Description
Texas Genco (“TGN”) is one of the largest wholesale electric power generating companies in the United States. TGN’s assets appear to be greatly undervalued at the current market price. TGN owns 11 electric power generation facilities and a 30.8% interest in one additional facility with an aggregate net generating capacity of 14,175 megawatts. TGN sells electric generation capacity, energy and ancillary services in the largest power market in the State of Texas, referred to as the “ERCOT market.” The ERCOT market consists of the majority of the population centers in the State of Texas and represents approximately 85% of the demand for power in the state. Collectively, the company’s facilities provide approximately 20% of the aggregate net generating capacity serving the ERCOT market.
This description was originally written on January 31, 2003. Management has indicated that their projections for 2003 (presented below) assume natural gas prices in early 2003 will be $4.00 per MMBTU and that TGN should generate $50 million in incremental gross margin for every $.50 increase in natural gas prices over $4.00 per MMBTU for the 26% of 2003 capacity which had not be sold by January and which was scheduled to be auctioned in the first half of 2003. As of May 22, natural gas prices are above $6.00. In addition, management indicated they believe the company will be able to bring back a significant amount of production capacity this summer that was previously mothballed. Neither of these improvements is incorporated into the analysis below. Also since the original write-up a nuclear power plant in which the company is a part-owner has been shut down to repair a leak. The amount of damage and potential down time are unknown.
TGN is 81% owned by CenterPoint Energy (“CNP”) (formerly Reliant Energy). On December 20, 2002 CNP made a pro rata taxable distribution of 19% of TGN to CNP shareholders. Reliant Resources (“RR”), the retail arm of CenterPoint which was also recently spun-off from CNP, has an option to buy CNP’s 81% stake in TGN until January 24, 2004. CNP has stated it expects to continue to own 81% of TGN until at least 2004 when RR’s option will be exercised or expire. CNP has also stated that if RR does not exercise its option, CNP will seek to sell TGN, either as a whole or by individual assets.
The Company has announced however that it intends to make quarterly dividend distributions of $0.25 per share.
TGN has sold 74% of its available capacity for 2003, with RR purchasing 58% of the entitlements. The ability to sell capacity entitlements reduces volatility in the company’s earnings and provides planning and forecasting benefits to the company. However, forward selling also creates operational risk. If a large base-load plant were to unexpectedly go out of service, TGN would be on the hook to find the capacity from an alternate, more expensive source.
In January, TGN announced it expected 2003 earnings to be $1.10 to $1.30 per share, EBITDA to be $330 million to $360 million (assuming a price of natural gas of $4.00) and capital expenditures to be $151 million. Since TGN has already sold 74% of its capacity for 2003, there is a fair degree of certainty to these projections, though a dramatic move in natural gas prices could still materially alter the outcome.
TGN’s plants are diversified in terms of dispatch type and fuel mix enabling the company to capture value along the dispatch curve. The table below outlines TGN’s dispatch profile:
Fuel Type Base-load Cyclic / Interm. Peaking Total
Gas/Oil 0 3,474 354 3,828
Gas 162 4,832 501 5,495
Nuclear 770 0 0 770
Lignite 1,612 0 0 1,612
Coal 2,470 0 0 2,470
Total 5,014 8,306 855 14,175
Most of the new capacity built in the ERCOT region has been natural gas-fired cyclical plants which are cheaper and more efficient and have pushed TGN’s intermediate and peaking units further down the dispatch curve. Since most capacity in the ERCOT region is generated by natural gas-fired plants, the marginal price of electricity is generally dependant on natural gas prices. The company’s base-load capacity consists primarily of lower-cost nuclear and coal units whose fuel costs are known and fully-hedged.
Since the fuel costs for the base-load plants are fixed under long-term contracts, there is little commodity risk. However, since electricity prices are dependent on natural gas prices, TGN’s profitability should increase if natural gas prices increase and vice-versa. Practically speaking, it would be a near impossibility for a new entrant to compete with TGN on the generation of base-load power. Coal is by far the most efficient fuel for base-load plants and, even in Texas, building a new large coal-fired plant and securing the distribution and supply of coal to the plant would be a Herculean task to get by local or state government authorities.
