Description

Please see important disclaimers at the end of the writeup.

LONG TALEN EQUITY

On or around May 17, Talen will emerge from bankruptcy and its equity will begin trading OTC. We think it’s a buy.

In this writeup we detail the assets, history, math, catalysts, and risks. Nuance abounds and we attempt to tackle most of it, but first we want to boil this down to a punchline. We like easy stuff and fortunately the math works without resorting to mental gymnastics. Three points:

1. Talen’s nuclear power plant, Susquehanna, provides 25-50% equity upside by itself;
2. Susquehanna is coveted by multiple strategics; and,
3. Nuclear Production Tax Credits (“PTCs”) are a game changer.

On point 1, nuclear power plants are rare because building them is costly, time consuming, complex, and exposed to NIMBY-ism. Moreover, nuclear power is valuable because it is ESG friendly[1], reliable, large-scale, and less exposed to input cost volatility. On the demand side, domestic power needs are up and to the right – you don’t need an AI chatbot to verify – and environmental issues remain front and center. Beyond logic, you can see the value of nukes in the Vistra acquisition of Energy Harbor as well as CEG’s multiple.

Susquehanna isn’t just any nuke. Susquehanna is the 6^th-largest nuke in the US with 2.5 GW capacity and cost $8 BN USD to build between 1973-1983 (recent examples of nuclear projects show higher costs; Google “Vogtle 3 and 4 cost” to see for yourself).  Thanks to scale and improved operations, Susquehanna is a top-quartile asset based on a low-$20’s cost-per-megawatt hour.

Applying ENGH’s 11x (implied nuclear multiple) to Susquehanna, we see $5.5 BN of value in Susquehanna alone. This compares to Plan EV of $4.5 BN ($2.5 BN equity cap) for the entire business.

On point 2, we urge readers to read CEG’s transcripts (no, seriously, anyone looking at TLN needs to do this). CEO Joe Dominguez’s commentary regarding nuclear M&A is jarring in its directness – there is no subtlety. Next, read the disclosures around the VST-ENGH transaction, which provides useful context around the strategic landscape and highlights a vision around creating a scaled-up low-carbon power company – “Vistra Vision”. Lastly, peruse Talen’s cleansing materials, where you will see that multiple bids and IOIs surfaced in the abbreviated bankruptcy go-shop.

We believe there is little doubt that interested parties are circling.

On point 3, Susquehanna has been a scarce and valuable asset for years, but the 10-year Nuclear PTCs that passed in 2022’s Inflation Reduction Act (“IRA”) are a game changer (we can’t emphasize this enough, what was a good pitch pre-PTC became an extraordinary one).

Nuclear PTCs provide an annual pricing floor ($44/MWH “PTC Floor” indexed to inflation), at a profitable level for Susquehanna, while preserving uncapped upside optionality. For a decade starting in 2024, Susquehanna will have input cost stability stapled to an asymmetric pricing skew. If you’re a nerd, you can NPV potential PTC cash flows and augment that with an estimate for the value of the embedded pricing call options, but that’s overkill. Common sense tells you government-insured downside protection – a subsidy – is valuable, especially when the equity has uncapped upside should power prices move above the PTC floor.

In addition to these three points, Talen also owns natural gas and coal power assets, digital infrastructure growth projects, and a litigation claim. All things considered, we get to 88% upside in our base case and believe this goes one of two ways. Either the company is bought in the near term or it up-lists to a major exchange in Q4’23.

Ultimately, keep this simple. How many ways can you play the obvious “nuclear renaissance” theme? Buy Talen equity and get a world-class nuke on the cheap.    

OVERVIEW:  TALEN ENERGY

History

On June 9, 2014, PPL Corp. announced that it planned to spin off its competitive energy business and combine it with PE firm Riverstone’s generation portfolio to create a new public entity called Talen Energy[2]. The company IPO’ed in 2015 and was taken private by Riverstone in late 2016. The take-private implied a $5.2 BN TEV[3] which corresponded to 7.3x forward EV/EBITDA at the time. Earnings remained solid for the first couple years, but then deteriorated due to depressed power prices, excess capacity, and unfavorable hedges. Over the past couple years, Talen struggled to juggle its levered balance sheet with the onerous capital requirements tied to hedging in a pre-PTC world. Ultimately, hedging-related working capital and liquidity issues led to a Chapter 11 filing in May 2022. After a relatively productive time in bankruptcy, Talen is re-emerging as an OTC-traded equity with a slimmed-down balance sheet (fully equitized unsecureds), a refreshed Board, and new executive leadership, and plans to uplist to a major exchange by year-end 2023.  

