Wholesale Power: A Smart Alternative to Regulated Utilities

Make no mistake: the tumble stocks took in late 2008 has changed the way we invest. The uncertain market has changed our risk appetite. Right now, most eyes have turned to the “widow and orphan stocks” – the stocks deemed safe enough for even the most unsophisticated and conservative investors.

Among them are regulated utilities.

Investors have long favored utilities for a few very good reasons: predictability, recession-resistant revenues, steady streams of dividends and government-sanctioned monopolies. They’re a safe haven for stressed investors in the midst of a recession. But, while much of the retail stock buying market focuses its attention on the predictable utility stocks, one deeply related and highly profitable niche is being left to the wayside.

I’m talking about wholesale power generation…

Many people don’t realize the fact that power companies — like PG&E, ConEd (ED), and my local friends at Baltimore Gas & Electric (BGLEP.PK) — don’t own all of this country’s power generation facilities. A different class of utility stocks, known as wholesale power generators, engages in turning commodities like coal, oil, and natural gas into a very different commodity – energy.

While most investors don’t think of energy as an investable commodity, it is. Utilities (and a number of other players) trade power just like retail investors trade stocks and options. And behind it all are the wholesale generation companies that power the grid.

NRG Energy (NRG) is one such company. This generation firm operates 48 power generating facilities internationally using coal, oil, natural gas, nuclear and alternative fuels. In the aggregate, the company is controls facilities that generate a total of more than 24,000 MW – enough to power between 4 and 8 million U.S. households, according to Wolfram Alpha. And, unlike most of its peers, NRG is actually in the process of constructing additional generation capacity right now.

In the highly leveraged power generation industry, NRG is a best-in-breed stock with phenomenal operating metrics and a strong balance sheet, all at a relatively cheap price.

NRG’s Operational Prowess

In spite of difficult economic conditions and a decrease in power demand, the company closed a record year in 2008 with net income of $1.2 billion. That huge income number was thanks in part to prescient hedging amid rising commodity costs, something that the company has proved itself very capable of since it emerged from bankruptcy proceedings in 2003 in the wake of an Enron-induced collapse of the unregulated utility space.

Since then, with a management team headed by energy industry veteran David Crane, the company is preparing to enter a new decade with a markedly different financial footprint.

And NRG is stepping up to the demands of that new decade by embracing alternative energy sources like solar thermal, and wind power – and keeping them monetized. In June, NRG penned its latest deal with Pacific Gas & Electric to provide 92 MW of clean solar thermal energy from its Lancaster, California generation center.

With the Golden State’s serious peak energy needs in the summer months, the deal is more than green-energy PR for PG&E – it’s a cost effective means of helping to quench California’s power shortage.

But California isn’t the only strategically smart locale in NRG’s portfolio. NRG owns 1,400 MW of in-city generation capacity in New York City, as well as generation assets centered on metro areas in Texas, the greater Northeast, Europe and Australia.

From a financial perspective, NRG is an attractive buyout candidate – and the company knows it. The company turned away a $7.5 billion takeover offer from Exelon (EXC) in October of 2008, as well as a $7.9 billion pre-crash offer back in 2006 from Mirant (MIR).

Both of those unrequited merger opportunities are telling about NRG’s management – while C-level stock options would have appreciated nicely under either offer, Crane and his team clearly believe that the company is on the path to be worth considerably more on its own in the intermediate term. I’m inclined to agree.

These Are Some Powerful Financials

NRG’s profitability isn’t the only thing that makes this stock attractive right now. The company is also making a very enticing value case for investors who aren’t afraid of going long in this market.

With a price-to-earnings ratio of 5.96, NRG investors are paying 88% less for this company’s earnings than for those of its industry peers. That’s thanks in large part to a nearly 20% slide that shares have taken since an analyst downgrade to “Hold” in early October.

That 20% discount in price has lead to some interesting valuation metrics – like a price-to-book ratio of 0.8. A P/B that low is nearly unheard of for asset-centric industries like power generation, and with the costs of building power plants 40% higher in the last three years according to analysts at Morningstar, chances are good that the market value of NRG’s generation assets exceeds what’s on the books… especially in hard-to-penetrate markets like New York City.

On a per-share basis, NRG sports $31.46 in net assets, of which nearly $6 per share is quick, liquid assets. All told, the company has $4 billion of liquidity, and enough hedging in place to ensure that its cash needs are more than adequately covered through 2010.

Technically Timely

Shares of NRG look attractive from a technical standpoint as well:

The company hit a seemingly impenetrable resistance level just below $29.50 for the third time back in October just as the stock’s downgrade sent it sliding. But that freefall stopped just a few days ago when shares collided with support at the 200-day moving average.

That’s significant because it tells us that while investors overcompensated in selling down to the $23 mark, the stock is still obedient to the technicals. It also means that with most indicators showing the stock as oversold right now, and shares sitting right above support, now should turn out to be a great time to pick up a stake in NRG.

Dealing With the Market’s Malaise

Like most stocks, NRG is highly susceptible to the market’s recent mood swings. And with investor confidence waning at the prospect of another tumble into 2010, that means that going long on this otherwise amazing power generation play leaves some risk on the table. That’s something that we’ll deal with by monitoring this play very closely in the coming days and weeks.