In October 2002, TGN announced its plan to temporarily remove from service, or “mothball,” approximately 3,400 MW of its gas-fired generating units through at least May 2003. The company decided to mothball these units because of unfavorable market conditions in the ERCOT market, including a surplus of generating capacity and a lack of bids for the output of these units in previous capacity auctions. Based on current indications in the auction market, the company believes the plants will be put back into service during the summer months and possibly fall. In the meantime, TGN can realize savings on the operation and maintenance of the mothballed plants which Deutsche Bank has estimated at about $20 million per year. Management did not dispute this figure on its January conference call.
TGN has a fairly clean balance sheet with only a minimal amount of debt.
Given its large non-natural gas base-load portfolio, TGN is in a unique position in the market. TGN can realize increased gross margins by either an increase in natural gas prices or an increase in spark spreads or both. If natural gas prices increase, the marginal price of electricity increases and TGN realizes drastic gross margin increases since natural gas prices do not affect the company’s base-load generation cost but do change the underlying price of electricity in the region. This is precisely what happened in late 2002 when TGN auctioned 74% of its capacity for 2003. Increasing natural gas prices created a significant gross margin jump for recently sold capacity entitlements. In addition, if spark spreads increase back to normal levels, the company can realize incremental margins by operating its mothballed plants and its peaking facilities. Spark spreads have been near all time lows as a result of the overcapacity in the ERCOT market. TGN is estimating that the excess reserve in 2003 will be near 20%. While this excess supply is keeping spreads low, if demand keeps pace with historical growth rates, the ERCOT market should be back in equilibrium in 2-3 years. The growth in demand for electricity in the U.S. has been very steady historically, with only a few minor bumps along the way. Since 1949, demand has only decreased from the prior year 3 times: 1974 (-0.74%), 1982 (-2.8%) and 2001 (-0.01%). The compound average growth rate for electricity demand has been approximately 5% since 1949 and approximately 2.2% since 1990.
TGN’s plants have tremendous long-term asset value which has not been adequately reflected in the stock price. The turmoil created by deregulation, the bankruptcy and financial degradation of Enron and other major players in the energy sector, fire-sale liquidations of energy assets, a weak economy with lackluster energy demand and the combination of an ebullient market and cheap capital that lead to an overbuilding of capacity has led to historically poor performance for utilities and a devaluing of generating assets. Even in this environment, based on recent power plant sales and the replacement cost of assets, TGN appears to be trading at a significant discount to asset value.
The table below details summary information concerning generating asset sales in 2002 expressed in price / kW:
Median $353
Weighted Average 311
Simple Average 565
Comp. Gas Average 362
Nuclear 504
Coal 353
Many of these sales were undertaken either out of desperation to shore up balance sheets or by mandatory deregulation at a time when wholesale electricity prices were deteriorating and the outlook was generally perceived as unfavorable. Another large acquisition that has some relevance is the sale of Orion Power Holdings in February of 2002. Some of the assets underlying the sale are comparable, but more relevant is the buyer – Reliant Resources. RR purchased Orion’s stock for $2.9 billion plus the assumption of $2.5 billion in debt and a $500 million obligation to purchase turbines to complete power plants under construction. Orion had 5,644 mW of generating capacity including 2,300 mW of coal-fired plants, 2,100 mW of natural gas-fired plants and approximately 650 mW of hydroelectric power. Approximately half the capacity is located in the northeast, including about 25% in New York City with the remaining capacity located in the Midwest. For various pricing and regulatory reasons, plants in the northeast sell for far higher valuations than plants in the Midwest or South. In aggregate, the purchase price amounts to approximately $1,050 per kW.
The table below shows the implied asset values for TGN based on the above data and an analysis by Deutsche Bank, which is discussed in further detail below. The Orion sale is not included since individual assets were not broken out:
TGN Plants Implied TGN Value ($MM) based on:
Fuel MW Median Avg Comp. Avg Deutsche
GAS/OIL 3,828 1,353 1,386 0
GAS 5,495 1,942 1,989 275
NUCLEAR 770 272 388 270
LIGNITE 1,612 570 569 564
COAL 2,470 873 872 865
Total 14,175 5,009 5,204 1,973
Less: Debt 125 125 125
Implied Equity Value 4,884 5,079 1,848
Per Share $61 $63 $23
In a research report published in January, Deutsche Bank estimates that the base-power plants would sell for approximately $350 per kW in the open market today and the remaining operating power plants would sell for about $50 per kW. The mothballed plants are valued at $0 in their analysis. This analysis appears to be a very conservative estimate based on a particularly poor operating environment for these plants. Certainly valuing over 3,000 MW of generating capacity in good working order that management believes will be at least used in the peak summer months at nothing errs on the conservative side. Nevertheless, that analysis still yields an asset value of approximately $23 per share after debt.
