NRG Energy, Inc. (NYSE:NRG)
Q1 2009 Earnings Call
April 30, 2009 9:00 am ET
Nahla Azmy - VP of IR
David Crane - President and CEO
John Ragan - COO
Bob Flexon - CFO
Mauricio Gutierrez - SVP of Commercial Operations
Lasan Johong - RBC Capital Markets
Anthony Crowdell - Jefferies & Company
Amit Thakar - Deutsche Bank
Neel Mitra - Simmons & Company
Leslie Rich - Columbia Management
Gregg Orrill - Barclays Capital
Welcome to the NRG Energy First Quarter 2009 Earnings Conference Call. (Operator Instructions).
It is now my pleasure to introduce your host Nahla Azmy, Vice President of Investor Relations for NRG Energy.
Good morning and welcome to our first quarter 2009 earnings call. This call is being broadcast live over the phone and from our website, at www.nrgenergy.com. You can access the call presentation and press release furnished with the SEC through a link on the Investor Relations page of our website. A replay and podcast of the call will be posted on our website. This call, including the formal presentation and question-and-answer session, will be limited to one hour. In the interest of time we ask that you please limit yourself to one question with just one follow-up.
During the course of this morning's presentation, management will reiterate forward-looking statements made in today's press release regarding future events and financial performance. These forward-looking statements are subject to material risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. We caution you to consider the important risk factors contained in our press release and other filings with the SEC that could cause actual results to differ materially from those in the forward-looking statements, in the press release and this conference call.
In addition, please note that the date of this conference call is April 30, 2009, and any forward-looking statements that we make today are based on assumptions that we believe to be reasonable as of this date. We undertake no obligation to update these statements as a result of future events, except as required by law.
During this morning's call, we will refer to both GAAP and non-GAAP financial measures of the company's operating and financial results. For complete information regarding our non-GAAP financial information and the most directly comparable GAAP measures and a quantitative reconciliation of those figures, please refer to today's press release and this presentation.
With that, I'd like to turn the call over to David Crane, NRG's President and Chief Executive Officer.
Today, I am joined here by John Ragan, our Chief Operating Officer; and Bob Flexon, our Chief Financial Officer. Both will be giving part of today's presentation, and also by Mauricio Gutierrez, who runs our commercial operations and will be available. He may or may not answer your questions depending on their level of commercial sensitivity.
I'm going to be referring to the slide deck with slide five by providing a summary of what I consider to be the highlights for the quarter and to put in the context of the philosophy of our business. As those of you who have followed NRG for the past five years are well aware, our business model, and of course, the way we manage the business always has been based on the fundamental facts that the competitive power generation business is a long lead time, capital intensive, highly cyclical commodity-driven business.
Operating in an industry with these basic characteristics, a well positioned company like NRG normally is aiming to tread water during the down cycles in order that it may surf the up cycles. In a sense, that's what we are doing in this mother of all down cycles and that we are treading water in a sense that we are posting healthy financial results off a strong operating performance.
My sense is that due to the very severity of this down cycle combined with our particularly robust liquidity and forward hedge position, we are doing much more than just treading water through the down cycle. By being nimble and proactive, we are putting ourselves in a position to thrive during the downturn so that we can thrive even more during the upswing, which inevitably will follow.
In the first quarter we began to do just that. We demonstrated that the key to thriving during the down cycle is to deliver on a core business plan, which has been purposely structured to withstand the down cycle while deploying the relative strength of our business to take advantage of the best and brightest opportunities in the marketplace.
This slide five illustrates that intrinsic, extrinsic one, two approach. During the first quarter, first of all, we got the most out of our assets. We achieved the best economic return available on our assets through significant improvement in our year-over-year reliability.
Second, we successfully matched our baseload hedge position and the first link collateral structure that supports it in order that they might deliver on their core promise, which is ensuring the base case profitability of the company. At the same time, we continue to pursue the down cycle portion of our forward hedge strategy by adding significantly to our coal purchases, while staying out of the forward market for power and gas hedges.
Third, we accessed the debt markets at the project company levels to raise over $500 million of reasonably priced non-recourse debt instead in support of the PPA-based GenConn projects.
Fourth, while executing successfully on our intrinsic business plan, we transacted successfully extrinsically as well, acquiring the development rights to eSolar's big solar thermal projects in the West, taking advantage of the relatively strong market conditions in Europe to contract for the sale of our ownership interest in MIBRAG for approximately $259 million and purchasing Reliant Energy's retail business for $287.5 million.
MIBRAG is still on track to close later in the second quarter and the Reliant acquisition is on track to close at midnight tonight. As such, I will have a few comments on Reliant Energy later in the presentation.
I wish to turn over to John Ragan, our Chief Operating Officer, for his review of the company's operational performance.
NRG has continued its strong operating and commercial performance during the first quarter of 2009. Slide seven highlights a few of these accomplishments.
