October 07, 2009 - 9:41am EST by
2009 2010
Price: 27.32 EPS n/a n/a
Shares Out. (in M): 269 P/E n/a n/a
Market Cap (in $M): 7,350 P/FCF n/a n/a
Net Debt (in $M): 6,500 EBIT 0 0
TEV (in $M): 1,380 TEV/EBIT n/a n/a

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NRG is a deregulated power generator heavy on coal, and coal is not very popular right now.  But even assuming the most damaging carbon legislation for NRG, the stock is still worth at least in the high $30s.  The upside could be a double or more assuming watered down legislation.  The most likely outcome is somewhere in between.



 The stock is the cheapest in the merchant generator industry.  It trades for 5.5x 2009 EBITDA and 8x 2009 free cash flow.  With above-market hedges rolling off over the next few years, profits will be flat and down for a few years, but investors already know this.  In the meantime, you will get three years of mostly hedged cash flow and a very smart capital allocator at the helm.

 Vincent975 in June of last year made a good case for NRG being worth $70 on the basis of EBITDA, free cash flow, and replacement cost.  I refer you to his write-up rather than repeating his valuation methodology, but I would adjust some of his valuation metrics for today to reflect lower natural gas prices.  NRG's natural gas hedges were above-market in the summer of 2008, while they are below-market now.  So something closer to a $50 share value is probably the better starting point.  $50 is around 8x EBITDA of $2.5 billion, which is what NRG is forecasted to do this year, and also what NRG would do under an "open" scenario (i.e. no hedges) of $7 natural gas.

 Just to reiterate the key attractions of NRG:  Power generation is a relatively steady business, as electricity volume demand tends to grow slightly in excess of population growth, with very few declines.  While this recession has knocked back the demand side of the equation (demand is down 3-5%), it has also served to decimate the new supply pipeline.  No good figures are available, but supply will be flat or minimal growth for the next several years in most regions.  Power can't be stored and there are limits to transporting it, so not only is the market immune to import competition, but it is composed of regional markets each with its own supply-demand dynamics.  NRG in Texas and the Northeast is in two of the most attractive markets.



 While the decline in natural gas prices has knocked the value of NRG shares down from $70 to $50, the stock has come commensurately, from $40 to $30, so the discount has remained the same.  But with natural gas prices much lower, the odds seem better than before that a future increase in natural gas prices will help NRG.

 In addition, two events of the past year have served to confirm and enhance the value of NRG.

 Exelon bid:  EXC made an all-stock offer for NRG late in 2008, which was withdrawn in July 2009.  The initial bid was worth $26.47 per NRG share, and after a price decline in EXC shares and a small bump in the exchange ratio, it was ultimately worth just over $28 per NRG share.  So this could be construed as validating the current share price and nothing more.  However, I think it provides a floor.  EXC was very forthcoming that it thought its own shares were undervalued, and that it took that into account in deciding the exchange ratio.  I believe EXC would have raised its bid were it not for its vociferous shareholder base, which didn't want to see EXC's favorable carbon position deteriorate regardless of the financial merits of the deal.

 Ultimately, consolidation seems inevitable (EXC was the second suitor in the past few years), although NRG could be the acquirer as well as the acquired.  CEO David Crane has a good record when it comes to acquisitions, so I am not too worried about NRG making a bad acquisition.  He walked away from buying Calpine last year as he knew he was offering a fair and full price.  He made a great acquisition in 2006 of Texas Genco, and the most recent one of Reliant's retail business seems to be a very shrewd deal as well.

 Reliant acquisition:  Earlier this year, NRG bought the retail business of Reliant.  Reliant was in financial distress, and the purchase price shows it.  NRG paid $290 million in cash, and will pump in about $3-400 million in working capital, mostly for collateral requirements.  Reliant retail will do $400 million in EBITDA this year; granted, this is an unusually good year for Reliant retail, but even if it reverts to the expected $250 million next year, NRG will have paid at most 2.8x EBITDA.  Not only is this a financially smart deal, it makes perfect sense operationally, as NRG secures a retail marketing arm for its entire baseload output in Texas.  This deal eliminates the inefficiency of having to hedge and deal with bid-ask spreads and external counterparties, for both Reliant retail and NRG.



 This is the big, scary unknown for most investors.  However, I think most investors have just stayed away from this industry because they are not properly versed, or are overly concerned about a much worse outcome for NRG than what the Waxman-Markey bill would imply.  I start with the assumption that the Waxman-Markey bill marks the worst-case for NRG in terms of general carbon framework - given the political difficulties, I just don't see how something drastically worse for coal plant operators could pass the Senate.

 Using the W-M framework, the two main components that need to be known are the price at which NRG will have to buy carbon credits and how much in initial allocation they will get.  At the levels implied by the existing draft, the carbon costs would be $15/ton at the high end, and the NRG would get 40% allocations, i.e. it would receive free credits to cover 40% of its carbon emissions initially.  NRG claims that under this scenario, W-M would be roughly profit-neutral to the company in 2012.  They don't disclose enough detail to calculate this completely ourselves, but there's enough to make a rough calculation that confirms this.

 NRG had a total of 73 GWh in generation in 2008.  From that, you back out 35 GWh of carbon-free generation and offsets (11 GWh South Central, 7.7 Gwh of gas at 2/3 recovery, and 9.5 GWh of nuclear at 200% recovery).  You are left with 38 GWh of "exposed" generation, or 52% of the total.  Assuming 40% allocation, NRG's exposure is only 12% of generation as we calculate it.  NRG had 61 million tons of carbon emissions in 2008, so 12% of that is 7.3 million tons, and at $15/ton cost, that's a pretax $110 million in extra costs.  It's possible that some renewable and other minor details could bring that down closer to zero.

 In any case, with EBITDA in the 2.5 billion range, the carbon impact is not going to be a significant hit in the early years.  Assuming that the allocations slowly phase out by year 2025, the present value of the carbon hit at an 8% discount rate is $2.6 billion after-tax, or roughly $10 per share.  Even assuming no allocation, the present value of the carbon hit is $13 per share.



 The stock is worth $50 or more based on various measures of value, including EBITDA and replacement cost.  Investors fear the carbon uncertainty, but rough calculations of the recent House bill impact appears to be a $10-13 present value hit.  Given the $28 stock price, there is a good cushion to work with.




 Carbon uncertainty lifts

 Natural gas prices increase


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