With shares otherwise perfectly aligned fundamentally and technically, this play looks ready to dive into right now. We’re taking our position at NRG’s current price of $23.59 for the model portfolio.

Disclosure: NRG is a holding in the Rhino Stock Report's model portfolio

Comments

[colinjsmith:]

I agree with all of your points - one additional utility-based pay are ESCO's or Energy Services Companies that stand to benefit from energy efficiency performance contracting.

Nov 06 06:40 PM

[john s. gordon:]

NRG benefits from modern low-heat-rate (higher thermal efficiency) plants compared to some of the pre-1950 dinosaurs that are still operating in various parts of the country.
since we don't know for sure what the impact of the various schemes for capntrade or carbon tax will be, we will have to keep an eye on this one.
> jack

Nov 07 09:12 AM

[Leila and Ella:]

Well written. I've been buying NRG all year for all the reasons you stated. Ran out of ammo during the recent dip and I'm conflicted about selling out some of my other profitable positions to add more NRG, but you may have tip the scale. Thanks. Keep up the good analysis.

Nov 07 02:03 PM

[ed ng:]

I was tempted to buy NRG as trades at a 'discount' to its peers (like Exelon) but more detailed research stopped me from doing so. Unfortunately it is prone to failing, again - simply, their debt level is too high. Leveraged loans totalled 3.77 bln maturing on 2011, and 4.44 bln maturing on Nov 2013. Net debt 8.74bln they borrowed is even larger than their current market cap !!!!

They earned roughly around 1bln TTM. If they aren't able to refinance the debt, or if they need to repay their debt solely on their net income, each year they need to earn more than 2bln from now on, which is around 100% profit growth.

Is this possible in best-case scenario? Is it possible they are going to lose liquidity on further credit crunch?

Exelon don't just trade at a premium of it's peers (like NRG) for no reason.

Nov 09 01:14 AM

[tooearly:]

Regarding the last post on NRG debt, you need to double-check your facts on the 2011 maturity. You might be looking at their *untapped* revolver due 2011, but their K shows they owe around $90 million for 2011.

Against their 2013 debt, NRG has about $2.2 billion in cash, and generates about $1 billion in free cash flow. The terms of that debt require NRG to offer a portion of their cash flow, so in 2010 they'll pay down about $400 million of it. I don't see a debt maturity in 4 years as being a particular risk relative to the amount of their cash and free cash flow.

Nov 09 08:36 AM

[ed ng:]

I am sorry you are talking to a loan and debt expert. I think it was you overlooked.
Concerning debt maturing 2011,
I. Maturity Date Feb 02 2011, a 1 bln leveraged loan - revolving credit for supporting the acquisition of Texas Genco by NRG energy, announced on Nov 11 2006 (There were 3 tranches, only the first tranche is relevant to this maturity). The M&A value was 231.7mln. Priced LIBOR 200bp, BoA-ML, MS were bookrunners.
II. Maturity Date Jun 08 2011, a 1 bln leveraged term loan announced on May 4 2007. The proceeds are for repayment of debt and general corporate purposes. NRG repaid 400m of its Term Loan B facility on Dec 29, 2006, CUSIP #622937NAJ6, priced LIBOR 200bp, again. Citi and CS were bookrunners.
III. 31 Dec 2011, 2 tranches inherited from Texas Genco LLC signed on Dec 14 2004, 7 years term loan B also at LIBOR 200bp, total tranche value 1.625bln. Staple financing. The proceeds were to finance 3.65 bln buyout of Texas Genco by GC Power Acquisition. Citi, DB, GS, MS were bookrunners.

Their profits growth track record were mostly achieved by M&A, not organic.

I am reiterating that NRG trades at a "PE, PB valuation basis discount" because they rely too much on debt. Look at the deals done by Exelon. They were mostly IG.

I am not recommending to buy/sell/hold Exelon, NRG. Just to point out the analysis is fundamentally flawed.

Nov 09 10:48 PM

[Leila and Ella:]

blah, blah, blah bottom line, the company is making lots of money -- enough to meet its debt obligations and more -- and is looking to make even more with the recent purchase of wind energy asset. Further, it's still selling under book value and less than what Warren Buffett paid for his share of the company = buy and buy lots of it while it's still under $25/share. Doubled down this morning.

Nov 11 10:25 AM

[ed ng:]

Their book value is just $15. Intangible like goodwill can meet debt obligation? Meeting debt obligation by refinancing?

Nov 11 12:04 PM

[ed ng:]

Don't forget if you followed him on ConocoPhilips you are caught LOL

Nov 11 12:05 PM

[Jonas Elmer...:]

Hey guys, glad to see that the discussion's heating up... Just to clarify a few points:

Yes, NRG is highly leveraged. That's par for the course in the power generation industry, and at present the company's debt service is relatively secure through 2010.

NRG's book value less intangibles and goodwill is around $17 per share, but that assumes that the company's power generation assets are only worth book. Like the article mentions, though, that's unlikely the case. I'd estimate that with a more realistic valuation on those properties, we're looking at $39.70 per share with those same intangibles discounted.

Morningstar's Travis Miller puts NRG's sum-of-the-parts valuation at closer to $50 per share.

Because the company is such a strong buyout candidate, that real-world valuation carries a lot more weight than it would otherwise.

Not sure about the ConocoPhilips reference...

Nov 11 02:14 PM