NRG ENERGY INC NRG
February 26, 2014 - 11:26pm EST by
todd1123
2014 2015
Price: 28.75 EPS NM NM
Shares Out. (in M): 335 P/E NM NM
Market Cap (in $M): 9,631 P/FCF 8.7x 8.5x
Net Debt (in $M): 13,828 EBIT 1,700 1,800
TEV ($): 23,459 TEV/EBIT 13.8x 13.0x

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  • Diversified Utilities
  • Underfollowed
  • Small Cap
  • Low multiple
  • Utility

Description

NRG Energy (ticker NRG) is a somewhat mis-loved, mis-understood and under-valued long opportunity that is largely mis-perceived for what it was 2 – 3 years ago (i.e. over-leveraged and allocating significant capital to solar “pipe-dream”) and still is largely ignored by the investment community given complicated end-markets and confusing structure … and the market does not properly value the changes that have taken place in the interim including: (a) changes in commodity markets, (b) early signs of regional S/D becoming more balanced driving power prices, (c) best-in-class capital allocators with a proven track-record / 4+ highly accretive transactions and (d) Yield vehicle better isolating the NRG merchant assets under-valuation (NRG “merchant” owns the largest fleet in US w/ >50 GW of power generation).  On a consolidated basis, NRG trades at a cheap multiple (sub-7x EBITDA-capex on 2016E / unhedged basis factoring in $5 natural gas and ~8x EBITDA-capex using $4.50 nat gas.  Stripping out the value of NRG Yield (NYLD is the ticker), NRG’s merchant assets trade at sub-4.5x EBITDA and ~5x EBITDA –capex using my 2016E estimates (factoring in $5 natural gas).  NRG presents a compelling risk-reward proposition with a total return potential of >60% using conservative base case assumptions ($4.50 natural gas) over the next 3 – 12 months and >120% applying $5 natural gas assumptions (more detailed discussion below).    

 

As discussed below, three material and new dynamics have transpired that the market is largely ignoring:

 

