Overview

NRG sells power, natural gas and home services with a focus on the Texas market.  Since CEO Mauricio Gutierrez took over in December 2015, NRG has undergone a significant transformation.  NRG has divested or exited 2/3rds of its generation capacity and is now predominantly a retail energy company providing electricity and natural gas to homes and businesses without owning the underlying generation assets. The crux of our thesis is NRG is a much better business than the market appreciates and as years pass under this newly transformed group, the market will slowly come to appreciate that. The new business mix is now defensive, recession proof, has high returns on capital, significant free cash flow generation, is no longer dependent on the price of natural gas and has a leading position in a concentrated market. On NRG’s preferred metric of free cash flow before growth, NRG trades at 7.2x the midpoint of this year’s guidance. Growth capex was $96m over the last twelve months and increases that multiple to 7.8x traditional FCF.

Business Overview

Since 2015, NRG has transformed from an integrated power producer to a mostly retail electricity provider.  As an IPP, NRG owned over 100 unregulated electricity generation assets. Unregulated electricity generation has not earned an attractive return on capital and has very volatile earnings depending on the asset’s fuel source and natural gas prices. NRG has significantly reduced that piece of the business, decreasing their owned generation capacity by ~66% since 2015. In 2020, NRG moved away from reporting segment earnings for generation and retail. Given the reduced disclosure, we estimate about 75% of FCF comes from retail and 25% comes from generation today.

We believe the retail electricity business is a much better business than most people believe. It is a unique business as most states have regulated markets with no choice of electricity providers. Only 13 states have customers participating in retail choice programs where they have the option of choosing their electricity providers. In Texas, this option is very popular but in other states, for example, such as in Massachusetts, Illinois, and Ohio, only 34%, 35%, and 46% of homes participate. Electricity deregulation is a relatively new feature of energy markets. In Texas, the largest retail market, the competitive market has existed since 2001. In Massachusetts, Illinois and Ohio the energy market was deregulated in 1998, 2002, and 2001.

A common view is that retail electricity is a no moat business that sells a commodity and has no customer switching costs. While those are mostly true, since NRG bought its first retail business (Reliant in 2009), NRG’s retail business has been a great business. It has very consistent and growing retail gross margins, a high and stable market share, and fantastic returns on capital. Looking purely at the quantitative metrics, NRG is clearly a good and stable business. First, the business has stable gross margins. NRG’s gross profit has been consistently ~2.5c per kwh sold and has grown with inflation over time (from 2009-2019) and has been steady regardless of changes in energy prices, energy price volatility, etc. These KPIs have shifted after Direct Energy acquisition which has a much higher proportion of business clients and natural gas sales. Second, NRG has a very strong and stable position in this industry with 42% market share in Texas and 27% across the United States. The industry is consolidated as well as the 2^nd largest player, Vistra, has ~30% market share in Texas. Lastly, NRG’s return on tangible equity is extremely high and was infinite last year.

We believe all of these are strong signs of a competitive advantage, so rather than dismissing the presence of a moat because NRG sells a commodity product and has no customer switching costs, we look further at why NRG’s retail electricity business has continued to be a great business for the 13 years they’ve owned it. Rather than a single smoking gun that explains why it is a good business, we find there are many small reasons that add up.

First, the product is a bit more sophisticated than a simple commodity. While it is mostly a commodity, there are a lot of options for customers to choose between. There are contract plans and no term plans, fixed rates and variable rates, different mixes of renewable energy, different cancellation fees, different term lengths, etc. With many options available, it complicates the purchasing process and moves it away from there being a single clear best option for every consumer.

Second, while there were 68 retail energy providers in Texas in 2019, the industry is very concentrated. As mentioned, NRG has 42% market share in Texas and Vistra has 30% market share. The 68 retail providers overstate the number of competitors as NRG owns 6+ of them, Vistra owns 4 of them, and Just Energy (third largest player with 5% share) owns three of them. The top three players control close to 80% of the market and the “68” competitors are really a long list of fragmented and uncompetitive players. Many come and go and never amount to more than 20k customers (NRG has 3m customers in Texas). In addition, some of these competitors have terrible reputations, bad scorecard ratings, and consumers that do research will likely avoid them.

Third, NRG has strong brands that have good customer recognition. In a market with seemingly a lot of options, brand recognition matters. NRG’s largest brand Reliant, has been in existence since the formation of the competitive electric market, is the second largest individual brand (behind TXU owned by Vistra), and is well recognized by consumers. The Houston Texans play at NRG Stadium (formerly Reliant Stadium). NRG’s brands have 45-70 NPS ratings compared to the average utility of 10-15.