First, NRG continued to have a strong safety performance during the quarter. The company posted an OSHA recordable rate of 1.47, which exceeds the top quartile benchmark for the industry. We had 27 facilities experience no recordable safety incidents.
Some of the activities that we focused on during the quarter to reinforce safe work practices have included a national safety stand down with all of our operational employees and rolling out a new contractor safety work policy to strengthen our expectations with contractors, as we increase the amount of construction that will continue to occur on our sites over the next few years. I will cover plant and commercial operations in more detail on the next few slides.
As you can see, our coal and nuclear operations performed very well during the quarter with outstanding availability and improved outage rates, all within the context of a more challenging operating environment for the baseload coal suite. Nuclear operations at STP continue to trend to flawless operations, achieving 100% operational availability during the quarter.
Our engineering, procurement and construction group moved forward with many projects during Q1. Since the completion of Huntley 67 and 68 baghouse projects in December and January, we have had outstanding operational performance from these two units with availability exceeding 96% after these major outages were completed.
This type of performance coming out of a major maintenance and construction outage is a true testament to the outstanding integration between our construction and plant operations groups, as these transitions can sometimes be a stumbling point from achieving solid execution in the completion phase of large complex projects.
Although not highlighted on the slide, Dunkirk 3 and 4 baghouse construction projects are on track and will be completed in May, while units 1 and 2 will be completed this fall.
Moving to Texas, our Cedar Bayou 4 combined cycle project is near completion with the units finishing their first fire and steam test during April. Our plant operations group working in parallel with the construction group has completed all readiness assessments and will take full control of the unit prior to June 1, when the unit begins commercial operations. Adding to our mid-merit portfolio, Cedar Bayou 4 will help in managing the load characteristic associated with the new Reliant Energy retail business.
Finally, construction has begun on our peaking units in Connecticut that are part of the NRG Repowering program.
Our commercial operations group continued to execute through the commodity price down cycle to protect and manage our generation portfolio. During the quarter, the group added additional whole commodity hedges for our baseload fleet. Additionally, the group has been focused on the integration requirements for rolling the supply management function of the Reliant Energy retail business into our established ERCOT portfolio team.
Now, turning to additional detail around our plant and commercial operations, slide eight illustrates the performance in the operating environment for NRG during Q1 2009. While there are certain market factors that are outside of the company's control, the factors that we can control, plant availability and reliability, continue to be managed very effectively.
The availability factor for our baseload plants improved to 92.9% from 90.5% in Q1 2008 and our forced outage rate improved to 1.6% as compared to 2% in Q1 2008. These are excellent results when considering that many of these units were being dispatched in a fashion more similar to intermediate units as compared to baseload units.
From a generation standpoint, our baseload plants generated 10% fewer megawatt hours in Q1 2009 as compared to Q1 2008. In addition to the normal maintenance outages we had at Limestone and Parish and the major baghouse outage that we completed at Huntley, reserve shutdowns and down cycling of our units have also impacted our baseload coal generation on a quarter-over-quarter basis.
The reserve shutdowns and cycling of our units that we experienced during Q1 are a direct affect of some of the macroeconomic factors that we are currently seeing in our economy.
As with the rest of the nation, we have seen downward pressure on both electric and natural gas demand during the quarter. The impact of lower electric demand has an overall dampening effect on electric generation. Secondarily, the precipitous drop in natural gas prices has created the opportunity for efficient combined cycle gas plants to displace baseload coal generation.
As the graph on slide eight illustrates, the more recent coal displacements by gas have been more prevalent in the Northeast markets during March when gas prices moved to their lowest level in the quarter. Over the past 10 years, we have only seen short periods of time when gas generation displaced coal, notably the winter of 2001 to 2002.
Looking forward over the longer term, we don't see a change in market dynamics where gas units would displace coal units in the merit order.
While these production declines created some additional operational challenges, our commercial operations strategy that was executed through 2008 significantly protected our gross margin for the fleet. Unlike some generators, NRG has and will continue to aggressively hedge our baseload generation over the longer term to provide a more certain cash flow profile.
Slide nine illustrates our energy and fuel hedges for the next five years. As we have seen the entire energy commodity complex move down, we have used the downturn in market prices to increase our coal hedging profile for the years 2010 through 2012. This is shown on the bar chart as new fuel hedges.
Now in regards to our long power position, we have been patient to enter into new hedges for the forward years. During 2008, we took advantage of hedging the generation portfolio from 2009 through 2013 when gas prices were significantly higher. We will continue to be patient during the downturn and look for selling opportunities when we see natural gas prices move down to more fundamental levels.
As we move into the next decade, our portfolio is well positioned to take advantage of the economic recovery and commodity price expansion. As shown, the company is well hedged through 2011, which will protect the baseload gross margins across the trough of the recession and the commodity price cycle.