  1. Recent natural gas px volatility is being mis-interpreted as “temporary”, but clarity on longer-term structural implications should be more apparent over the next few months as tight 2014 is a “bridge” to US being an exporter in the out years which will result in nat gas forward price signals increasing: In the past few months, n-term natural gas prices have risen to heightened levels driven largely by the abnormally cold winter conditions which has helped drive inventory levels to >10-year lows with an expectation that we will end March at sub-1 TcF of inventory (notably, any further cold weather in March will put a disproportionate amount of stress on nat gas inventory levels which could augment n-term and l-term price signals for the commodity).  While spot natural gas prices have moved to >$5 levels, the forward curve has largely remained stubbornly constant at ~$4 (given NRG and other IPPs hedge out their n-term exposure, focusing on 2015 – 2016 is important).   My view is that (a) inventory levels have dropped to abnormally low levels and will require demand destruction or a significant supply response to help balance the inventory situation in the next 12-mths (our conversations suggest the market is over-estimating the magnitude of both supply and demand and think re-building inventory levels by October 2014 will require future price signals to increase) and (b) moreover, a “tight” 2014 helps bridge the advent of LNG terminals that are set to come on-line in late 2015 – 2016 which.  Overall, I believe there is solid evidence of natural gas fundamentals changing (and the market is ignoring these signals) and believe the futures market will change over the next few months.  NRG is the largest beneficiary of l-term natural gas price movements as every $1 move in nat gas equates to >$850 - $900MM of EBITDA on unhedged basis (stripping out NYLD assets, this equates to >35 – 40% EBITDA up-lift in NRG’s merchant assets and >90 – 100% FCF / share up-lift for NRG’s merchant assets).  $5 natural gas prices versus $4 imply >$2.50 – $2.75 / share of additional FCF for NRG or >$25 – $30 / share of value.         
  2. NRG’s Yield vehicle is creative (1-year lead on competitors) and highly accretive (dropping down assets at >13x EBITDA multiple and “creating” merchant assets for sub-5x EBITDA): In 2013, NRG opportunistically formed NRG Yield (ticker NYLD) to own and operate the l-term contracted renewable and conventional generation assets.  NYLD trades on a dividend yield and projected growth rate as the drop-down pipeline is increasingly evident.  NYLD effectively allows NRG to drop down l-term contractual assets at highly accretive (>12 – 15x EBITDA) multiples.  This vehicle is incredibly creative as it allows NRG to better highlight the underlying value being applied to the merchant fleet.  Historically, NRG’s solar projects were viewed by investors as a negative overhang given solar financing was consolidated on the BS but the underlying earnings power was minimal during construction - so the NRG valuation was dragged down by solar.  On a go-forward basis and given NYLD is getting close to its 1-year public anniversary, I anticipate an active year ahead for NRG in dropping down projects which will isolate the value of NRG standalone.  One aspect of NYLD largely ignored by investment community are NRG’s CA assets / though the market ignores these assets, there is an increased probability of NRG dropping down these assets with up to $200MM of EBITDA contribution (clarity over the next 6 – 18 months) which is incremental to the valuation #s further below (provides significant further up-lift to NRG’s merchant asset valuation.
  3. Management’s capital allocation track-record is impressive and helps cushion any n-term volatility: Both Genon and Edison Mission acquisitions were opportunistic and highly accretive (i.e. sub-4x PF EBITDA multiples factoring in synergies for both acquisitions) on a standalone basis.  Genon provided NRG w/ PJM exposure which is operating at bottom-of-the-cycle conditions (more clarity on this market will come over the next few months but S/D are improving given significant coal retirements) and has generally been viewed by the Street as a successful acquisition given the cost synergies opportunities, diversification into PJM and upside optionality from S/D balancing.  Edison Mission provides NRG with bottom-of-cycle conditions in the Midwest (~4.3 MW) and allows NRG’ merchant assets to “create” a very cheap call option (NYLD paying the majority of the PP for l-term contractual assets) on natural gas optionality (i.e. >$100 - $150MM of sensitivity to $1 moves in nat gas).  More importantly, given NRG’s track record around acquisitions (i.e. Reliant in 2009, solar investments in 2010 – 2014, Genon 2012, NYLD vehicle in 2013, Edison Mission early 2014, etc) highlight management’s impressive track record of being opportunistic and contrarian.  While difficult to gauge, my sense is that the market is somewhat complacent on management’s capital allocation priorities in the future (acquisitions and share repurchases).  Any hint of management focusing more attention on isolating the value of NRG’s merchant assets (via share repurchases, contemplating spinning off partial or all NYLD shares to stakeholders, etc) would be viewed quite favorably and this is a free yet powerful option.

 

Valuation snapshot: Given the dynamics above, NRG’s merchant assets are significantly under-valued based on 2014E and more importantly on 2016E / “open” (un-hedged) #s.  As highlighted below, NRG’s merchant assets trade at sub-4.5x EBITDA and ~5x EBITDA-capex using $5 natural gas prices (equity trades at >30% FCF yield).  If we assume $4.50 natural gas (instead of $5 bucks), implies ~4.9x EBITDA, ~6x EBITDA-capex and ~24% FCF yield. 

 

      NRG Consolidated   Less: NYLD (1)   PF NRG "merchant"
      $ amt multiple   $ amt multiple   $ amt multiple
              to nrg (2)      
a Mkt Cap   9,631     5,103 4,221   5,410  
b PF Net Debt   13,828     5,058 5,058   8,770  
c TEV   23,459     10,161 9,279   14,180  
d Less: 2-yrs FCF   2,200     534 534   1,666  
e PF TEV   21,259     9,627 8,745   12,514  
                     
f 16E EBITDA (2)   3,810 5.6x   824 11.7x   2,986 4.2x
g 16E EBITDA-Capex   3,128 6.8x   635 15.2x   2,493 5.0x
                     
h 2014E FCF - % yield   11%     5%     15%  
i 2016E FCF - % yield   23%     9%     32%  
                     