Assets

Talen owns and operates ~12.4 GW of thermal generation assets including nuclear, gas, and coal primarily across the PJM (84%) and ERCOT (13%) regions. Of total generation, nuclear is fully half (50%) and comes from a dual-unit power plant in Pennsylvania called Susquehanna. 35% is natural gas, 9% is coal (via minority interests), and 6% is planned retirement. Current plans call for Talen to be out of coal by the end of 2025, either through conversions, retirements, or divestitures. For the ESG-minded readers, we would highlight the fact that Talen is already substantively out of wholly-owned coal.

              In addition to the generation portfolio, Talen has invested north of $300 MM into digital infrastructure growth projects via Cumulus Digital Holdings. More specifically, there are currently two efforts, one centered on hyperscale datacenters and the other on crypto mining. We’ll get into details later, but these projects are more than PowerPoint decks. Data has already built its first data hall and the mining business is operational and should be doing well at current BTC prices.

              Finally, it’s worth noting that Talen is involved in a fraudulent conveyance litigation with PPL regarding a distribution taken from the proceeds of Talen Montana’s hydro-electric facilities in November 2014. Talen is seeking $1.2 BN in compensatory and punitive damages as Talen Montana was left unable to service its obligations. We think Talen could end up with north of $100 MM in a settlement.

              Regarding asset retirement obligations, Susquehanna has operating visibility until 2042 and will likely apply for and get an extension to 2062. The decommissioning trust is currently funded to the tune of $1.4 BN. With 20-40 years of compounding, we estimate this trust will be overfunded (depending on the achieved returns, this could become significant). As for other obligations, the main issues will be around the coal minority interests, but to tackle this we assume that all near-term free cash flow is used to satisfy these claims (i.e., we conservatively assume 0 net value for these assets).

Pro Forma Capital Structure

Talen has been in the market recently for bank funding (revolver and term loans) and bonds. On emergence, we see it like this:

Source: offering memorandums, internal estimates

For liquidity flexibility, Talen is emerging with a sizable $700 MM undrawn revolver with no LC sub-facility as well as a zero-net-debt Term Loan C / LC facility ($470 MM TL-C and $75 LCs; the TL-C use of proceeds is to sit in restricted cash and face LC counterparties). $1.78 BN of new debt is spread across a new TL-B ($580 MM) and secured notes ($1.2 BN). Lower Mount Bethel, a natural gas power plant in Pennsylvania, has a term loan against it ($281 MM) and some smaller old bonds complete the picture. $2.2 BN gross debt, $2.0 BN net. Note that it is important nobody excludes Restricted Cash given it is simply the TL-C proceeds sitting in a bank account. There is also $185mm of asset-level debt at Cumulus, which is non-recourse to the parent and therefore fair to exclude in the above capitalization snapshot.

For restricted payments, there is a $160 MM general basket and a $150 MM starter for a builder basket, totaling $310 MM RP capacity that can grow. Given modest capital expenditure needs beyond maintenance, excess free cash flow can be returned to shareholders in short order.

Current State of Play

              As noted, Talen expects to emerge with $2 BN net debt and Plan equity value of $2.5 BN on the back of a $1.4 BN rights offering and the full equitization of unsecured claims.

Large holders include Rubric, Nuveen, Monarch and Citadel[4]. Nuveen’s involvement warrants attention, given they are the largest holder of Vistra Vision (15%) and will want to see Vision separate from Vistra’s other assets (“Tradition”) as soon as possible. To do this, Vision needs additional scale to stand on its own and to help pay down debt at Tradition[5].

Mark (“Mac”) McFarland is the new CEO, having just left his role as CEO of California Resources (“CRC”). Before CRC, Mac held CEO roles for GenOn and Luminant (a subsidiary of Energy Future Holdings – now known as Vistra Energy). Mac is a known and respected commodity in this industry and has strategically vital connectivity into all key players. We spoke with him and found him to be credible and rational. Furthermore, we believe he is incentivized to do what’s best for shareholders (this is our assumption, we lack detail, but can make inferences from his comp structure as the CEO of CRC).

A reconstituted Board has been put together led by Chairman Stephen Schaefer, an industry veteran dating back to 1993 who sits on the Boards of GenOn, Texgen Power, Just Energy, and Alpine Summit Energy Partners. Mr. Schaefer was a partner at Riverstone from 2004-2015 (the same firm that took over Talen) and obviously knows these assets well.

Go-Forward Timeline

              The debt financing kicked off April 20^th with Citi, Goldman Sachs, and RBC acting as lead arrangers. The equity rights offering is happening now (May) and has been reduced to $1.4 BN from its original $1.55 BN. In a matter of days, Talen should begin publicly trading over the counter (“OTC”).

