Electricity producer/wholesaler Mirant (MIR; $10.61 per share; MV $1.5 billion), which reports 3Q10 earnings this Friday (November 5), is in the process of merging with rival RRI Energy (RRI; $3.76 per share; MV $1.3 billion). Both companies appear materially undervalued on a standalone basis, with each trading at less than half of tangible book value and less than $200K per megawatt of electrical generating capacity, compared to a range of $300-700K for industry participants Dynegy (DYN), NRG Energy (NRG), Calpine (CPN) and AES Corp. (AES):
|Mirant: Comparable Company Analysis1|
|Company / |
|EV / |
|MV / Tangible Book||Net Debt / |
|AES Corp. / AES||$9.5 bn||$28.9 bn||40,529 MW||$712,000 per MW||2.0x||2.9x|
|Calpine / CPN||$5.6 bn||$14.8 bn||24,738 MW||$600,000 per MW||1.2x||2.0x|
|NRG Energy / NRG||$5.1 bn||$10.2 bn||24,005 MW||$425,000 per MW||1.1x||1.1x|
|Dynegy / DYN||$0.6 bn||$3.8 bn||12,221 MW||$313,000 per MW||0.2x||1.2x|
|Averages:||$513,000 per MW||1.1x||1.8x|
|Mirant / MIR||$1.5 bn||$1.4 bn||10,076 MW||$141,000 per MW||0.4x||0.0x|
|RRI Energy / RRI||$1.3 bn||$2.5 bn||14,581 MW||$174,000 per MW||0.4x||0.3x|
1 - Based on closing share prices as of October 29, 2010. All balance sheet values are as of June 30, 2010, except for Calpine (as of September 30, 2010). Generating capacity is based on recently available data.
2 - Enterprise value includes net pension liabilities, net derivatives, restricted cash, funds on deposit and investments. AES enterprise value includes $14.6 billion of non-recourse debt.
Lots of questions may be on investors' minds including the following:
1) Why is Mirant issuing shares to buy RRI when its own stock appears to be materially undervalued?
2) Are Mirant's assets inferior to its competitors as suggested by the above valuation table?
3) Is there a cross-read from Blackstone's recent bid for Dynegy? (Blackstone is offering an implied >$300k per MW of Dynegy's generating capacity - more than twice Mirant's valuation)
4) Is Mirant "doomed" given historically low natural gas prices (which correlate with electricity prices) and declining "dark spreads," i.e. the narrowing of the spread between electricity prices and the price of coal (major fuel source used by Mirant to produce electricity)?
5) Why is Mirant spending ~$500 million to build 760 MW of gas-fired capacity at Marsh Landing in California ( >$650k per MW), when the company's implied valuation is ~$150 per MW?
The clue to some of the above questions may be Mirant's dependence on coal as a fuel source (~80% of total fuel used). But, then again, the acquisition of RRI should change that as the combined company, to be called GenOn Energy, will have nearly 40% of capacity based on natural gas (with another ~30% dual-source).
Be it as it may, Mirant is one of the best-capitalized companies in the industry, and the balance sheet of the combined Mirant/RRI will carry less leverage than either of DYN, NRG, CPN or AES. While Mirant's trading multiples are negatively affected - and rightfully so, to an extent - by relatively heavy reliance on coal in electricity generation as well as declining benefits of hedging in 2011 and beyond, earnings-based valuation measures can be notoriously misleading. Analysts expect Mirant to earn $1.54 EPS this year but only $0.12 next year as a large portion of hedging benefits goes away. The assumption in analysts' expectations, of course, is that "dark spreads" will remain depressed in 2011. With the price of electricity correlated with hard-to-predict natural gas prices, we question analysts' ability to forecast dark spreads with precision. We can envision a scenario in which dark spreads surprise on the upside just as Mirant and RRI are starting to benefit from merger-related cost synergies ($150 million, to be fully realized starting in January 2012) . The result would be financial performance that might necessitate a material upward adjustment in the Street's valuation of the combined entity, GenOn. The below table provides estimate ranges for the fair value of Mirant as implied by the valuation of its competitors:
|Mirant - Estimate of the Equity Fair Value Range|
|Fair Value Multiples||Estimated Fair Value|
|($ in billions)||Low||High||Low||High|
|Valuation based on…|
|…comparable EV / generating capacity multiples:1||$313K/MW||$534K/MW||$3.2||$5.4|
|Add: Derivate assets, net||0.7||0.7|
|Add: Funds on deposit||0.2||0.2|
|Less: Pension liability, net||(0.1)||(0.1)|
|Estimated equity value of Mirant - based on generating capacity (1):2||$3.3||$5.5|
|$22 per share||$38 per share|
|Valuation based on…|
|…comparable price / tangible book multiples:3||0.4x||1.5x||$1.8||$6.4|
|Estimated equity value of Mirant - based on tangible book (2):2||$1.8||$6.4|
|$12 per share||$44 per share|
|Estimated equity value of Mirant - average of (1) and (2):2||$2.5 billion||$5.9 billion|
|$17 per share||$41 per share|
1 - See comparable company table. Low value multiple is based on Dynegy's recent multiple, high value estimate on 25% discount to recent multiple of AES.
2 - Based on shares outstanding of 146 million.
3 - See comparable company table. Low value multiple is based on two times Dynegy's recent multiple, high value estimate on 25% discount to recent multiple of AES. Note that Dynegy is significantly more leveraged than Mirant and may be considered a distressed equity.
With a strong balance sheet and a market valuation barely in excess of one-third of tangible book value, the current Mirant offers strong downside protection and above-average upside, in our view. The pending merger with RRI has been approved by Mirant and RRI Energy shareholders on October 25. While it remains subject to clearance by the U.S. Department of Justice, Mirant management expects to “complete the merger by the end of the year.” Although Mirant shareholders might be giving away more value than receiving in the 100%-stock merger (based on relative undervaluation of Mirant versus RRI stock and the unfavorable treatment of ~$2.7 billion of Mirant's federal NOLs), the merger reduces Mirant's dependence on coal versus natural gas, which may prove beneficial over time.
In summary, the above questions may hint at possible reasons why "Mr. Market" is valuing Mirant at a discount to its peers. While not all answers are favorable to Mirant, our conclusion is that the risk-reward implied by Mirant's share price is attractive. By the way, this also seems to be the view of John Paulson, whose hedge fund owns more than 12% of the company.
Disclosure: No positions