(1) Includes ROFO + Edison Mission drop-downs            
(2) Pro forma for NRG's equity stake              
(3) Assumes $5 nat gas                   

What’s NRG’s merchant assets worth: Applying relatively conservative multiples to NRG’s fleet (~8x EBITDA and sub-10x EBITDA-capex) and factoring in 2-years of FCF generation gets to a $55 - $60 / share of value (relative to current $28.50 / share or >100% upside). In the scenario where management takes a more aggressive stance to capital allocation via share repurchases, acquisitions or other shareholder-friendly approaches, my upside valuation is well north of >$60 / share.

 

FV - merchant assets   Lev     PF Shares    Px /       
    FCF % yield   Mkt Cap Out   Share Current   % upside
Base - $4.50 gas   1,279 8.0%   15,987 335   $47.72 $28.75   66%
Upside - $5.00 gas   1,716 8.0%   21,455 335   $64.05 $28.75   123%
Downside - $4.00 gas 841 10.0%   8,414 335   $25.12 $28.75   -13%

Downside protection: Given NRG’s merchant assets generate >$850MM of FCF over the next few years at $4 natural gas prices (i.e. mid-teens FCF yield on 2016E basis), “creating” NRG for a sub-6x EBITDA multiple in the scenario where nat gas futures do nothing (every $1 move in nat gas above $4 equates to >$850 - $900MM of additional FCF); upside optionality also from Texas markets and regional S/D dynamics (given the upward volatility in power prices this past winter, this has surprised market observers as it suggests markets are a bit more sensitive and in some cases “balanced” in regions that most believed to be far out of balance – witness New England)

 

Another creative trade is to consider hedging out NYLD and thereby “creating” the NRG merchant biz for sub-4.5x EBITDA and ~5x EBITDA-capex (NYLD MLP structure may limit ability to do for some folks)

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
Neither I nor others I advise hold a material investment in the issuer's securities.

Catalyst

(a) nat gas (upside from $4 that's baked in), (b) regional S/D driving power prices, (c) accretive acquisitions on the come, (d) greater clarity on Edison Mission transaction, (e) Yield vehicle drop-downs highlighting value at NRG's merchant assets 
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    Description

    NRG Energy (ticker NRG) is a somewhat mis-loved, mis-understood and under-valued long opportunity that is largely mis-perceived for what it was 2 – 3 years ago (i.e. over-leveraged and allocating significant capital to solar “pipe-dream”) and still is largely ignored by the investment community given complicated end-markets and confusing structure … and the market does not properly value the changes that have taken place in the interim including: (a) changes in commodity markets, (b) early signs of regional S/D becoming more balanced driving power prices, (c) best-in-class capital allocators with a proven track-record / 4+ highly accretive transactions and (d) Yield vehicle better isolating the NRG merchant assets under-valuation (NRG “merchant” owns the largest fleet in US w/ >50 GW of power generation).  On a consolidated basis, NRG trades at a cheap multiple (sub-7x EBITDA-capex on 2016E / unhedged basis factoring in $5 natural gas and ~8x EBITDA-capex using $4.50 nat gas.  Stripping out the value of NRG Yield (NYLD is the ticker), NRG’s merchant assets trade at sub-4.5x EBITDA and ~5x EBITDA –capex using my 2016E estimates (factoring in $5 natural gas).  NRG presents a compelling risk-reward proposition with a total return potential of >60% using conservative base case assumptions ($4.50 natural gas) over the next 3 – 12 months and >120% applying $5 natural gas assumptions (more detailed discussion below).    