              After this initial flurry of activity, the next steps are path dependent. In our view, M&A activity could happen at any time once this bankruptcy process is officially behind the company. Absent a deal, we believe the company will pursue a CleanCo / LegacyCo separation and look to up-list the CleanCo entity on a major exchange. This effort will require months of legal and financial work, so we figure Q4’23 is a decent guess.

Plan Math

              The Plan TEV is $4.5 BN. This writeup assumes the stock begins trading flat to this Plan value.

              The appropriate reference level of adjusted EBITDA is trickier than usual and requires a bit of explanation. A relatively recent power spike led to an outsized hedging gain that drove Talen’s estimated EBITDA for 2023E to something like $1.1 BN. 2024 is noisy due to a non-recurring loss of $86mm from pre-petition hedging activities – so the Company has appropriately guided EBITDA lower. But based on the forward curve, EBITDA could track toward the mid-$700s in 2026 and beyond. And beyond the model-able financials, the 2023 bump is a feature, not a bug, and could certainly repeat every few years. And with PTCs in Talen’s back pocket, there is no offsetting downside risk – only upside gravy.

              The important numbers appear to be $1.1 BN (a “spike” year) and $750 MM (a normal year consistent with out-year prices). We feel most comfortable using the $750 MM as a normalized level. On this basis, the create is 6.0x EBITDA.

              We also want to flag the tax assets tied to net operating losses of $1.5 BN[6]. The EV/EBITDA valuation doesn’t capture this asset, and in fairness it is unclear how the NOLs would survive a CoC outcome, but you can at least see the value of the tax shield in the lack of cash taxes paid.

If you put it together, “6x EBITDA” doesn’t really do this justice since we get a PTC buffer eliminating downside earnings volatility and a tax asset enhancing FCF conversion. In our approach, we don’t add a line item for this NOL to the SOTP, but it would be stupid to ignore it. We allow it to fall into the general “upside” bucket.

With a somewhat disjointed collection of assets, we find a sum-of-the-parts approach warranted. The bulk of the value is the nuke, but we think it would be a mistake to sleep on the rest. Though you can get more granular, to keep it simple we reduced it to four pieces:

Source: internal estimates and calculations

NUCLEAR ENERGY

US Nuclear Industry

              At the end of 2021, there were 93 reactors at 55 power plants in 28 states combining for generation capacity of 95 GW[7]. This is down from a peak capacity of 102 GW (in 2012) due to 11 few reactors in service. However, annual generation from nuclear power actually increased from 2013-2019 due to plant upgrades and high utilization rates. Overall, nuclear power has maintained a ~20% share of US electricity generation for many years:

Source: https://www.eia.gov/energyexplained/electricity/electricity-in-the-us-generation-capacity-and-sales.php

Nuclear Production Tax Credits (“PTCs”)

              The Inflation Reduction Act was signed into law on August 16^th, 2022 and included 10-year nuclear PTCs. For those of us involved with Talen at the time, this was a home-run outcome; leading up to the IRA, most observers thought the odds of nuclear PTCs being written into law were sub-50%. Not only that, but the details (numbers of years, price levels) were better than we dreamed of.

              The zero-emission nuclear production credit provides up to $15/MWh when gross receipts drop to $25/MWh (calculated on an annual basis), yielding a $40/MWh floor level. In addition, there are built-in inflation escalators and other wrinkles that raise this floor a few dollars higher than that. Importantly, when we look back at decades of data, we see that gross receipts (price + capacity payments) have traded in excess of this $25 lower bound with the exception of 2020 (and even then, it was ~$22-ish, which would almost get us back to $40 with credits; we doubt the circumstances around Covid will repeat).

Susquehanna – Talen’s Crown Jewel

              The recent Term Loan Investor Presentation lays out some of the key facts:

Source: Talen Energy April 2023 Term Loan Investor Presentation

As you can see, Susquehanna is a dual-unit 2.5 GW nuclear plant in Pennsylvania, owned 90% / 10% by Talen and Allegheny Electric. It has two decades of remaining regulator-approved life and will likely apply for another 20-year extension. Due to its scale and a focus on operational excellence, it ranks highly in terms of cost performance. Of note, Constellation (“CEG”) owns a sister plant called Limerick that is located 100 miles away in Pennsylvania. The two plants were built at about the same time, with very similar designs, using General Electric BWR-4s (boiling water reactors). We have heard that management at CEG loves Susquehanna and believes there are substantial cost synergies from consolidation, both at Susquehanna itself and in unpacking the structural cost savings made at Susquehanna since 2016 and rolling that out across all of CEG’s fleet.