While NRG has been written up in the past (reference egec’s write-up from June 2012), we think the equity is well worth revisiting as a long opportunity (currently trading around ~$24 / share with a >16% FCF yield using our 2015E “un-hedged” estimates).  At current levels, NRG trades for less than ~6x 2-year forward / un-hedged EBITDA and ~7x EBITDA less maintenance capex.  In contrast to its lofty leverage in the recent past when standalone NRG had >5x net debt / EBITDA (and analysts were worried about solar being a liability and the business suffering from liquidity concerns in a $3 natural gas environment), the company has significantly de-risked the balance sheet through its recent purchase of GenOn and currently is accessing the credit markets at sub-5% rates highlighting the credit markets (NRG will be leveraged at less than 3x net debt / EBITDA based on our 2015E un-hedged estimates). 

 

The crux of our thesis is that: (a) NRG’s core Texas market will witness a growing supply / demand imbalance especially during critical on-peak periods - for the supply imbalance to be fixed, we believe power prices in TX will increase to a level that incentivizes new build economics, (b) given the imbalance in TX, we think that local regulators will ultimately make changes to the market structure to force forward power prices upwards that will increase NRG’s cash flow, (c) while NRG has significant hedges through 2014 on its natural gas exposure, we believe the market under-appreciates the significant upside optionality of natural gas prices (every $1 roughly equates to an additional ~20% increase in EBITDA or the equivalent of ~$10 per share) and is myopically focused on natural gas prices falling back to $2 - $3 levels while losing sight of abnormally hot weather that impacted natural gas prices in 2012, (d) NRG’s ownership in solar project assets has been an overhang on the stock but we think is at an the “earnings power inflection point” (lower spend  and beginning of harvest stage) that will enhance overall value, (e) given the significant cash flow generation, NRG will likely utilize excess FCF to buy back shares and pay out a larger dividend as the company has effectively removed restrictions in their debt agreements that historically limited capital return to shareholders and (f) NRG’s recent GenOn acquisition is value enhancing and offers significant upside. 

 

While there are many moving parts to the NRG story, we think there are four areas of ”differentiation” between our views and the “Street”:

 

1. Mis-perceived as natural gas play: market is myopically focused and fearful of NRG’s “un-hedged” earnings power (2015E-onwards) and valued by market as a pure-play natural gas bet but we think TX supply / demand characteristics will provide improved earnings visibility
2. Under-appreciated acquisition of GenOn adds significant synergies / earnings power upside: market fails to recognize both the significant hedges in place through 2014 limiting natural gas volatility but also does not properly factor in the earnings power up-lift from the increase in TX heat rates that we expect over time; in addition, the Street does not factor in synergies upside from the recently closed Genon acquisition (we think the Street is giving partial credit to the ~$300MM of FCF synergies that management communicated in July 2012 / time of the deal announcement, but we believe this will ultimately exceed >$450MM and provide >$4 / share of upside to Street’s “partial” view)
3. Overhang around capital allocation (in the past) should become a tailwind moving forward: Given (a) restrictions on debt documents, (b) a historical focus on solar initiatives and (c) a leveraged capital structure with >5x net debt / EBITDA (before the GenOn deal), NRG management was limited in share repurchases.  However, given recent debt re-financings, a more focused capital allocation policy limiting growth (i.e. solar) investments and a de-risked balance sheet (and synergies on the come), we think management will be more shareholder friendly with a greater focus on share buybacks and dividends
4. Mis-priced w/ a >16% FCF yield and sub-6.5x EBITDA multiple: we think a $35 / share FV is reasonable applying a ~7x EBITDA multiple and ~8.5x EBITDA – capex to our 2015E estimates (assume a conservative natural gas price and implies a low teens FCF yield); factoring in the dividend, our base case valuation is for ~50% upside to current levels 

 

While our base case valuation for NRG is ~$35 / share (before factoring in the dividend), we think a valuation of >$50 / share is attainable if natural gas prices move up to ~$5 in the medium term.  Regarding downside protection, we think a low $20s / share valuation (versus current ~$24 / share) is punitive as it assumes the TX generation assets suffer from a $750 - $1Bln fall-off in earnings power as the hedges roll-off (i.e. >75% reduction in earnings power) partially offset by synergies, solar earnings and GenOn assets and NRG trades at a punitive sub-7x EBITDA multiple and ~9x EBITDA – capex multiple on this reduced earnings estimate.          

NRG’s core Texas market will witness a growing supply / demand imbalance especially during critical on-peak periods that will result in local regulators ultimately making changes to the market structure to force forward power prices upwards -- this  will increase NRG’s cash flow.  In addition, while NRG does have hedges through 2014 on its natural gas exposure, we believe the market under-appreciates the significant upside optionality of natural gas prices (every $1 roughly equates to an additional ~20% increase in EBITDA or the equivalent of ~$10 per share) and is myopically focused on natural gas prices falling back to $2 - $3 levels (while losing sight of abnormally hot weather that impacted natural gas prices in 2012).  Finally, we believe NRG will likely utilize excess FCF to buy back shares and pay out a larger dividend as the company has effectively removed restrictions in their debt agreement that historically limited capital return to shareholders.