7 Reasons Why NRG’s Offer for Calpine is Laughable

After the market closed on May 21, Harbinger Capital Partners (“Harbinger”) revealed that Calpine Corp. ((CPN) or the “Company”), of which Harbinger owns 24%, received an offer from NRG Energy Inc. (NRG) that valued CPN at roughly $11.3B or $22.60 per share. This represents a paltry premium to CPN’s current share price and investors should realize this move is simply an attempt by NRG to steal the Company from investors who may have difficulty in assessing how valuable the reorganized CPN and its fleet of power generating assets will be.

Unfortunately, Harbinger appears willing to sell CPN sooner rather than later. Harbinger holds a significant chunk of the Company’s warrants which expire in August. In order for those warrants to generate value for Harbinger, CPN stock must exceed $23.88 by August 25th. Second, since Harbinger was involved in the reorganization of CPN, its cost basis for the common shares it owns is probably extremely low, making a sale in the $24 range more than acceptable. In addition, SPO Advisory Corp. (“SPO”), which owns 15% (or more) of CPN, appears to be aligned with Harbinger, which means nearly 40% or more of the shares is controlled by these two entities. This would be similar to Harbinger’s push to sell Northwestern Energy (NWE) once it emerged from bankruptcy a few years ago. Nonetheless, discussing why NRG’s offer makes little sense for those that did not receive shares through debt for equity swaps may help sway the remaining investors and Board.

Before discussing why NRG’s offer is a joke, it’s important to note that CPN’s Board made a serious mistake by not disclosing the NRG offer. CPN is owned by the shareholders and those shareholders should determine what price the Company will sell for. While the NRG offer is a pittance, the Board should have immediately notified shareholders when the offer was made on May 14, rather than be upstaged by Harbinger. Since that time, CPN has retained Goldman Sachs (“GS”) as an adviser, but shareholders should be aware that GS will have every incentive to see a deal through and “earn” its fee as a percent of the deal value, likely debt refinancing, and other asset sale assignments that would accompany this merger as opposed to earning a small retainer from CPN. Irrespective of what GS advises, the Board and investors should note the following as reasons why NRG’s offer is laughable and why CPN should remain independent:

Young and Modern Fleet: The weighted average age of the Company’s power plants is under 10 years. In contrast, NRG’s plants are over 35 years old. In fact, the second youngest fleet is held by Dynegy (DYN) which has an average age of over 20 years. Construction costs for new power plants are very costly due to raw material costs and longer lead times, yet in this $11B proposed deal, NRG would be able to double its power generating capacity and acquire the most modern fleet of power assets available in one fell swoop.

Green Power Generation: With the exception of 17 geothermal plants in California’s geyser region, CPN’s entire fleet of assets uses natural gas (“NG”) which is far cleaner than coal and oil-fired production. It’s also important to note that CPN’s combined cycle fleet consumes less fuel to generate electricity compared to older boiler and steam turbine facilities, making it cutting edge in regards to even NG power production. In fact, out of the top 25 power generators, CPN generates the lowest amount of SO₂ and NOx and ranks sixth in terms of lowest CO₂ emissions. In comparison, NRG is in the middle of the pack for both SO₂ and NOx and is in the bottom third for CO₂ emissions.

NRG and CPN produce roughly the same total MWs but NRG relies on coal for about 40% of its power production. Based on increasing carbon legislation, it’s likely that coal-produced energy will face greater scrutiny and higher emission cost controls relative to NG. Table I compares CPN’s emissions against industry averages, clearly illustrating how clean CPN’s power generation is.

TABLE I: AIR POLLUTION EMISSION RATES

CPN’s geothermal plants are virtually zero emission and benefit from regulations that promote green energy. As carbon legislation ratchets up, the Company’s geothermal plants should also benefit as the market for renewable energy credits (“RECs”) increases. By trying to steal CPN, NRG can basically phase out its older and less viable plants that will carry the burden of costly emission controls with virtually brand new, clean energy plants.

Geographic Concentration: The bulk of the Company’s production is located in the West and in Texas. These two regions tend to get extremely hot during the summer and capacity has tightened such that reserve margins for Texas are expected to decline from 13% to 8% from 2008-2012 while reserve margins in California are projected to decline from 18% to 11% from 2008-2016. Reserve margins reflect how much total power capacity exceeds peak demand.