The analysis below estimates TGN’s asset value by valuing its power plants at replacement cost. This is an imprecise exercise since newer plants are more efficient than many of TGN’s. The Adjusted Asset Value column attempts to adjust for differences in efficiency by assuming replacement cost is calculated by efficiency (operating cost per MW) as opposed to building a replica plant. For example, TGN’s cost to operate its intermediate plants is approximately $36.82 per MW which is higher than the $25.61 operating cost of a new, more efficient intermediate plant but lower than the less efficient and less costly peaking plants. The adjusted cost therefore compares TGN’s intermediate plants to the replacement cost of a cheaper peaking plant, even though TGN’s intermediate plants are more efficient than a typical peaking plant.
Cost to Oper TGN Oper TGN Adj. Adj.
Build Cost Cost Assets Cost to Asset Asset
per kW per MW per MW (MW) Replace Value Value
Natural Gas,
Combined Cycle 600 25.61 36.82 8,306 250 4,984 2,077
Natural Gas,
Peaking 250 48.42 36.82 855 250 214 214
Coal 950 21.49 16.87 4,082 600 3,878 2,449
Nuclear N/A N/A 41.28 770 350 270 270
Total 9,345 5,009
Less: Debt 125 125
Implied Equity Value 9,220 4,884
Per Share $ 115 $ 61
The range of value for the base-load plants is $1.7 billion to $2.7 billion, implying that at current market values investors are getting the difficult to replace base-load plants at a 20% to 50% discount to the underlying asset value less debt and 9,323 MW of intermediate and peaking gas plants for free which have a replacement value in excess of $2 billion.
Even in a poor wholesale electricity market, TGN trades at reasonable earnings / cash flow multiples
Since TGN has sold 74% of its on-line capacity and since most of the company’s sold capacity is from its base-load units which have virtually no commodity price risk, TGN’s 2003 estimates are more than just a guess. The company has already locked in approximately $490 million of gross margin for 2003 and hopes to lock in a majority of its remaining capacity in the 1st quarter of 2003. The company’s EBITDA projections for selling its remaining capacity assume natural gas prices are at $4.00 which is more than a 20% discount from prevailing rates. However, the unsold capacity remains highly sensitive to natural gas prices. On the 26% of capacity not yet sold, a $0.50 change in the price of natural gas equates to approximately $50 million of gross margin won or lost.
The following table shows TGN’s current trading statistics using the low end of the company’s projections for the 2003 figures [prices were calculated as of January 31, 2003]:
Pricing Statistics
Price / Tangible Book 55.1%
2003e P / E 12.3 - 14.5x
EV / EBITDA 2002 24.2x
EV / EBITDA less Capex 2002 NM
EV / EBITDA 2003 4.3x
EV / EBITDA less Capex 2003 7.8x
2002 Dividend Payout >100%
2003 Dividend Payout 44.7%
Dividend Yield 6.25%
While these trading statistics are not compelling on an absolute basis, in light of the current market condition in which wholesale electricity prices and spark spreads are near all time lows and where excess capacity still exists in the ERCOT market it appears TGN is at least reasonably priced under the current circumstances. However, when looking at the earnings potential of the underlying assets in a normalized supply / demand environment when producers have the ability to create a wider spark spread, TGN looks quite cheap. The table below details TGN’s current value to its peak performance years in 1998 - 2000 when spark spreads were greater:
Price to peak performance
EV / 1998 EBITDA 1.4x
EV / 1998 EBITDA less 2003E Capex 1.7x
EV / 1999 EBITDA 1.8x
EV / 1999 EBITDA less 1999 Capex 1.9x
EV / 1999 EBITDA less 2003E Capex 2.2x
EV / 2000 EBITDA 2.9x
EV / 2000 EBITDA less 2000 Capex 6.1x
EV / 2000 EBITDA less 2003E Capex 4.2x
Fair multiples of cash flow suggests the following prices would be reasonable if TGN’s projections are accurate:
Price per share assuming:
4.0x EV/1998 EBITDA $ 47.54
4.0x EV/1999 EBITDA 38.54
4.0x EV/2000 EBITDA 22.54
6.0x EV / 1999 EBITDA less 2003E Capex 70.20
6.0x EV / 1999 EBITDA less 2003E Capex 56.70
6.0x EV / 2000 EBITDA less 2003E Capex 32.70
By way of comparison, RR purchased Orion for 12.4x 2001 EBITDA (Orion’s peak year). Orion had no cash flow net of capital expenditures in 2001.