     

    As discussed below, three material and new dynamics have transpired that the market is largely ignoring:

     

    1. Recent natural gas px volatility is being mis-interpreted as “temporary”, but clarity on longer-term structural implications should be more apparent over the next few months as tight 2014 is a “bridge” to US being an exporter in the out years which will result in nat gas forward price signals increasing: In the past few months, n-term natural gas prices have risen to heightened levels driven largely by the abnormally cold winter conditions which has helped drive inventory levels to >10-year lows with an expectation that we will end March at sub-1 TcF of inventory (notably, any further cold weather in March will put a disproportionate amount of stress on nat gas inventory levels which could augment n-term and l-term price signals for the commodity).  While spot natural gas prices have moved to >$5 levels, the forward curve has largely remained stubbornly constant at ~$4 (given NRG and other IPPs hedge out their n-term exposure, focusing on 2015 – 2016 is important).   My view is that (a) inventory levels have dropped to abnormally low levels and will require demand destruction or a significant supply response to help balance the inventory situation in the next 12-mths (our conversations suggest the market is over-estimating the magnitude of both supply and demand and think re-building inventory levels by October 2014 will require future price signals to increase) and (b) moreover, a “tight” 2014 helps bridge the advent of LNG terminals that are set to come on-line in late 2015 – 2016 which.  Overall, I believe there is solid evidence of natural gas fundamentals changing (and the market is ignoring these signals) and believe the futures market will change over the next few months.  NRG is the largest beneficiary of l-term natural gas price movements as every $1 move in nat gas equates to >$850 - $900MM of EBITDA on unhedged basis (stripping out NYLD assets, this equates to >35 – 40% EBITDA up-lift in NRG’s merchant assets and >90 – 100% FCF / share up-lift for NRG’s merchant assets).  $5 natural gas prices versus $4 imply >$2.50 – $2.75 / share of additional FCF for NRG or >$25 – $30 / share of value.         
    2. NRG’s Yield vehicle is creative (1-year lead on competitors) and highly accretive (dropping down assets at >13x EBITDA multiple and “creating” merchant assets for sub-5x EBITDA): In 2013, NRG opportunistically formed NRG Yield (ticker NYLD) to own and operate the l-term contracted renewable and conventional generation assets.  NYLD trades on a dividend yield and projected growth rate as the drop-down pipeline is increasingly evident.  NYLD effectively allows NRG to drop down l-term contractual assets at highly accretive (>12 – 15x EBITDA) multiples.  This vehicle is incredibly creative as it allows NRG to better highlight the underlying value being applied to the merchant fleet.  Historically, NRG’s solar projects were viewed by investors as a negative overhang given solar financing was consolidated on the BS but the underlying earnings power was minimal during construction - so the NRG valuation was dragged down by solar.  On a go-forward basis and given NYLD is getting close to its 1-year public anniversary, I anticipate an active year ahead for NRG in dropping down projects which will isolate the value of NRG standalone.  One aspect of NYLD largely ignored by investment community are NRG’s CA assets / though the market ignores these assets, there is an increased probability of NRG dropping down these assets with up to $200MM of EBITDA contribution (clarity over the next 6 – 18 months) which is incremental to the valuation #s further below (provides significant further up-lift to NRG’s merchant asset valuation.
    3. Management’s capital allocation track-record is impressive and helps cushion any n-term volatility: Both Genon and Edison Mission acquisitions were opportunistic and highly accretive (i.e. sub-4x PF EBITDA multiples factoring in synergies for both acquisitions) on a standalone basis.  Genon provided NRG w/ PJM exposure which is operating at bottom-of-the-cycle conditions (more clarity on this market will come over the next few months but S/D are improving given significant coal retirements) and has generally been viewed by the Street as a successful acquisition given the cost synergies opportunities, diversification into PJM and upside optionality from S/D balancing.  Edison Mission provides NRG with bottom-of-cycle conditions in the Midwest (~4.3 MW) and allows NRG’ merchant assets to “create” a very cheap call option (NYLD paying the majority of the PP for l-term contractual assets) on natural gas optionality (i.e. >$100 - $150MM of sensitivity to $1 moves in nat gas).  More importantly, given NRG’s track record around acquisitions (i.e. Reliant in 2009, solar investments in 2010 – 2014, Genon 2012, NYLD vehicle in 2013, Edison Mission early 2014, etc) highlight management’s impressive track record of being opportunistic and contrarian.  While difficult to gauge, my sense is that the market is somewhat complacent on management’s capital allocation priorities in the future (acquisitions and share repurchases).  Any hint of management focusing more attention on isolating the value of NRG’s merchant assets (via share repurchases, contemplating spinning off partial or all NYLD shares to stakeholders, etc) would be viewed quite favorably and this is a free yet powerful option.