This means the lower the reserve margins, the higher the price for electricity because intermediate and peaking power sources like NG, which have higher variable costs than baseload sources like coal and nuclear, experience greater demand. Basically, it’s the marginal demand over baseload that drives energy prices and CPN is perfectly situated to capitalize on this. Western states like California are becoming increasingly focused on green energy and legislation which should further enhance CPN’s asset value relative to higher emission power sources. Furthermore, California and Texas are both transitioning into nodal pricing schedules which should benefit CPN.

Peak Season Ahead of CPN: CPN’s operating results are seasonal with its strongest quarter being fiscal Q3 (also calendar). Given that gas prices are higher than last year, the summer season could be very strong for CPN. This is not much different than selling Marvel Entertainment (MVL) before the release of Iron Man. Investors are basically selling on the cheap, ahead of what could be a very favorable summer for the Company, allowing NRG to capture that benefit for a song.

Net Operating Losses (“NOLs”): CPN has $5B in NOLs in the U.S. and $650MM in Canada. IRC Section 382 usually doesn’t allow NOLs to be carried over in an acquisition, meaning that the Board should value the Company in the context of a standalone that provides these tax benefits to shareholders, as opposed to letting CPN be sold on the cheap for shares in NRG that may not be able to preserve these NOLs.

Exiting Bankruptcy Dynamics: Charts I and II illustrate the performance of NRG and Mirant Corp. (MIR), two CPN peers, upon emerging from bankruptcy. These charts should be considered by the Board and CPN investors because, while there’s no guarantee that CPN performs in the same fashion, exiting from bankruptcy provides similar dynamics to those offered in spin-offs and NRG’s weak offer robs CPN investors from experiencing those benefits.

CHART I: MIR HISTORICAL PERFORMANCE

CHART II: NRG HISTORICAL PERFORMANCE

CPN’s historical operating figures are difficult to discern unless one accounts for the variety of charges and expenses recognized over the past few years related to the Company’s struggles. In addition, CPN exited bankruptcy with a considerable debt load which now stands around $10B based on its latest quarterly filing. This results in very tight interest coverage with a Debt/LTM EBITDA multiple over 6.0x. While that leverage may be a cause of concern, CPN is well positioned to actually utilize that debt to drive shareholder returns, provided the Board and CPN investors elect to have CPN remain independent.

During bankruptcy proceedings and since reemerging in the public markets, the Company has trimmed its fleet of plants and is focused solely on its core markets. As CPN anniversaries these benefits, operating results should improve relative to historical figures. As CPN continues to monetize its non-core assets, it can use those proceeds to pay down the principal on its debt load.

CPN also trimmed its workforce and overhead costs and will continue to find ways to rationalize overhead to further boost operating margins. The Company should also benefit from tailwinds such as tight energy markets, lower reserve margins, and improving commodity margins. Today’s power market is much different than it was a few years ago with overcapacity that led to slackening energy prices. With tighter capacity, CPN should generate stronger results than those experienced in less favorable time periods and reflected in historical figures.

The historical figures also ignores three new projects (2 in California, 1 in Canada) that will contribute another 2,200MWs, or boost CPN’s total power generating capacity by almost 10%. These projects have all secured production contracts, with the first plant coming online in 2008. Once one begins to account for these catalysts, it should become clear that CPN stock could have a very impressive track to run if provided the opportunity.

Valuation: Since CPN has hired GS to coerce itself into a merger and perhaps over 40% of CPN shares are in favor of a deal with NRG, a rudimentary overview may be more beneficial than a long drawn out valuation analysis. NRG’s current market capitalization is about $10B and its proposal values CPN at approximately $11B.

NRG and CPN have roughly the same power generating capacity but CPN is superior to NRG in terms of its asset portfolio. The average age of CPN’s plants is under 10 years while NRG plants are over 35 years old. CPN uses clean NG and even cleaner geothermal for its power while NRG relies on a mix of sources including nearly 40% from coal. In the face of greater scrutiny in regards to emissions control, coal power generation could face costlier emission controls that NRG would have to allocate for. NRG's assets that utilize coal would decline in value while CPN's should rise. CPN is also entrenched in some of the best geographies in terms of power demand due to hotter summers relative to the rest of the country, as well as changes in regards to nodal pricing. CPN also has three new plants that will come online in the coming years that will boost its production capacity by roughly 10%.

