2012, 89%, for 2013 and 59% for 2014.

NRG breaks out its sensitivity to natural gas each quarter. Given their natural gas hedges described above, NRG has exposure to a 0.50/MMbtu move up/down in gas of $18mm/$0 in 2012, $66/$-42 in 2013 and $137/$-121 in 2014 (Source: q1 2012 presentation, slide 15). This illustrates how NRG is insulated from weakness in the near term price of natural gas.

Retail power

NRG bought Reliant Energy Retail in 2009 For $300mm. Reliant sells power to homes and business, often at a contracted term of one year with a fixed price. As a tradeoff for fixed price certainty, the price is typically above the more volatile spot price. Since NRG is both the power generator and  the provider to the retail customer these businesses complement each other well, with retail earning higher profits in a falling natural gas environment and lower profits in a rising natural gas environment. This acts to dampen NRG’s exposure to short term natural gas prices. NRG is growing the retail business both organically and through recent acquisitions of Green Mountain and Energy plus. For a graphical representation please see NRG q4 2011 presentation, slide 12.

In 2011 the retail segment generated $665mm in ebitda and in 2012 NRG guides towards $625-700mm ebitda.

Solar/renewable portfolio

The “solar” landscape is currently littered with solar companies performing extremely poorly. That’s because most of the solar businesses represented in the public markets are solar manufacturers. NRG is not a solar manufacturer, but is a producer of solar power and it purchases solar modules to generate electricity which it then sells to businesses and consumers.

David Crane has repeatedly expressed an opinion that these solar projects are the best deals he’s ever seen in his career. Inputs into that judgment are very low risk project construction, long term (20-25 year) power purchase agreements committed to by high quality counterparties, non-recourse project loan guarantees, and cash grants and tax benefits. All in, the projects are expected to generate mid-high teens return on equity and a 2-5 year payback period.  It’s also another step that diversifies NRG from the commodity price cycle. These various solar projects remain “well on track, on budget, and well ahead of schedule” as of May 2012.

For a detailed illustration of the economics of the solar deals, please see the presentation “NRG: More Than Megawatts” 5/12 /2010, slide 23. NRG has recently been a bit more discrete in waving the flag for these solar deals, which I’m guessing is a reasonable response to the recent press that we’re recently seen regarding government supported business ventures.

Roughly 75% of the planned growth investment in 2012 is in the solar group with the rest in conventional investments. At some point during 2014, all the solar projects are projected to be online. This is expected to product over $330mm in ebitda in 2014.

Capital Structure
NRG has stated its preference for a minimum cash buffer of $700mm. NRG ended 2011 with $1.1b in cash, so $400mm in currently “excess cash”. Considered in conjunction with the 2012 expected free cash flow ($700-900) and expected uses ($41mm for the dividend, $77mm scheduled debt paydown, and $384mm in growth investments). This leaves $700mm-900mm for excess deployable cash expected at the end of 2012.

$1,796mm of NRG debt is non-recourse out of total gross debt of $9,832 (end 2011). This non-recourse debt is predominantly project finance for the growing solar portfolio. In two solar projects (Ivanpah and Agua Caliente) NRG owns 51% of the project. As the debt for these projects is consolidated the net debt has been reduced by $517 to account for partner interest.

Capital allocation

NRG has been very cash generative and so it’s no surprise that shareholders have had a desire for a higher level of capital return. Unfortunately NRG’s hands were tied by a restricted payment (RP) basket that was included in bond issuances that restricted how much cash NRG could return to shareholders by a formula governed by increases in GAAP net income, with adjustments (slide 30 of q1, 2012 results). NRG refinanced these issues in mid 2011, and later stated their intention to refinance the last remaining issue with the RP indenture at/near its first call date of 1/15/2012. NRG was also clear that this action would allow them to make more significant cash returns than they were able to do under the RP basket.

Despite the restrictions of the RP basket, it did allow for capacity to buy back shares. This capacity was enhanced by a favorable tax ruling in 2010. In 2008/2009/2010 NRG repurchased $500mm/180mm/430mm worth of stock, respectively, reducing diluted shares by 17% over that period and a total of 24% since 2006. Also $581mm of debt was paid down in 2010.

In the Q1 2012 NRG surprised shareholders by announcing that they would not call the last remaining bond with the RP indenture because they were concerned that the price of natural gas was so low. They did announce the initiation of a dividend, but at the initial level of $81mm/year (2.5% yield at current price) this was a relatively minor action compared to NRG’s prodigious cash flow. The logic stated was that they wanted to maintain a strong balance sheet during this period, and also, should the low natural gas environment put other firms in distress, NRG wanted to have the ability to purchase assets that may come up for sale. “We will seek to build a “war chest” from sell downs and sale of non-core assets to take advantage of new opportunities that the current environment may present”(q4 2011 slides). As a shareholder, one was left to consider whether the desire for a strong balance sheet signaled a high level of concern from management regarding future profitability.