As you are aware, natural gas price is one of the primary commodities that impact our future gross margins. Therefore, understanding what will create a reversal of the downward trend and gas prices that we have seen since the middle of last year is a critical piece of the puzzle.
Slide 10 illustrates the relationship between US rig count and gas prices for the past 15 years. As shown, there is a general correlation between a decrease in rig count followed by an increase in prices. In the US, we are currently experiencing a significant reduction in rig count. As of the middle of March, natural gas rig count had dropped to a level of 760 rigs in operation. Industry consensus is that approximately 800 rigs are required to maintain existing production levels.
With decreased industrial demand being somewhat offset by coal to gas fuel switching, any pickup in industrial demand, further reductions in rig count, accelerated decline rates for shale gas production or unexpected weather events could provide the catalyst for gas prices to rebound.
Additionally, with the lack of capital flowing into both the gas and power infrastructure sectors, the potential for expanded dark and spark spread margins is a possible outcome as the economy strengthens and a period where infrastructure may be more constrained than in the recent past.
Turning now to heat rates, the lower right graph on slide 10 indicates the change in ERCOT heat rates over the past two months. As shown, heat rate continues to trend upwards after 2011 due to expectations around economic expansion, the uncertainty around future regulatory and legislative actions and the impact of current capital constraints that will affect future generation projects within ERCOT.
To summarize, the commercial operations group will continue to actively manage the generation fleet by taking advantage of opportunities that allow us to prudently hedge both our fuel requirements and our generation position. In addition, our plant operations organization will focus on continuous improvement of operating practice that will drive employee safety and improve plant performance.
Now, I will turn it over to Bob who will discuss our financial results.
While the current declines in the power prices and commodity markets and overall power demand that John just referred to have all combined to create very difficult and challenging times for the power generators, as David mentioned in his opening comments, it's the business environment such as today's that our business model has been designed for in order to protect shareholder value along with other company stakeholders.
Three key principles serving us well that have not changed since NRG's early days includes actively managing the portfolio to generate consistent free cash flow, maintaining ample and diverse liquidity sources to support commercial hedging and capital allocation and prudent balance sheet management.
With the backdrop of these lower prices in demand, the first quarter results as highlighted on slide 12 clearly benefited from our hedge position, much like we expect the near to medium term will. In fact, our first quarter 10-Q disclosure will show that as of March 31, 2009, the fair value of all of our commercial hedges were nearly $1.6 billion in the money to NRG.
In regards to the prudent balance sheet management when the Repowering growth program was launched back in 2006, we set a goal of protecting the corporate balance sheet as we pursued opportunities. Consistent with this goal, we added $500 million of credit capacity for long lead time materials and equipment for NINA, and just the other day we completed the $534 million GenConn financing to provide our equity contribution and construction funds. Add to that $58.5 million in tax exempt financing at an interest rate of 45 basis points with maturity not until 2042.
Turning to the financial results on slide 13, adjusted EBITDA for the first quarter of 2009 was $477 million, a 9% reduction from the first quarter 2008 results of $525 million. As noted a moment ago, the current quarter experienced lower generation, capacity and commodity prices, but these declines were largely offset by hedges that mitigated the negative impact to our financial results.
Included in our net earnings but excluded from adjusted EBITDA were $332 million of mark-to-market gains in our economic hedges. This compares to $170 million loss in the first quarter of 2008. Additionally, $5 million in expenses related to the Exelon defense and $12 million associated with the acquisition of Reliant's retail business are excluded from adjusted EBITDA.
The Texas region's results were favorable to last year due to lower fuel costs and higher hedge prices for our baseload units in 2009 nine versus 2008. Fuel costs were lower due to $15 million coal supply contract settlement in 2008. As John highlighted, the region also benefited from excellent baseload plant operating performance where equivalent forced outage rates for Limestone, Parish and FTP were all below 0.5% for the quarter.
Although the Northeast region experience lower power prices and generation, the hedging program combined with the load obligations resulted in the region's net energy margins increasing by $4 million in the first quarter of '09 compared to '08. The biggest driver for the quarter-over-quarter decline is lower capacity revenues in New York, driven by New York ISO reduction and installed reserve margin requirements and the ICAP in-city mitigation rules put into effect in March 2008.
Turning to South Central, EBITDA declined $34 million to $29 million as there were a number of drivers, including lower generation, lower demand and a decline in contract revenue. In the first quarter of 2009, the net capacity factor, a measurement of total plant output, is compared to the nameplate capacity for our Big Cajun II facility was 85% versus the exceptional performance of 92% in the first three months of 2008.
The current quarter decline is attributable to two specific events, a six-day unplanned outage, which lowered output by 139,000 megawatt hours followed by a five-day reserve shutdown on unit 2 lowering output by another 121,000 megawatt hours. The lower generation impacted the amount of megawatt hours available for the region to sell into the merchant market, and when combined with decline in commodity prices, impacted EBITDA by $16 million quarter-over-quarter.South Central's first quarter 2008 was its highest single quarterly EBITDA since NRG emerged from bankruptcy.