Despite these differences, NRG believes CPN is worth just $1B or so more than its current valuation, implying the two are worth virtually the same even though CPN’s asset base is incredibly superior to NRG and in fact, all independent power producers (“IPPs”). Just a quick review of the asset differences should make investors and the Board question why NRG is offering such a low price.

The answer is tied to a few factors. The first is that CPN was restructured under Robert May’s leadership and May will not remain as permanent CEO. NRG is trying to seize on the lack of permanent leadership at CPN through this lowball offer. The second factor relates to NRG expecting investors and the Board to rely on the noisy historical financials that, even once scrubbed for one-time items and restructuring charges, belie where CPN's operating results can be in the coming years.

As previously discussed, the Company is poised to benefit from a variety of industry tailwinds and company-specific drivers. These factors, combined with a leaner company that is not burdened by poorly performing non-core assets, should result in CPN producing operating results that exceed its historical performance by a wide margin. In January 2008, CPN revealed that it expected to generate about $1.75B in adjusted EBITDA for 2008 which is a 25% increase over its 2007 adjusted EBITDA and probably did not account for the spike in gas prices that is currently being experienced.

IPPs with high debt loads such as DYN and MIR trade for 17-18x EV/EBITDA, which is where CPN currently stands based on its LTM adjusted EBITDA. However, CPN is poised to increase EBITDA by 25% if not more. Assuming shareholders hold out for the next 12 months, shares in CPN could be valued at $35 per share. Given the discrepancies in capital structures among IPPs, valuing CPN off EV/Revenues could provide a useful tool. Peers such as NRG, MIR, and DYN trade for 3-4x EV/LTM Revenues. Using CPN’s LTM revenues as of March 31, 2008, the Company would be valued between $30-$45 per share on a fully diluted basis (500MM shares) based on its peer's comparable range.

Disclosure: Author manages a hedge fund that is long CPN.

Comments

[CrossProfit]

Amit,
As usual, very informative article. Good luck on raising h*ll on this one. You may be out gunned here with 40% of the vote locked in. Class action takes forever though might be only alternative, depending on your position size. Have you written to management? If not yet, do so only after consulting.

CrossProfit
Disclosure: no position in CPN or NRG.

[PeterSimpson]

Very good information, I bought CPN around 30 cents/share and took some profit around $2 or so but held on to half of my shares. I rode them all the way to the bottom and now am part of the other 60% holding warrants that expire this fall. I am totally against CPN selling at this price offered by NRG on a personal level as I want to be in-the-money this fall and exercise my warrants in order to recover some lost $$.

[User 199864]

You lose all credibility when you ramble about one company wanting to "steal" another company while you hold a position on the one being "stolen". Like Harbinger, you play games as well and don't add value to anythng. Speculating and flipping would be more suitable terms than "investing".

[ElectricGuy]

It would be my opinion that buying CPN for 23.00 per share is not only a steal, but a murder...

CPN has just come out to bankruptcy and its stock price is in the "new" category right now. This usually takes about a year or so to correct. If you look at the underling numbers (as pointed out in this article), the fair price to acquire should be around $38.00 to $42.00 right now. If NRG waits, say one year, I believe the price would be even higher.

The one item this article did not address is future electrical demand. People will be charging their pluggable Toyota Prius (maybe released in 2010), GM Volt and other cars at home. :)

Mr. Chokshi is correct...

[ATM]

Amit,

Intentionally or not, there is so much misleading information in your article. Let's just go through the 7 reasons.

Young and Modern Fleet - Calpine's assets were YOUNGER when it filed for bankruptcy. Similar to real estates, the age of a property has a low baring on valuation. Location matters. About 25% of Calpine's assets is in the Southeast where there is still significant excess power supply.

Green Power Generation – Geothermal only accounts for 11% of Calpine’s generation fleet. It’s right that natural-gas fired power plants emit fewer pollutants than coal plants. However, the uncertainty surrounding the upcoming carbon regulation means that it is difficult to assign a value on Calpine’s greenness.

Geographic concentration – The author makes it sound like NRG is buying Calpine for its exposure in TX and CA. The fact is that NRG has more than 40% of capacity in TX where it generates more than 50% of its EBITDA.

Peak Season Ahead of CPN – I thought summer comes around every year. Are you suggesting that power M&A is off-limits in spring? How about all these asset transactions (Int’l Power, GSC, Tenaska and Sierra Pacific) in the recent months?