Risks
1) Natural gas prices are highly volatile and unpredictable.
While conditions have been favorable for capacity sales for 2003 thus far and appear favorable for the auctions in the next few months, prices can change very rapidly. Natural gas is currently trading for about $5.50/MMBtu, up from $4.50 only a few months ago. The company needs to sell its remaining capacity with natural gas at $4.00 to meet its projections. It appears that if natural gas fell to $3.00 to $3.25, TGN would have difficulty paying its planned dividend and may even begin to consider mothballing additional plants if the outlook appears poor. Natural gas prices were in this range as recently as a few months ago. This analysis however assumes that the oversupply in the ERCOT market is so great that generators have absolutely no pricing power at all and electricity prices move in lockstep with natural gas prices. In reality, such a scenario is unsustainable if spark spreads are negative for any lengthy period of time. In fact, if wholesale prices remain stable and natural gas prices plummet, the company would make less gross margin on its base-load plants but would make more gross margin on its gas-fired plants and may be able to use its mothballed capacity longer than currently anticipated. Essentially, the portfolio of assets creates somewhat of a natural hedge to fluctuating natural gas prices.
2) Spark spreads are also highly volatile and unpredictable, particularly since deregulation in power generation is a new phenomenon. It is difficult to project with any accuracy when the reserve margin may return to a more manageable level allowing generators to increase the spark spread and bring mothballed plants back on line. TGN’s mothballed natural gas plants have a higher heat rate (i.e. are less efficient) than newer plants and therefore are further down the dispatch curve, meaning spark spreads will have to move well into positive territory for newer plants before becoming positive for some of TGN’s plants.
3) In its higher profitability years of 1998 – 2000, TGN was a regulated utility with less competition. There is no history to point to for guidance on what the potential profitability of TGN or other regional generating assets may bring at a better stage of the cycle. On the downside, we do know from 2002 results that if spark spreads and natural gas prices are low, the company could have difficulty paying its dividend which would probably be catastrophic for the stock price in the near term.
4) TGN’s mothballed plants are relatively old and inefficient. They are costlier to operate than newer cyclic and intermediate plants and are not the ideal peaking facilities either. They will contribute cash flow in peak summer months if spark spreads are high enough and could be operated more frequently if spark spreads continue higher. However, Jay Dobson, the Deutsche analyst, believes there would be no buyers currently for these assets beyond their site value. Part of this is a result of the poor near-term wholesale electricity outlook which is causing the plants to be mothballed, part is the relative inefficiency of the plants and part is that it is currently very much a buyer’s market for generating assets.
5) RR may exercise its option to buy 81% of TGN. Many believe if they do exercise their option they will also attempt to buy in the remaining shares. It is entirely possible they will attempt to buy the remaining shares at a substantial discount to what we believe is the intrinsic value of the company. The board of directors consists of 2 members who have been named by CNP and three independent board members that will be nominated shortly. CNP expects to appoint 2 additional (presumably non-independent) directors to the board later this year. There are no contractual or explicit protections for the minority shareholders.