The West region's decline of $16 million from 2008 was due to planned outages and the exploration of a tolling agreement at El Segundo in April 2008. The planned outages included a major overhaul of units 3 and 4 at El Segundo and planned maintenance at Encina, including the lagoon dredging.
Cash flow from operations on slide 14 increased by $79 million over the first quarter of 2008 to $139 million in the first quarter of 2009. The closeout of commercial trade positions and lower commodity prices combined with the quarter's earnings offset the working capital increases driven by higher coal inventories and other working capital changes.
Environmental CapEx was $58 million in the quarter, primarily related to the baghouse projects at n our Western New York plant. Our Repowering investments included $37 million of expenditures for STP 3 and 4, $28 million for the Langford Wind Project and $31 million related to payment of yearend project accruals.
Slide 15 outlines the company's liquidity position as of March 31, 2009. Total financial liquidity, excluding funds deposited by hedge counterparties, was $3.1 billion at the end of the quarter compared to $3.4 billion at the end of last year.
The liquidity decline from yearend 2008 is a normal first quarter occurrence due to the timing of payments, which include $197 million term loan B mandatory pay down, an excess cash flow offer, $173 million of the semiannual payments on the interest for our high-yield bonds and $68 million in the property tax payments for the Texas region.
In addition, the company purchased $35 million of RGGI emission allowances during the quarter. Adding to liquidity was the return of approximately $24 million in letters of credit previously required for RGGI auctions.
Slide 16 provides the updated 2009 guidance for the generation business. This excludes costs associated with the Exelon defense and the Reliant retail transaction and integration, as well as the expected contributions from the retail business, which we'll provide in our second quarter earnings release.
For the generation business, we're maintaining our original guidance adjusted for the pending sale of MIBRAG. Previous guidance included $25 million of adjusted EBITDA contribution from MIBRAG during the second half 2009. However, the sale is expected to close during the second quarter.
As highlighted in this morning's press release, a number of market conditions are pressuring earnings, which include the lower commodity and capacity prices, transmission outages in the Northeast and South Central regions, lower generation from our gas fired plants and emission credit pricing. If these trends continue into the summer season, our guidance could be subject to a downward adjustment.
Free cash flow from recurring operations is expected to be $1.18 billion. The environmental CapEx guidance reflects expenditures before the benefit of the tax exempt financing at Dunkirk. Repowering investments net of third-party funding increased by $36 million from prior guidance, primarily as a result of initiating construction for the Langford wind project, which previously included only the turbine capital.
The two box numbers on the right highlight the free cash flow yields for 2009 given current share price and guidance levels. Using our stock price of $17.18 as of the close of the markets on April 29, NRG's free cash flow with the base business is $4.41 a share, which translates to a yield in excess of 25%.
I'll finish with a 2009 capital allocation outlook on slide 17, beginning with business reinvestment. We will continue to make the investments required to achieve our stated objective of top decile operating performance for our baseload fleet. Our environmental investments in 2009 are largely concentrated in the Northeast region to complete the Western New York baghouse projects and the ramp-up in spending for the Indian River plant to comply with state environmental agreements.
Capital management to-date includes the previously mentioned term loan B debt pay down, the financing for NINA, tax exempt financing for the Dunkirk baghouse project and financing of our GenConn Repowering project in Connecticut. Growth-oriented investments during the quarter totaled $87 million for Cedar Bayou 4, GenConn, the balance of plant construction at Langford and the continuing progress at STP 3 and STP 4.
In the near future, we expect to close the announced transaction with the eSolar, providing the platform for the development of 500 megawatts of solar power generation. On May 1, NRG is expected to close on the purchase of Reliant's retail business. Funding for the strategic transaction will be enhanced by the sale of MIBRAG, which, as I mentioned earlier, we anticipate being completed by the end of the second quarter with expected proceeds of €202 million or $259 million.
I'll now turn it back to David.
Moving on as we look forward, if any of you were to look up our core values on our website; safety, teamwork, respect, integrity, value creation and exemplary leadership; you will see that they spell out the acronym STRIVE.
Last year at our Annual Internal Management Meeting we focused on bringing those values to bear on capturing the extraordinary value and growth opportunities that were emerging in our industry as a result of the twin overriding societal dynamics of our age, fostering sustainability and combating climate change.
This led to our "Strive to Thrive" model which captures our intent to drive into renewables and other alternative energy solutions, and as the title suggests, solutions conceived for this century not for the last.
Since that time, the horizon of opportunity in our sector has expanded immensely as the extraordinary growth opportunity in alternative energy has been enhanced by the arrival of the new administration in Washington, which is totally in sync with these twin societal goals, and furthermore, has armed itself through the stimulus with extraordinary capacity to invest in furtherance of its sustainability and climate change objectives.
