Description

Reliant is an unregulated electric utility company. Though the financials are intimidating, we found that with some work Reliant is comprehensible. Reliant has visible free cash flow now – lots of it – which will become more visible within a few quarters. Cutting cap-ex to maintenance levels, the current free cash flow yield to equity is in the mid-teens. [$375 million of free cash flow in 2004 based on maintenance cap-ex, not including a scheduled one-time $175 million payment to former parent Centerpoint. By late ’04 we expect cap-ex to be running at the maintenance level.]

We are seeing an opportunity for a triple or more here without a whole lot of downside risk. Not a lot of those available these days in stocks institutions can actually buy. VIC Value Meter at 1. RRI reminds us of the kind of opportunities we were seeing last March or in 2002.

We think of Reliant as two independent parts. This is no doubt oversimplified, but not by much.
1) The company has an unregulated electric utility in Houston where they are the incumbant in a deregulated market, providing electricity to customers (no generation). They own the customers and a market entrant must take them away, but the customers are sticky. RRI has been allowed to raise prices twice a year to maintain their spread as natural gas prices went up - current pricing is based on $6+ natural gas. The utility produces conservatively $500 million of EBIT (north of $700MM in ’03), very clean all in cash and without a lot of assets employed in the business. There is a lot of noise around that business now because they overearned by $150 million in 2003 due to favorable hedging profits, and Wall Street saw this as "guiding down" for 2004. It looks reasonably stable to us. For every customer they lose in Houston they’re taking a customer or two from the incumbant in the other regions in which they operate. $500 million we put a 6x EBIT multiple on (10x after tax earnings), so there’s $3 billion. Could be more. Just as important as getting the valuation of this right, we are counting on the cash flow of the utility business to cover our downside until things get better in the wholesale business. Our biggest risk of losing money is that we are wrong on the stability of this cash flow stream, but we have asked a lot of questions and we don't think we are.

2) $6.4 billion of net debt. That’s pretty easy. We’ll call it $6.4 billion. There is no short-term maturity to worry about unlike other players in this industry – their first big unsecured maturity is in 2007. The company has in excess of $1 billion in available credit. ($1.0 billion of secured notes come due in October of ’05.)

3) Now we get to the wholesale business, which is the key to the valuation. Everybody knows what happened here – massively overbuilt during the bubble, and then we had the bust and supply exceeds demand as far as the eye can see, right? OK. Lets keep it simple. This business is currently breakeven on an EBIT measure. RRI owns 20,000 MW of capacity. Some of it is mothballed and some of it is in bad markets so call it 18,000 MW if you want to. It’s not going to matter when you put together the valuation. There is a margin of safety a mile wide here.

We were new to this industry and when we tried to understand the energy wholesale business the first step we took was is this a telecom bubble where overcapacity could be just unmeasurable? Or is it more like a commercial real estate cycle where things overshoot and everybody panics, but in two or three years demand absorbs the supply? It looks like commercial real estate to us, and it is measurable. We have seen articles in the press projecting oversupply for the next decade - these are the same analysts who were predicting shortages for the next decade three years ago and we think they are just as wrong now as they were then.

a) First, this is a regional business. Some regions got much more overbuilt than others. The excess appears to be in the 0-15% range in the regions where Reliant’s wholesale assets are concentrated (they own very little in Texas, which is probably the most overbuilt market in the country – that is where their unregulated utility business is – they are BUYERS of power in Texas in a big way.) Thus the Texas glut is likely to work FOR them, not AGAINST them in the coming years.

RRI’s power generation assets are concentrated in some of the least overbuilt regions – Mid-Atlantic for one. Calpine’s last earnings release mentioned three regions that could be getting tight in supply/demand balance – over 1/3 of RRI’s assets are in those three regions, and that is in addition to the 29% that is in the MidAtlantic region where supply/demand looks OK to us. Calpine also mentioned a few regions where they have more supply to deliver to the market - those regions are not RRI's footprint.

b) Power demand grows at 2-3%, with GDP. Makes sense. Coming out of a recession, GDP is increasing at much higher rates (Q3 – 8%, Q4 – 4%) so excess capacity may be getting absorbed faster than anybody is thinking. We're not predicting a short-term fix here. But even at 2-3% this looks like 2 or 3 year absorption, not 10-15 years as some articles in the press have recently suggested.

c) There has been an overshoot of building because these assets have 3-5 year lead times, capital was free, and “it looked like a good idea at the time”. Hotel and office building markets overshoot for the same reason, but nobody calls them "unanalyzable". There was additional capacity coming on line in 2003, but very little new capacity will be added in 2004 with virtually none in 2005. The 3-5 year lead time becomes your friend if you own RRI in a year or two when supply starts to look a just a little bit tight, spark spreads start to return to norm in a couple of regions, and it dawns on Wall Street that it will be three years before any relief will come.

d) We took a good look at replacement cost of the wholesale power assets, because nothing is going to get built until you can earn a return on replacement cost. Microeconomic forces push asset values to converge on the cost of replicating them. The relevant unit to place a multiple on is a kilowatt of capacity. It costs $400-500/kw to build a gas turbine plant and $1,000/kw or more to build a coal plant. RRI has a mix of coal and gas. At the current price Mr. Market is giving us the opportunity to buy a high quality asset portfolio for a little over $300/kw, which not coincidently is in the range of what the smart vulture buyers are paying for these assets when banks wind up owning them. Actually RRI is arguably an even better deal, as those are gas assets we see trading in the private market and RRI has a lot of coal assets which are worth much more. Goldman and AIG have been active players here.

VALUATION
Put this all together and you get a very simple formula.

Value =
18,000 MW of wholesale capacity x $600,000 (reflecting a conservative replacement cost of $600/kw on the mix of natural gas and coal plants) = $11 billion

+ Retail EBIT of $500 million x 6 multiple = $3 billion

less net debt of $6.4 billion

equals $7.6 billion, or $26 a share.

Downside seems well covered by the earnings power of the unregulated utility business and the asset value. Management fully recognizes that there is no need to do anything stupid here – there is no liquidity crisis so they don’t have to issue equity and they don’t HAVE TO sell assets. They don't HAVE TO do anything. Though they’ve been selling the assets they can get decent prices for (their European business and a contracted wholesale facility were sold in the fourth quarter for decent prices which they used to pay down a lot of debt.) And they have signaled that they would like to de-leverage further, but there is no need for a firesale or an equity issuance anywhere near this price.

Near term the stock could be volatile because our analysis is nothing like the consensus opinion on the industry. But within 3 years, probably sooner, we are pretty confident we’ll be selling this stock for $20-30, and we just don’t see risk nearly commensurate with that kind of upside. The stock does require a multiyear time horizon, may require a strong stomach as there are likely to be more fireworks from their more poorly capitalized competitors, and a recognition that the stock could certainly trade lower temporarily.

We can go into a lot more detail on the numbers, but wanted to keep this simple and just give a framework for understanding what looks like a much more complicated situation than it really is, and may be one of the few multibillion deep value opportunities available today. The Q&A on the 4Q conference call is very interesting regarding earnings power, as is the company’s 100 page presentation it released with 4Q earnings. You’ll see that at more normalized spark spreads it is not at all difficult to see $2.00-2.50 per share of earnings power.

Catalyst

Recognition, free cash flow emerging later this year, any signs of rising spark spreads in certain regions