Description

Summary: This is a hated name among utility investors with the spinoff down over 20%.  The spinoff dynamics are creating this opportunity with 1) the spinoff entity has been under invested and not part of the overall strategy for the parent so we believe there is an opportunity for them to invest and grow their asset base without the burden to payout a utility-style dividend, 2) investors have sold off the spin as large mutual fund utility investors are uninterested in the small stub receiving just 0.125 shares of Talen for each share of PPL creating technical selling pressure; 3) cost cutting opportunities are avast as the entity bore significant costs of the parent and was not optimally managed from an operations perspective; 4) upside from an uplift in capacity auction prices that we don’t think is being priced in.  Our base case is a low to mid $20’s stock price or 50% upside from current prices at a 7.5x 2016 EBITDA multiple (which is still at a discount to peers which trade between 7.5x-8.8x 2016 ebitda).  We think one catalyst could come in the next month with the incremental PJM auctions providing an uplift to capacity prices and higher ebitda numbers in the out years and a quick re-rating in the stock.  $1bn in Ebitda for 2016 could easily be $1.2bn depending on the results of the auction.

Background

• Talen is an independent power producer (like CPN, DYN, NRG) with about 15GW of generating capacity and was recently formed from a spinoff from PPL utility assets in combination with Riverstone Holdings (35% owner)
• The stock spun out at $20/share and is down over 20% since trading began in early June
• Between 45-50% of PPL’s investors are income and index pressures creating pressure on TLN’s share price
• As way of background, these are assets that the PPL parent utility did not want to own nor did they invest to grow them; and utility investors would not give any credit for them as well (so you have the typical spin dynamics of underinvested and likely underappreciated assets that perhaps can now grow and flourish on its own)
• Hybrid utilities like PPL would continuously underinvest in the generation side of the business (Talen)  as investors would encourage and reward a growing dividend which was a result of increasing capital investment in their non-generation businesses; they could not invest capital in the generation as the volatility in that business would make it difficult to grow the dividend consistently
• PPL’s CFO Paul Farr became the CEO of the spinco and would look to acquisitions to grow the business recently spending $1.1bn which will increase their generating capacity to 17.6GW (expected to close by end of year)
• Proforma for the acquisition – the capacity by fuel type will be coal: 34%, natural gas: 33%, dual fuel: 16%, Nuclear: 13%, Oil: 2%, Renewables: 2%
• Management sees 2016 accretion of $160MM in EBITDA

Thesis

• Uplift from PJM auction misunderstood – we are not calling for any specific uplift but most analyst believe it could $30-50/MWd uplift in the incremental and base auctions
• PJM interconnection (the largest US electricity grid) have created a performance based plan to increase reliability at power plants (this new plan was a result of price spikes and outages from the polar vortex – something that the regulators want to avoid in the future);
• The essence of the restructured plan will allow generators that are available during peak periods of demand to receive higher payouts than other plants that are not available.  Those with a portfolio of assets are able to use the portfolio to their advantage as they can use all their assets to meet the commitments in the auction; higher capacity performance payments incrementally go directly to the bottomline
• A $10/MW increase in capacity payments is worth about $40MM in ebitda; we agree that the uplift could be meaningful for the Company.  At $50/mwd uplift this could be worth $11-$12/share alone to the share price;
• Meaningful cost cutting opportunities are available
• The generation assets bore a portion of the costs associated with the larger parent utility that were unnecessary.  The businesses only have a handful of customers, fewer regulatory reporting requirements and a smaller workforce than the non-regulated utility to manage the operations. Despite the businesses being very different from an operation’s perspective, they have the same IT systems (HR, financial systems, etc.), audit and compliance oversight, etc.  These costs are bloated and for the most part hybrid utilities tend to starve their merchant assets while maintaining a high cost base relative to the independent power producers. 
• TSA pre-spin costs go away – these are transition support costs that they have while they place their own independent systems on their own platforms; they said it would take two years to put this in place and represents $45MM in costs in 2016 that will be mostly gone by 2017
• Calpine has 80% more generation capacity yet has similar or even slightly lower non-fuel operations and maintenance than Talen so we do believe there are many opportunities
• The Company has talked about $155MM in cost savings/synergies by 2017 from overhead reductions and streamlining the operations;  These are cost only synergies and does not reflect capital expenditures synergies via procurement with scale and other considerations
• Operating leverage – we think the Company can significantly add more assets without significantly increasing the cost structure. 
• Acquisition of MacGen – which emerged out of bankruptcy in April 2014 was an example of one asset they bought for an attractive multiple; they have guided to $120MM and $30MM in ebitda and FCF accretion in 2016;
• After adjusting for tax benefits and  possibly selling the Harquahala plant (which is money losing - $10MM drag to ebitda), the acquisition price was attractive at 5.9x-6.7x 2016 ebitda
• The Company notes that there are 82GW of operating capacity owned by hybrid utilities and 42GW owned by private equity; so the opportunity to grow and add some of these to their platform could continue to be very accretive
• Power price optionality
• They have been a drag on most merchant generators driven by weak natural gas prices.  We think that the downside is limited at current prices of natural gas and that any uplift from here is fairly significant; every $1/mwh of power price volatility is worth about $50-$55MM in ebitda

Risks

• Unfavorable capacity auction results
• Lower power prices
• Riverstone owns 35% or 45MM shares and even though there is a six month lockup - there is a concern about this overhang

Catalyst

- Earnings results

- PJM Auction results in the next month

- Closing off recent acquisition