6) RR, which has purchased 58% of TGN’s capacity for 2003, is a serious credit risk. RR is rated B+ by S&P and B3 by Moody’s, both on review for downgrade. RR is under scrutiny because it has $5.9 billion of debt due before September 2003, including $3.6 billion which matures before March 31. RR has said it is confident it will not have a problem refinancing the debt, mostly likely on a secured basis. Analysts following the industry seem to believe that RR will likely survive the immediate liquidity crisis but it is by no means a certainty. To make matters worse for RR, they are being sued by the state of California for market manipulation, ‘overcharging’ of customers and anti-competitive behavior related to some of its acquisitions, by several classes of ratepayers with similar complaints, by FERC for ‘round-trip’ trades among other things and is being investigated by the SEC for potential financial reporting violations. [there have been many updates to the RR story since this was written].
7) Power Plant Expansion. While it appears the oversupply situation is dwindling, independent power operators could continue to build new, more efficient plants in the ERCOT region which could marginalize some of TGN’s older gas-fired plants. Currently a shortage of capital, which appears to be very scarce in the industry at the moment, and a lack of sufficient spark spread have prevented new proposals from being filed. If spark spreads increase, renewed interest may develop and new plants may be built. The major advantage for the company in the meantime is that it can take several years to build a new plant including requisite regulatory approvals.
8) Asbestos litigation – from a company filing: “Our facilities are the subject of a number of lawsuits filed by a large number of individuals who claim injury due to exposure to asbestos while working at sites along the Texas Gulf Coast. Most of these claimants have been workers who participated in construction of various industrial facilities, including power plants, and some of the claimants have worked at locations owned by us. We anticipate that additional claims like those received may be asserted in the future, and we intend to continue our practice of vigorously contesting claims that we do not consider to have merit. Although their ultimate outcome cannot be predicted at this time, we do not believe, based on our experience to date, that these matters, either individually or in the aggregate, will have a material adverse effect on our financial position, results of operations or cash flows.”
Justification of Expected Value:
If the assets are valued as follows:
- $350/kW for base-load (vs ~$600/kW adjusted replacement cost)
- $75/kW for operating gas plants (vs ~$250/kW adjusted replacement cost and $50/kW DB estimate)
- $50/kW (vs ~$250/kW adjusted replacement cost and $0 DB estimate),
the price would be approximately $27 per share.
Justification for Downside Case:
In the disaster scenario, natural gas prices and spark spreads are very low at the end of 2003 and as a result the dividend for 2004 appears in jeopardy. The stock is trading poorly which makes it more likely that RR can exercise its purchase option. RR then offers to buy the remaining 19% of the stock at a premium to market. Some shareholders are happy to take the premium given the beating they have taken in the stock over the previous 6 months and other shareholders are forced to sell at a loss. Immediately after the spin-off and prior to the reports of favorable auction results for 2003, TGN traded in the $10 to $12 per share range. At the time, the wholesale market for electricity did not look particularly favorable and there was some question about whether the company could pay its dividend as promised. If future prospects for the company look similar in December 2003, the stock could easily fall back to those levels or worse. The asset value, the lack of debt and the ability to pay at least some dividend however should provide a cushion.
Justification of Upside Case:
If the reserve margin shrinks and spark spreads grow as oversupply diminishes, TGN’s profitability will grow and the value of its underlying assets will be highlighted. In theory, the valuation of the assets should converge with their replacement cost. If TGN were to be valued at 65% of its adjusted asset value (which has already been heavily discounted from replacement cost), the stock would trade at approximately $40 per share.
The above is merely the opinion of the author and should not be construed as investment advice. The author is currently long TGN stock.
Catalyst
In January of 2004, RR’s option to buy CNP’s 81% of the company at market expires. If RR does not exercise its option, then TGN will be sold to the highest bidder. These assets will certainly attract a lot of attention from both industry players and LBO firms. In theory, the price should be bid up closer to intrinsic value. If however RR does exercise its option, which seems to be the prevailing wisdom, the stock may sink since there will not be an open auction to sell the company. If this is the case, the next catalyst will simply be ongoing changes in natural gas prices, spark spreads and reserve margin in ERCOT.
There is an interesting underlying dynamic at work, however. RR may not have the resources necessary to purchase TGN. The higher TGN’s price goes prior to January 2004, the more difficult it will be for RR to purchase and the higher the price will continue to go as an open auction looks more likely. Conversely, assuming RR is aware of this potential dynamic, RR may announce well in advance of January that they intend to exercise their option which would probably put a lid on the stock, at least temporarily.