Utilities are simple: Slow growth and a high yield.
In fact, these high yields are evidence that management can’t effectively reinvest that capital into the business. This is why companies like Exelon (EXC) pay a 4.9% dividend yield, because it is only growing revenue by a pathetic 3.4% a year. This has resulted in a stagnant bottom line since 2007, an all-too-common story in the utilities industry. There is a yin to this yang. The utilities industry is highly regulated. This only makes sense, because no one wants competing power plants in their neighborhood. This government regulation helps ensure some profitability for entrenched firms. This, in turn, helps provide economic moats to many large utility companies. The entry costs are enormous.
According to the CEO of NRG Energy (NRG), the base load energy supply in the U.S. is, on average, over 30 years old. He went on to say that most power plants are built to last 30 to 40 years. This is a turning point in our nation’s energy supply, and for NRG, an historic opportunity. Many of the large U.S. utilities have been spending consistently over the past decades to keep up with environmental reforms. This requires retrofitting plants alongside the normal maintenance expenses. Not only is there maintenance, presumably these plants will start needing massive amounts of refurbishing or even rebuilding in the coming decade. The United States is notoriously tough on nuclear power, but it has a piece of the pie. These coming plants are often being built with the ability to switch between coal and natural gas in order to profit from lower prices for either one.
Now back to where NRG fits in: NRG is taking what it views as an amazing opportunity and striking while the iron is hot.
You and I are not alone in buying NRG. Warren Buffet bought $113 million in shares in the second quarter. He thought it was worth it at 75% above the current price. Blackrock also initiated a position in the fourth quarter: around 10% of the outstanding shares.
The management of NRG is looking out for the shareholder’s interests for one simple reason: They are shareholders. The CEO, David Crane, owns $11.5 million in shares after a $3.5 million acquisition two weeks ago. This buying spree was part of a broader $7.7 million buying spree by management in the first week of the new year. Total insider ownership is up 28% in the last 12 months. 55% of David Crane’s salary comes in the form of stock and options, enough to ensure his loyalty to shareholder’s interests. As we know, however, it is not enough for management to have their hearts in the right place. Their minds have to be their too, which they have shown on multiple occasions.
In 2009, NRG sold its stake in MIBRAG from 24 times 2008 earnings. This was a strategic decision to return focus to American markets. In the end, this was a good move for the shareholders. This $280 million could then be reinvested in the core segments of NRG, adding to the strength of its U.S. assets. Another great example of the great management team was turning down the bid from Exelon. This bid seemed like a sweet deal at the time, coming with a nice premium. The offer peaked at $28.10 per share, well above the price at the time but also well below the actual value of this company.
NRG is currently trading at approximately half of its book value. This is due to declining EPS since 2008. This is a worrisome trend, and can’t be left unexplained. I will give answer to the decline in 2010 in a later report. The 2009 decline was due to a 270% rise in “corporate” expenses. This was made up of mark-downs on commodities hedges and costs related to the acquisition of Reliant. Regular valuations over the last decade would put NRG’s shares at around $40 apiece, and at least at $30. Technical analysis reveals the same thing. The summer and fall sell off in shares bottomed strongly and has since been rising with increasing force.
On top of this value, there is a strong contrarian play to be had with NRG. Kapitall does a great job of finding cheap, good companies quickly. NRG has shown up on four of these screens. It was the eighth most undervalued utility relative to analyst targets a few days ago. NRG was the only utility on the list of 15 deeply undervalued companies for 2011. It made the list of 20 highly efficient companies underperforming. NRG was the most oversold S&P 500 stock according to the Relative Strength Index. Finally, it was the 16th worst performer in the S&P 500 last year.
In buying NRG, a risk is taken. Profitability has declined in recent quarters due to increased costs, even as revenue continue to hit record highs. Here is a breakdown of where that revenue is coming from:
- Reliant Retail (in Texas): 45%
- Texas: 32%
- Northeast: 13%
- South Central: 6%
- West: 2%
- International: 2%
Reliant Energy is NRG’s retail business in Texas. Reliant actually contributed to greater than 100% of 2009’s net revenue. This was due to the 270% rise in “corporate” expenses mentioned earlier. It was purchased in early 2009 for $287.5 million in cash. This is astounding because it contributed $962 million in net income to NRG in 2009 alone. After a lot of searching, the truth comes forth. With this acquisition, NRG also took on $3 billion in derivative liabilities.
Here is a breakdown of power generation by fuel type:
- Natural Gas: 45%
- Coal: 32%
- Oil: 16%
- Nuclear: 5%
- Renewables: 2%
NRG Energy has cut emissions from continuing operations by 25% in the past decade, and it plans to make the emissions from all its plants equivalent to those of a very clean natural gas plant in the coming decade. This is part of a broader vision to differentiate itself from competitors. One in four Americans identify themselves as a green consumer, but only one in eight reflects this in their spending patterns. Take this in combination with the fact that the average American spends 1.7% of income on electricity, and NRG sees opportunity. They intend to make themselves the go-to man for green electricity as a way to separate from other utilities. They believe they can do this and charge a bit more without losing costumers.
NRG Energy is taking a whole new approach to the utilities business. This new approach is effective, and is growing revenue by 17% per year. It is also heavily sponsored by its own management along with some of America’s major investing institutions. The fair value for NRG Energy is around $40 per share assuming earnings stay flat. NRG is using its $4.1 billion cash position to buy its way into becoming the utility of the future with solar, wind, geothermal, natural gas, and other renewable fuels.