Even beyond alternative energy, the financial crisis has separated those like NRG who are in a strong liquidity and hedge position from those who are not, and has transformed the power generation business from a raging seller's market to the most significant buyer's market that I've seen in my 20 years in this industry.
We are seeing attractive growth opportunities in alternative energy, in our fossil fuel-based generation business, and in assets and businesses closely related to our core generation business, both upstream and downstream. We are pursuing opportunities in all three areas and already have had significant success as demonstrated by the Reliant acquisition.
In respect to that acquisition, we are following the path that we followed with the successful execution and integration of the Texas Genco acquisition back in 2006. The Genco M&A effort then and the Reliant M&A effort now are based on the three key elements depicted on slide 19. The net result of this collaborative approach has been that, as I mentioned earlier, we close tomorrow one month ahead of schedule and less than two months since the deal was announced.
The strategic logic of combining our leading generation position in South Texas with Reliant's retail electricity franchise has been well understood, so I won't repeat the rationale set forth on the top of slide 20. Tonight, at midnight, we at NRG working with our new colleagues from Reliant Energy assume the responsibility for turning that strategic logic from rhetoric into financial reality.
I want to emphasize that neither we at NRG nor our new colleagues at Reliant Energy take that challenge lightly, as we are well aware that the retail electricity business is a management-intensive, highly competitive, intensely public business in which mistakes and poor performance are not quickly forgotten or easily repaired.
Just as an illustration of the management challenge, while we expect Reliant to provide about 10% of our EBITDA going forward, the amount of new personnel, the head count additions of this transaction increases our overall head count by about a third.
Tonight, as we take up that task I want to assure all of you, our shareholders that we are taking our responsibility very seriously and we intend to keep you informed to the fullest extent possible.
I want to start today in terms of keeping you informed on slide 21 by providing you with an overview of our approach to the integration of Reliant into NRG. As depicted, we believe success in retail is derived from five core competencies. In two of these competencies, marketing branding and customer service, Reliant Energy is in our opinion best-in-class and NRG's approach is to let them do what they do best. Like with Texas Genco, our first integration priority in terms of the customer-facing side of the retail business is "Don't break it."
A third core competency, government and regulatory affairs, in this case we're talking about in Austin, Texas, is an area where both companies are active and we already are working together in a close and harmonious fashion. You might think that this area has been difficult to synchronize since we as generators and Reliant as retailers approach the power business from different perspectives in ERCOT, but as both companies have as an overriding objective the proper and rational functioning of the ERCOT market, this has been relatively easy.
Finally, there is wholesale supply and the risk management and credit required to support retail. Our assessment that these are the areas where there have been issues in the past for Reliant and for other generation short retailers both in Texas and elsewhere.
This is the area of the retail business that NRG will assume direct responsibility for starting at midnight tonight with the merger of the real-time desk, the adoption of a unified risk management policy and the novation of the Merrill Lynch credit sleeve. Of course, that's all on top of the 11,000 megawatts of base, intermediate and peaking capacity that NRG has standing ready to support Reliant and their customer load requirements.
As we go forward, we are thinking about the integration of Reliant in two phases, a stabilization phase, which is projected to last for the remainder of 2009, and the integration optimization phase, which is tentatively scheduled for the following 12 months or in calendar year 2010.
As we reported to you in the quarters to come, we will advise you of our progress and satisfying these objectives and we will do so with considerably more quantification than we are providing at this preliminary juncture.
Let me just say what I think is particularly noteworthy about this combination. Unlike a lot of acquisitions, we are not looking at these two integration phases as some sort of financial loss leaders. We expect the new Reliant Energy to be EBITDA and free cash flow generative to NRG virtually from day one, adding to our firepower to enhance the overall business of NRG and other dimensions.
Another aspect of the Reliant acquisition which is exciting to us is the extent to which Reliant and its 1.7 million customers, all of whom reside in a progressive resource-rich energy market like Texas, opens new windows of opportunities for us in mass market alternative energy such as rooftop, solar, distributed generation, smart meters and other efficiency technologies. We are just beginning to evaluate where NRG and Reliant have the greatest combined competitive advantage in this category of opportunities, a category which I call "Distributed Green."
I can assure you that we expect to be very active very soon in this regard. One of the reasons we expect to be very active very soon is because we need to be if we wish to capture the opportunity. Distributed Green solutions is what Washington wants above all else, and between the stimulus and the push for federal climate change legislation and/or a federal renewable energy standard, Washington wants it as soon as possible and it intends to provide a very substantial amount of financial support to make it happen.
Fortunately for us, the Repowering NRG and econrg initiatives, which we announced and began to pursue in 2006, put us in a relatively strong position to gain federal support for a variety of our projects. Almost every new project we have been investing in either advances sustainability, combats climate change or does both. As depicted on slide 24 we have applications either prepared or submitted for a broad range of first mover technology projects being developed by NRG.
