NRG Energy: Uncertainty Remains Regarding Profitability

| About: NRG Energy, (NRG)

Ever since NRG Energy Inc. (NYSE:NRG) exited Chapter 11 bankruptcy as a stand-alone entity in 2003, the company has been regaining strength and today, it is the second largest retail energy provider in the domestic market, with 2 million customers. Although the company's Mid-Atlantic fleet, which represents 26% of capacity through the purchase of nine Genon Energy's coal plants, has shown some issues, bullish gas and power prices should drive growth in the future.

After 2009's price drops, the company refocused its strategy on diversifying its revenue stream by investing in renewable energy, which should bring high returns on capital. However, the gas price drops over the past few years have put a strain on the firm's cash flow and balance sheet, causing some uncertainty among investors. This Friday the firm will be reporting its most recent quarterly earnings, which will give us a clearer view of what to expect for this fiscal year, but in the meantime I will focus on the existing data.

Profitability is one of the main factors one must look at when analyzing a company. It is not the only reason behind a company's existence, but also a key element when determining whether to invest in a company or not to. Thus, in this article I will look into NRG's earnings growth, profit margins, profitability ratios and cash flow. Additionally, I will evaluate which institutional investors bought the stock in the recent quarters.

First, let's take a look at NRG's earnings growth. For many stock investors, the most important thing is growth in earnings, because it's what fuels aggressive growth stocks. Therefore, it is of utmost importance that investors have an idea of how long a company can sustain a certain level of earnings expansion, since a company's valuation and its stock price are almost completely dependent on this fact.

Last quarter, NRG retrieved EPS of $0.37, compared to $-0.01 per share on the same quarter in the previous year. Some investors are bullish on the idea that the company will improve its quarterly EPS growth in the near future. Also, Wall Street research analysts just upgraded the company's EPS growth for the current year, increasing their estimates to 455.60%.

I also look at the three-year annual average EPS growth rate to get a perspective on how the company grew in recent years. NRG generated a very discouraging -11.93% annualized average EPS growth in the past 3 years, considering that the best growth stocks show 3 year average EPS growth rates above that level.

Sales and Revenue Growth
A key step in analyzing NRG is studying how sales grew in the recent quarters or years. Why is this important? Well, revenue growth cannot be masked with accounting tricks or via cost-cutting strategies. This metric tells you simply how demanded a company's products or services are. The firm reported a 49.72% quarterly sales growth year over year, surpassing my minimum requirement of 15% growth rate for these kind of companies, which is encouraging.

When betting on a company, an investor wants to see sales grow or improve over time - and not just in the last reported quarter. Looking at the company's financials in comparison to previous years will give participants a much better idea of how well a company is doing. In NRG's case, the three-year average annual sales generated a growth rate of -2.01%, well below the 15% mark, which is the minimum I am looking for in growing companies.

Gross Profit Margin

The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of the goods/services sold. A company that operates on a higher profit margin than its competitors is more efficient and investors will tend to pay more for businesses that have higher efficiency ratings, as these should be able to make a decent profit as long as overhead costs are controlled.

In reviewing NRG's gross margin over the past five years, an investor can see that the it has been strongly decreasing. In fact, the five-year low for the gross margin was reported at 26.5%, while its five-year high for this ratio was achieved over the past twelve months, when the margin reached 28.0%. Since the TTM gross profit margin of 28.0% is below the 5-year average of 45.2% it's clear that management has not been efficient in improving this key profitability metric.

Operating Margin = Operating Income / Total Sales

The operating margin is a measure of the proportion of a company's revenue that is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs such as interest on debt. If a company's margin is increasing, it is earning more per dollar of sales, therefore, the higher the margin, the better.

Over the past 5 years, NRG's operating margin has also been decreasing. For example, in 2009, the company reported an operating margin of 33.0%, but the company's TTM operating margin stands at 5.8%, below the 5-year average of 16.5%. This implies that there has been a reduction in the percentage of the total sales left over after paying for variable costs of production such as wages and raw materials compared to the 5-year average. I always stress that it is essential to find companies with improving profit margins. While a declining margin does not prevent me from investing in the company, I'm discouraged by this fact and hope to see this trend reverted sometime soon.

Net Profit Margin = Net Income / Total Sales
This ratio measures how much out of every dollar of sales a company actually keeps in earnings. The profit margin is a very useful metric when comparing companies in the same - or similar - industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors.

Over the past 5 years, NRG's net profit margin shrank, compared to the 5 year average. While the TTM ratio marked 4.10%, the 5-year average was 8.1%, showing a strong decline.

ROA - Return on Assets = Net Income / Total Assets
ROA is an indicator of how profitable a company is relative to its total assets and indicates how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage and is sometimes referred to as "returns on investment."

The firm's 2012 ROA of 1.39% is slightly below the 5-year average of 2.65%, which implies that the management has lessened its ability to use the company's assets to generate earnings over the past five years.

Free Cash Flow = Operating Cash Flow - Capital Expenditure
Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base and it's important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.

NRG generated a ratio of cash flow from operations/total sales of -15.05, which is very weak considering that the higher this percentage is, the more cash will be available from sales. If a company is generating a negative cash flow, this means that even though it can generate revenue, it is losing money.

Institutional Investors
Several institutional investors have been buying NRG stock in recent quarters. This is important because hedge funds use strict fundamental procedures before investing in a stock. In the most recent quarter, both Paul Tudor Jones and Larry Robbins - among other investment gurus - bought the company's shares at an average price of $28.28.

Analyst Outlook
Currently, many analysts have a positive outlook for NRG, despite the aforementioned negative metrics. Analysts at Yahoo Finance, for one, are predicting that the company will retrieve EPS of $1.50 for FY 2013 and an EPS of $1.84 for FY 2014. Analysts at Bloomberg are also estimating revenue growth, bumping 2013's $11.40B million to a solid $13.03B million for FY 2014.

Looking forward

Although NRG's balance sheet is unconvincing on many levels, there are factors that could catalyze growth in the future five-year period. A rebound in the power market, for example, would not only reboot prices, but also allow the company to generate strong returns on capital via its diversified fleet of nuclear, coal, natural gas and renewable energy operations.

However, regulatory risks remain present and could cause further shutdowns of important power plants, leading to a decline in earnings. Although the stock's current trading price of 15.80x trailing earnings is right on average with the industry median, I think investors would be wise to await this Friday, when the company will be reporting its most recent quarterly earnings.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.