However, on the q1 2012 call David Crane stated that, while not formal guidance, he feels the $1.8b - $2b ebitda the company is currently generating is around trough levels. When pushed on the word “trough” in the Q&A he responded, “Well, it’s not a formal multi-year guidance of the company but certainly that’s what I expect, yes”. Current 2014-2015 natural gas futures are priced around $4-4.50. Presumably the thinking is that even if gas were to decline from that arguably distressed level without being hedged, the solar projects would be coming online and the solar ebitda should be able to make up a good portion of the deficit. David Crane also pointed out that although the NRG share price has traded with a high degree of correlation to natural gas prices, since NRG is hedged as previously stated, that “..near-term gas prices are amongst the least relevant of all commodity prices to our financial performance.”

While David Crane’s reasons noted above for not executing the refinancing and buyback sound plausible – the sheer size of cash generation ($900mm fcf before growth capex / $3.5b market cap = 25%) plus the diminished concern on near term gas prices and confidence in medium to long term ebitda outlook appear to make this an extremely attractive opportunity to buy back shares.

Having followed NRG for a while now, I find David Crane to be a great operator and a great communicator who has also made some great capital allocation decisions. I think he’s quite earnest and I enjoy listening to him talk about the power business. But NRG is very cash generative and the current share prices in an extremely attractive opportunity for the company to buy back shares. The way Crane talk about buybacks on the quarterly calls successfully conveys the view that he is very aware of this dynamic. Considering other opportunities, I’m hard pressed to imagine what investment opportunity could present itself that would be more attractive, on a risk adjusted basis, than buying back shares with a 25% fcf yield. Share buybacks are very attractive. If there is an attractive reason for building a “war chest” then I don’t think that’s been communicated well. Perhaps David Crane is saving up for a more dramatic corporate action of some sort.

Valuation

Given the sensitivity the various segments of the business have to the commodity cycle (convention/direct, retail/counter, solar/neutral) it’s difficult to determine an exact value. But the following is illustrative…at a price of $32 (more than double the current price), NRG would trade with a 12% fcfe yield (before growth capex) and an ev/ebitda of 8.4x.  It should be noted that the current discount to this valuation is generated in an extremely low gas price environment. The intrinsic value of this company is significantly made of up the earnings it will produce in years beyond the near term – as it is for any company. Factoring in a normal natural gas pricing environment will only provide uplift to current earnings. 

Summary

NRG is a prudently managed merchant power company that has successfully taken steps to reduce its exposure to the commodity price cycle. The current stock valuation reflects an under appreciation of this dynamic which should reward investors with a medium-long term time horizon. The company is highly cash generative and has historically been shareholder friendly. While the company has not taken steps to buy back shares, this is a possibility with David Crane saying that he can be opportunistic regarding the last remaining bonds containing the RP basket.

Risks (see the 10k for a full list)
•       Natural gas stays very low for an extended period of time due to the shale revolution, or due to a significant decrease in industrial demand that could result from an economic downturn.
•       NRG has a strong safety record, but it operates power generation assets, including nuclear, so one can’t rule out any operational risk.
•       NRG is run with fairly significant leverage which could give them less flexibility during an unexpected hardship.
•       While NRG has been well positioned on its environment spending over the years, any new legislation or EPA action that would reduce profitability of generating electricity using carbon fuels would negatively impact NRG.
•       Though all the solar financing seem to be in place, if public opinion turns against government support for solar deals, that sentiment may negatively impact the NRG share price.
•       Delay or cost overruns of any of the solar of conventional projects currently under construction.

NRG share price (6/05/2012)                                                         $15.50       
                                                                                                       FY 2011       
Cash & equivalents                                                                            1105
Gross Debt                                                                                         9832
Less: partnership interest in Ivanpah / Agua Caliente                        517
Plus: nrg share of unconsolidated affiliates                                         244
Net debt                                                                                             8454 
Fully diluted shares                                                                              228
Market cap                                                                                         3516
Preferred shares                                                                                  248       
EV                                                                                                   12,218 
               
                                                                                                           2011    2012
Wholesale                                                                                           1155    1250
Retail                                                                                                     665      663
Consoliated ebitda (MtM)                                                                    1820    1913
              
Interest payments                                                                              (769)    (650)
Income tax                                                                                            (26)     (50)
Collateral payments / working cap / other                                            141      (50)
Cash from operations                                                                          1166    1163
Reclassifying (payments) of financing of acquired
derivatives                                                                                             (83)         0
Adjusted CF from operations                                                                1083   1163
Maintenance capex                                                                               (200)  (250)
Preferred divs                                                                                          (9)       (9)
FCF from recurring operations                                                                874     904
              
Environmental capex                                                                              (51)       
FCF after maintenance capex and environmental                                   823    904
              
Repowering / growth investments                                                       (298)  (120)
Solar                                                                                                    (980)   (264)
FCF                                                                                                       (455)    520
              
Net debt / ebitda                                                                                      4.6    4.4
Ev/ebitda                                                                                                  6.7    6.4
Fcf to equity before growth capex                                                        24.9%  25.7%

Catalyst