Our overriding goal, and you are likely to hear this theme again many times in the future, is to be a first mover in the energy business that climate change and sustainability will create. I can't emphasize enough that this is where we expect the growth to be in our industry, this is where the shareholder vitae will be realized and it will be realized by those who are nimble and proactive in its pursuit.
In terms of Washington issues, let us move from the stimulus, which obviously is fact, to the highly uncertain world of prospective legislation. While there has been a lot of focus on climate change legislation, and we at NRG, as a member of the US Climate Action Partnership favor responsible climate change legislation, the most dramatic development in this area in this Congress has been the reemergence of a tough federal renewable energy standard which may be enacted as part of comprehensive climate change legislation or may be enacted on a standalone basis.
Federal RES is a policy initiative that is not part of the US cap blueprint, which favors a pure cap-and-trade approach to regulating greenhouse gas emissions. It's too early to tell whether a federal RES will become law. From a public policy perspective, we would prefer to see a federal clean energy standard with the key difference being between a RES and a CES being that clean coal and new nuclear would also qualify under a CES.
Our preference, obviously, is logical in terms of clean coal and new nuclear's critical role in combating climate change, but it would also go a long way in reducing the cost and addressing the interregional inequities in wealth transfer that would occur under federal RES between the wind, solar and geothermal-have states and the renewable-have-not states.
That leads to our preliminary assessment of the impact of a federal RES on incumbent generators. Our analysis indicates that so long as the transmission exists to wield these new power sources, an influx of new renewable generation on wholesale power pricing is going to be most severe in low growth markets, which have not yet experienced a significant degree of market penetration from wind and other renewables.
From our perspective that gives us a high level of concern about MISO and Western PJM as demonstrated on slide 26, which have experienced to-date only one-fourth the level of renewable penetration as we have seen to-date in ERCOT. Of course, this assessment is very preliminary and depends on legislation, regulation, and most importantly, transmission build-out of projects, such as the Green Power Express, which has recently achieved the first step of favorable rate treatment from the FERC.
Moving on to slide 27 and climate change legislation itself, it would be foolish for me to comment on the prospects for this major legislation or its content during the period when the bill is being marked up in subcommittee as we speak. One important note is that it seems clearer by the day that if comprehensive climate change legislation is to pass, it has to be a moderate bill that is not punitive in the early years to the coal states or to coal dominated power generators.
This leaves NRG in the same position with respect to climate change that we've been in since the beginning. Under a properly structured bill, we will not be negatively impacted financially by climate change legislation until the very end of the next decade. Further, we will only be negatively impacted then to the extent that we fail in our low and no carbon Repowering program, and that we do not intend to do as we've demonstrated by our progress and our value accretive successes today.
So, moving to the conclusion on slide 28, sustainability, climate change, competitive access to capital, and by that in this environment I mean access to low cost government supported capital and taking advantage of the benefits of the commodity price cycle to lock-in the input leg of our dark spread. That is how value is created in this market environment. I'm as confident as I've ever been that the type of value creation we have demonstrated with the Reliant Energy transaction and other initiatives is the type of value creation you will continue to see from us as we go forward.
With that, we are happy to answer any questions.
(Operator Instructions). Our first question today is coming from the line of Lasan Johong, RBC Capital Markets.
Lasan Johong - RBC Capital Markets
If you take a look at page nine of your presentation, it looks like you are taking a little bit of a bet on that for gas prices, at least in 2012 anyway. I'm not objecting to that, I think that's probably not a bad move. If you take that to the logical conclusion, one could suggest that at the bottom of the natural gas pricing formula you might want to monetize some of that $1.6 billion of in the money hedges, and then do a double benefit to shareholders by selling out that hedge and using to pay down debt potentially, and then riding the upside back again on the gas prices.
Is this a strategy that you would consider doing?
Lasan, it's a strategy that we would consider doing, I guess I would say on the margin. It's a core part of our overall business model to be pretty heavily hedged with our baseload and we like the level of hedges that we have. You are right.
We see the dynamic that you are talking about, and we never say never if you're talking about taking off hedges, and then ride it back up. That's something Mauricio and his team consider every day and he is looking at me in a very grouchy fashion. So I will just leave it at that.
Lasan Johong - RBC Capital Markets
How concerned are you about the Texas wind situation, since it's starting to have an impact on your numbers?
Obviously, for this year you mentioned that over the next couple of years the baseload is pretty well hedged out. So it shouldn't have really much effect on us over the next couple of years, and I guess the wind investment will start slowing down a little bit. So I think as we go forward, the main thing that's really going to drive us is gas prices in Texas. That's really is going to be the thing that moves the needle for us.