Fourth, scale is important, and NRG is 8x bigger than the third largest player and the scale difference only gets more noticeable from there. Scale has two noticeable benefits. First, scale is important for collateral requirements with buying electricity, hedging, etc. Second, NRG as a large player is able to sign long-term low-cost power purchase agreements (effectively leasing capacity rather than owning it in a capital-intensive manner), that isn’t available to small players or is more costly to them. Both Reliant (NRG) and TXU (Vistra) are suppliers of last resort for (designated by the Public Utility Commission of Texas) different areas of the state. That backstop position provides electricity as a safety net for consumers whose provider is unable to continue service and is a testament to the stability they can provide to the market, supplier, generators, and counterparties due to their scale and longevity.

Fifth, the business has good annual retention rates of 75-80%. For context, satellite TV’s (DISH) retention rate has averaged 80% over the last 10 years. One could argue that electricity and TV/internet both have no switching costs. However, both hold onto customers for many years. If there are virtually no switching costs, then why is the retention rate so good? One reason we think is that while there are certainly customers that want to switch to what they deem as the most attractive plan at the end of every contract period, for the vast majority of consumers there is a lot of inertia and shopping around their utility bill isn’t on their top list of priorities.

Sixth, we think good service matters. Customers are not going to notice when things are going smoothly but do notice when there are issues. Power to Choose, a nonprofit run by the Public Utility Commission of Texas, puts together a scorecard based on complaint ratios for all the providers. Each provider is given 1 to 5 stars with 5 stars being the lowest amount of complaints and three stars being the average amount of complaints. Reliant is one of six retail providers with a five-star rating. In comparison, looking at two 1-star providers, we see their complaints per customer are 6x and 32x higher than Reliant. We note that Direct Energy was a three-star provider when they were acquired by NRG and have since moved to a four-star provider under NRG’s management.

We believe all these aspects stack to create a business with competitive advantages and a moat over new entrants and smaller retail electricity providers.

Common Misconceptions

We believe there are two common misconceptions about NRG that are worth addressing.

One common belief is that because NRG delivers more electricity than they generate internally, that they are short power prices and benefit when prices fall and are hurt when prices rise. That isn’t correct and the NRG isn’t short power prices. They are always balanced. If a customer signs up for a 12-month fixed price contract, they are using forward purchasing, hedging, swaps, insurance, storage, fuel diversity and much more to match expected energy consumption. With the large portfolio that they have, it is very predictable what the average home will use and when they will use it based on seasonal patterns and weather forecasts.

Another common view, given the business’s historical focus on being an integrated power producer (with both asset generation and retail sales), is that the business model only works as an IPP. NRG is still effectively an IPP but has opted to go the asset light approach. NRG still has underlying assets that provide it with electricity through lease agreements and long-term purchase contracts. We think of this as NRG adopting the NVR model to homebuilding. NVR uses an asset light approach to the most capital-intensive part of the business (land owning) while other peers opt to go the capital-intensive approach and tie up capital in land. NRG is doing the same with the generation assets.

Accounting

As noted, NRG focuses on free cash flow before growth. There are few reasons why this is a much better metric than net income. First, the business has extensive hedging which gets marked to market and makes for significant swings in net income as hedges extend beyond one quarter. Over time these do even out as the delivery period comes due. These mark to market swings do not flow through the cash flow statement making the cash flow statement better. Second, NRG’s depreciation and amortization is significantly higher than maintenance capex and total capex. This is due to two reasons. First, there is some intangible amortization from acquisitions that is non-economic. Second, building new and doing major renovations on power plants are extremely capital intensive, but as NRG has taken the asset-light approach, they have chosen to run these assets for cash and will exit or shut them down if they require unjustified low-return capital expenditures.

Valuation

NRG trades at 7.8x FCF. We believe NRG can grow low single digits due to organic customer account growth and growing gross profit per kwh delivered. NRG pays a 3.4% dividend and buys back significant amounts of shares with the rest of its FCF. We believe that as more time passes under NRG’s new transformed business, investors will recognize the quality of the business and will eventually pay at least 12x FCF. At 12x FCF, NRG’s stock will generate 30-35% IRRs over the next three years.

Risks

Plant Outages – Major unexpected plant outages can be very disruptive to the business, however as NRG recently showed with its WA Parish outage, insurance will cover the cost to fix the unit and the lost earnings over the year that it will take to fix it.

Leverage – NRG is targeting net leverage of 3.1x at 2022 year end, but remains junk rated (BB+). Overtime, NRG aims to return to investment grade by de-leveraging through earnings growth.

Regulation – NRG exists because markets have deregulated and chosen to promote competition. If markets went in the reverse direction and moved back to more regulation, NRG would not need to exist.