     

    Valuation snapshot: Given the dynamics above, NRG’s merchant assets are significantly under-valued based on 2014E and more importantly on 2016E / “open” (un-hedged) #s.  As highlighted below, NRG’s merchant assets trade at sub-4.5x EBITDA and ~5x EBITDA-capex using $5 natural gas prices (equity trades at >30% FCF yield).  If we assume $4.50 natural gas (instead of $5 bucks), implies ~4.9x EBITDA, ~6x EBITDA-capex and ~24% FCF yield. 

     

          NRG Consolidated   Less: NYLD (1)   PF NRG "merchant"
          $ amt multiple   $ amt multiple   $ amt multiple
                  to nrg (2)      
    a Mkt Cap   9,631     5,103 4,221   5,410  
    b PF Net Debt   13,828     5,058 5,058   8,770  
    c TEV   23,459     10,161 9,279   14,180  
    d Less: 2-yrs FCF   2,200     534 534   1,666  
    e PF TEV   21,259     9,627 8,745   12,514  
                         
    f 16E EBITDA (2)   3,810 5.6x   824 11.7x   2,986 4.2x
    g 16E EBITDA-Capex   3,128 6.8x   635 15.2x   2,493 5.0x
                         
    h 2014E FCF - % yield   11%     5%     15%  
    i 2016E FCF - % yield   23%     9%     32%  
                         
    (1) Includes ROFO + Edison Mission drop-downs            
    (2) Pro forma for NRG's equity stake              
    (3) Assumes $5 nat gas                   

    What’s NRG’s merchant assets worth: Applying relatively conservative multiples to NRG’s fleet (~8x EBITDA and sub-10x EBITDA-capex) and factoring in 2-years of FCF generation gets to a $55 - $60 / share of value (relative to current $28.50 / share or >100% upside). In the scenario where management takes a more aggressive stance to capital allocation via share repurchases, acquisitions or other shareholder-friendly approaches, my upside valuation is well north of >$60 / share.

     

    FV - merchant assets   Lev     PF Shares    Px /       
        FCF % yield   Mkt Cap Out   Share Current   % upside
    Base - $4.50 gas   1,279 8.0%   15,987 335   $47.72 $28.75   66%
    Upside - $5.00 gas   1,716 8.0%   21,455 335   $64.05 $28.75   123%
    Downside - $4.00 gas 841 10.0%   8,414 335   $25.12 $28.75   -13%

    Downside protection: Given NRG’s merchant assets generate >$850MM of FCF over the next few years at $4 natural gas prices (i.e. mid-teens FCF yield on 2016E basis), “creating” NRG for a sub-6x EBITDA multiple in the scenario where nat gas futures do nothing (every $1 move in nat gas above $4 equates to >$850 - $900MM of additional FCF); upside optionality also from Texas markets and regional S/D dynamics (given the upward volatility in power prices this past winter, this has surprised market observers as it suggests markets are a bit more sensitive and in some cases “balanced” in regions that most believed to be far out of balance – witness New England)

     

    Another creative trade is to consider hedging out NYLD and thereby “creating” the NRG merchant biz for sub-4.5x EBITDA and ~5x EBITDA-capex (NYLD MLP structure may limit ability to do for some folks)

     

    I do not hold a position of employment, directorship, or consultancy with the issuer.
    Neither I nor others I advise hold a material investment in the issuer's securities.

    Catalyst

    (a) nat gas (upside from $4 that's baked in), (b) regional S/D driving power prices, (c) accretive acquisitions on the come, (d) greater clarity on Edison Mission transaction, (e) Yield vehicle drop-downs highlighting value at NRG's merchant assets 
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