The discussion we just had with the decline in rig count and what we think will be a falloff in production as well as a recovery of higher gas usage, we would think that prices get strong recovery and that around our baseload is what really drives the needle for us.
What Bob is saying and your question is, certainly our theme is renewables are a fact of life. They've been a fact of life in Texas for the last couple of years and I think that's going to spread into all of the markets in the United States. Our approach more generally rather than just be concerned and wring our hands over the renewable penetration, first we want to be a leader in renewables as we start to do.
We also are looking at, of course, our gas plants from a firming perspective and making sure that market structures in the markets are properly structured, so that the fossil fuel generation that stands behind renewables is properly compensated.
We have a multipart strategy, but I just want to emphasize that we recognize that that is going to be a much bigger part of the mix in all of the markets going forward than it's been in the past. The fact that Texas is first gives us a chance to work out what the optimal portfolio is going forward.
Our next question will be coming from the line of Anthony Crowdell of Jefferies & Company.
Anthony Crowdell - Jefferies & Company
Just want to go over my understanding of the Annual Shareholder Meeting. I believe the one in 2008 was held like May 13. Is it a requirement that the shareholder meeting be held within 13 months of the previous one?
The NRG Board hasn't decided when this year's [shareholders] will be, but it will decide in the next few weeks. I think what the Board is trying to decide is balance between having it as soon as it can obviously, but also having it at a time when the shareholders are as fully informed as is realistically possible with information that's relative to the important decisions that have to be made.
As to what exactly is required under Delaware law, my understanding is that the way that the law reads is that if a company does not have an annual shareholder meeting within 13 months, then a shareholder or a director can petition the Delaware court to set a date. There is no affirmative obligation on the board to have it within that time period off the top. You would have to check that with a Delaware lawyer, but that's my understanding.
Our next question will be coming from the line of Amit Thakar of Deutsche Bank.
Amit Thakar - Deutsche Bank
I had a quick question on some of the credit development. Obviously, we have a little bit more visibility on who is going to be building the projects when the PCC announces at the end of March. I guess we have been hearing anecdotally that some of the priority is going to be given to some of the projects that are going to move load from the West zone to the South zone first, and given some of the initial coal plants that are planned for the South zone and some of the wind in Kennedy County and other coastal regions within the South zone.
Have you guys been seeing forwards where we will see the South zone heat rates falling relative to the West zone, and has there been any kind of follow-through in the Eastern zone, which obviously impacts you guys more?
This quarter, as you know, the POCT announced the selection of the transmission service providers. What we are hearing is the transmission providers that were not selected are appealing the POCT orders. So, I think that's going to slow down probably the process. Also, the POCT laid out a more detailed timeline for the completion of these first projects a very aggressive timeline through 2013. The developments on what happens with these transmission providers were not selected. I think they're going to slow down the process.
Now, with respect to wind penetration, we are seeing more megawatts in the South (inaudible) and Gulf wind farms along the West and the North zone. There is more wind going into all the regions in Texas. This is primarily affecting some of the hours in the off-peak, but definitely not affecting on-peak heat rates in the Houston zone or displacing gas.
Keep in mind that most of the weak prices that we have seen in this first quarter in Texas and across the Eastern Interconnect have been driven primarily by the lower demand quarter-on-quarter, which have been around 3.5 to 5% on a weather normalized basis.
So if I have to put an order of what is affecting heat rates, I would say first demand and then wind probably in Texas on some of the off-peak hours.
Our next question will be coming from the line of Neel Mitra of Simmons & Company.
Neel Mitra - Simmons & Company
I wanted to understand the earnings profile from South Central, the change between 2008 and 2009. First, you stated that earnings were adversely affected from the lower market prices. I just wanted to know how much of the load is either un-contracted or the pricing on the contract moved with current power prices.
Second, from what I understand some of your load contracts began to roll-off in March. I wanted your thoughts on setting new contracts in this low gas price environment.
In terms of the results, the main thing on South Central is nothing has changed in the contracts this year. It's just that you have length in the off-peak periods. With merchant prices coming down and you sell that power into the merchant market, so that had an impact in terms of the pricing.
The other part of that is the capacity factor year-over-year was down. So that, again, takes megawatts you typically can sell into the merchant market during the periods where you have length. You have less to sell and what you're selling had a lower price. So that was the real driver in terms of what was happening.
You also had some power supply that we have in MISO that we bring, and then there was a transmission outage, so we lost a little bit on that as well. So that's really what drove it. Again, we're comparing against the first quarter last year where the South Central organization everything broke the right way and the output from the plant was at record levels and the pricing was strong. So, that's really the main difference when you look at the 2009 results.
Neel Mitra - Simmons & Company
On the Texas gas plants, I know historically you've guided between $100 million to $250 million with EBITDA. I was just wondering how this year would compare to that with the weak spark spread environment, but also with an offset from Cedar Bayou coming on in June.