NOLs – With Q1 net losses of more than $200M, it will take years for Calpine to utilize the full amount of the NOLs, even if we assume that power market continues to tighten from here. Time value of money, anyone?

Exiting Bankruptcy Dynamics – Are you saying that power companies out of Ch. 11 will always experience share price appreciation? That’s investment made easy.

Valuation – I don’t know where you got these multiples. If your internal power analyst were feeding you these numbers, you need to find a replacement quick. Calpine is trading at 11.2x of 2009E EBITDA whereas NRG is trading at 7.3x.

STOP FOOLING RETAIL INVESTORS!

[Amit Chokshi]

ATM,

You state that I'm trying to intentionally mislead readers when you seem to be unable to read what I clearly stated in regards to certain points or ignore it in an attempt to create hollow criticisms for my points. For example, in Exiting Bankruptcy Dynamics you ask "are you saying that power cos out of Ch 11 will always experience share price appreciation" when I specifically and clearly wrote that there's "no guarantee" that CPN would perform in the same fashion to NRG and MIR in the second sentence of that segment.

For Valuation you ask me where I got my multiples. I explicitly mention that the multiples are from highly levered IPPs like MIR and DYN for EV/EBITDA and for EVLTM Revenues for DYN, MIR, and NRG could also be used to value CPN. I don't see how when I explain the methodology how I'm fooling or misleading anyone, I'm clearly showing what I'm using for valuation. Secondly, using NRG's EV/EBITDA comp is not useful because it's gone through the deleveraging process in recent years. NRG was levered at 10.0x EV/EBITDA when it emerged from bankruptcy and valued in the mid teens EV/EBITDA in the first year coming out of bk.

NOLs - CPN was unprofitable for one quarter yet you assume they won't generate profits such that the $5+B in NOLs would be worth very little. Discount the $5+B over a long period of time and it's still worth something to CPN as a stand alone. Secondly, part of what contributed to CPN's Q1 loss was higher than usual interest expense tied to liabilities subject to compromise which were part of exiting bk and will not repeat and on top of that CPN has been divesting assets for gains. You say I mislead readers yet you try to suggest a Q1 loss would carry on so that those NOLs would have little value.

Peak Season - Yes summer comes around every year but NG is higher now than it was last year.

Geographic concentration - I didn't imply that NRG is buying CPN for its geographic concentration. I stated, as with the other 6 points, why the NRG offer undervalues CPN and why CPN's concentration in those two regions is a benefit. But since you brought it up, have you read what NRG intends to do if it acquires CPN? NRG will sell its own plants in TX and keep CPN's and part of that strategy by NRG ties to the other points you take issue with in green power and CPN's fleet age.

Green Power: Sure, we don't know what carbon legislation will entail but a company that generates power using gas and geothermal vs a company that relies on coal for 40% of its power generation is probably going to be on the right side of any legislation. I never assigned a specific value there but I IMO rightly suggest in an environment of increasing legislation focused on emission control, CPN is the best positioned out of all IPPs and provide data on emmission/air pollutants to back that assertion up.

Fleet Age: Yes I realize CPN's fleet was younger when it was in bk, so what? When looking at major IPPs, CPN has the youngest fleet, NRG has an old fleet with a skew towards higher pollution plants. With longer lead times and higher material costs for new plants, the age of CPN's fleet, basically brand new, is a huge plus. Yeah, when CPN was in bk its fleet was that many years younger and the problem back then was massive overcapacity in the power markets. Now with the opposite occurring, having essentially brand new plants is an advantage. Even against other NG plants, CPN's fleet has superior heat rates (better fuel efficiency).

Finally, I should have mentioned this earlier but let me point readers to NRG's situation just two years ago. Back in May 2006, MIR made a hostile offer to buy NRG for about $7.7B in equity and a total enterprise value of about $16B. That was a 33% premium to NRG's share price and that deal valued NRG at 5.0x LTM Revenues and 20x EV/EBITDA. If you used those multiples for CPN, the share price would be at a minimum of $36 per share. But more importantly, NRG laughed off the offer and was able to remain independent and over two years, basically went from being worth $5.8B pre MIR to $7.7B pre offer to now $10B+ in equity value. But apparently, what I've presented is just a twisted attempt to squeeze a few pennies out of my holding in CPN.