I was just looking at that this morning and a good portion of our output for this year is hedged. When we take a look at where the gross margin on the gas plant in Texas will come in, we're still in the $100 million to $150 million range for this year all-in with Cedar Bayou.
Our next question is from the line of Leslie Rich, Columbia Management.
Leslie Rich - Columbia Management
I wondered if you could walk through the working capital change year-over-year again. Again, you mentioned part of the reason was higher coal inventories. But what were some of the other components?
If you go to slide 14, you see the big inflow on the collateral and the big outflow on the working capital. You have to look at those two numbers net. What's creating a lot of noise in the working capital is last year we had those natural gas option trades. We had options and we had some swaps. Basically what happened is that on the collateral side, you have the big source coming in from the swaps where they were out of the money, and then when they settled this year, you had the decrease in the asset. We had kind of an asset of margin paid at the beginning of the year where we had posted collateral. When that position closed out this year that asset goes away. So, that's actually the source you're seeing showing up there.
On the other side of it we had options where we had premiums that we had collected. So we were holding money at the end of the year that when the option position settled in the first quarter, we actually got to keep that money. So you actually had something that when you're holding the money, since it's someone else's at that time, it's a liability. When it gets settled, you get the decrease in the liability which is the used which is the big negative that you see there. So that's what is happening in those two line items. You have to look at those things net. If you collapse them down between the options and the swaps, it's a very small number, maybe in the order of magnitude of $30 million or so.
Now take that aside and go to some of the other business reasons. Coal inventories are building for two reasons. Strategically, we're actually building the inventory at South Central because we got some outage work that we want to do later in the year where they unload the coal in the river cells. In Texas, we've been building the WA Parish coal inventories as well, and then in the Northeast with the reserve shutdowns that we've been experiencing, they've been building up. So they are really the two main drivers of the changes in the working capital and the collateral.
Some of that was understandable. The options is a difficult one to explain, but you have to look at it net and the number is not as big as it shows on these line items.
Leslie Rich - Columbia Management
As you look at the change over the past two months and you see 2010 come down, but the backend of the curve go up, to what would you attribute that, and really how much liquidity is out there or are we backing into that number based on the gas price?
So the question is if the outer end of that actually being traded or is it more theoretical? Is that the question, is there liquidity out there?
I think you pointed out one of the reasons why the market has moved off slightly. Liquidity is very thin on the back years, not only Texas but I would say across the power markets. The other two reasons is, one, I believe it's partly the recognition of a slowdown in absorption of new generation not only on wind but just across the merits of order, natural gas.
I would say last is probably just the uncertainty around regulatory legislation, around carbon, climate change, et cetera. So when you combine those three things, I think they're just putting some upward pressure on the curve, but clearly liquidity is one of the factors.
We will take the last question from Greg Orrill of Barclays Capital.
Gregg Orrill - Barclays Capital
If you do have time, I would be interested in the question on the effective tax rate, but otherwise I wanted to reconcile some of the statement on the Reliant retail contribution being 10% of adjusted EBITDA and the idea that if current conditions continue the yearly guidance for EBITDA might have to come down. Is the idea that the Reliant contribution would work up to 10% of EBITDA?
Before Bob gives you an accurate answer, first of all I would said approximately 10% may be the closest whole number compared to us adding to head count of a third, so I won't put the 10% in stone.
I think when you think of the contribution this year, when we put the guidance out before, again, we were admittedly on the low end. We're closing the transaction a month earlier than what we had previously thought when we had the last call. So the contributions this year will be greater than what we anticipated from Reliant retail.
I think any weakness we have during the course of this year on the generation, I think to a large extent would be offset with retail performance and the additional month that we have. So, I'm not going to change the numbers that are out there at this point in time. We will do that in the second quarter. Again, I think the numbers that are out there are conservative.
Gregg Orrill - Barclays Capital
Your comment would have contemplated the transaction closing.
Yes, but it is closing a month earlier than we had previously talked about.
Gregg Orrill - Barclays Capital
Your comment on the trend in EBITDA?
Correct. When we had these options it created unrealized capital gain at the end of the year, which we were able to offset that with capital losses. Now when you go into 2009, you reverse that accrual and it creates a capital loss. We don't have any capital gains to offset that capital loss with, so it spikes the effective tax rate by 19%. Net-net, we are even on a cash basis, but you had a benefit last year that although it did not go through the rate it went through paid in capital, this year it goes through the effective tax rate so it spiked the rate on us.
Economically, there's not an impact. Our cash taxes are the same. Our cash tax rate will be about 10%. It's just the way that the accruals and the ETR worked out. So while the effective tax rate is 60%, literally 19% of that is caused by this option transaction.
On that note I think we need to conclude. We know other people have calls. We appreciate everyone taking the interest in NRG and we look forward to speaking to you next quarter.
This concludes today's teleconference. You may disconnect your lines at this time and thank you for your participation.
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