[Sunjay]

Hi Amit,

I disagree with you on your point regarding fleet age. Yes CPN's assets are young but if they don't generate and cannot sell power to the marke, it does not matter how young they are. Just because a unit is new doesn't mena it is worth more.

BTW, ERCOT has revised up reserve margin recently. Your numbers seem to be outdated.

[IPP investor]

I am not sure how you are planning to be on the positive side of the carbon legislation where around 90% of CPN is sold under long-term PPA and sure NG is 33% better than coal plants but more generation using NG will further pressure gross margins. Even now it is kind of out of reach for a pure merchant plant to use NG and make money. Most of the plants were built after IPP crisis of 2001 and I am not sure how much margins were locked during soft market...

[Freeman]

As a professional investor, I normally do not comment on these sites, but I will make an exception in this case. There are too many inaccuracies not to. Plus, my father-in-law reads these things and is often swayed.

I am knowledgeable about both NRG and Calpine and the industry. FYI – Mirant and Dynegy don’t trade at 17-18x EBITDA, they trade far lower, so check your numbers or look at analyst reports. You say that Calpine's fleet is younger than NRG's. That is certainly true, but coal and nuclear plants earn far more than natural gas units, especially in a rising natural gas price environment. As such, coal and nuclear plants are worth far more than natural gas plants, even considering carbon legislation. Look how much KKR and TPG paid for TXU Energy.

To truly understand the earnings power of each company, you need to understand the sensitivities to commodity prices. NRG benefits more than Calpine from rising natural gas prices and Calpine benefits more than NRG from expanding heat rates. Natgas has skyrocketed and the expansion of heat rates could be slowed by a recession or new low cost supply additions. NRG's current EBITDA is encumbered by bad hedges, so its misleading to value the business using those numbers. If they reset these hedges (like they did once before), the will generate almost double the EBITDA of Calpine. Even if they don’t reset the hedges, the earnings power of NRG will become more visible as the hedges expire in the coming years. Again, they will make far more money that Calpine. So you tell me which business is worth more? And CO2 legislation does not bridge the gap!

So to all Calpine shareholders out there - keep your company. We, as knowledgeable NRG shareholders do not want it. If I wanted to own the company, I could buy it in the open market like you all did.

[Value Dope]

i checked yahoo finance for DYN and MIR, key stats both are at 17x EV/EBITDA. What a professional investor u are...and oh yeah KKR and TPG paid a lot for TXU...back during a private equity bubble...sounds like this pro investor is a Tilson type of moron. NRG screwed up with bad hedges so don't count that too, lol...what bucketshop does Freeman work for?

[Freeman]

Good luck investing if you're using yahoo finance to calculate your EV/EBITDA multiples. Open up a 10K tough guy or read Mirant's and Dynegy's conference call transcripts. Maybe try looking at their guidance. If you're looking for a short cut read some of Citi's power research.

NRG's hedges are clearly below market, but when you calculate a DCF you use forward cash flows as well as the current period's. That means NRG's "open" EBITDA should be factored into its intrinsic value. This "open" EBITDA is far higher than the company's 2008 guidance.

[Value Dope]

I opened the 10-k and 10-q to come up with trailing EBITDA for MIR and DYN, the EV/EBITDA values are CORRECT on YAHOO FINANCE! Maybe CITI is wrong Freeman? wouldn't be the first time.

"open" EBITDA lol, intrinsic vaue, DCF lol, right so nobody can predict where energy prices will be but you use a DCF to value NRG...Someone sounds like he's talking out of his butthole here, look in the mirror Freeman. What bucket shop do u work for?

[Freeman]

It’s hard to argue with your crack analysis (lol as you would say), but here’s my attempt. Kudos to actually looking through the 10K and 10Q. Did you read the document or merely look at the financial statements? Something tells me you only looked at the financial statements. It is not good enough to take operating income and add D&A to it to get EBITDA. You’ll have to spend more than two minutes on this to get an accurate number. I am glad you matched Yahoo’s calculation. You’re both wrong.

One easy way to figure out Mirant’s EBITDA is to look at the company’s presentations. This is an accurate number (although I don’t add in interest income as that is removed from EV). If you take this number and then calculate the enterprise value, I think you’ll see that EV/EBITDA is not 17x on a trailing or forward EBITDA basis. It’s absurd that you still maintain it trades there. And make sure you are using trailing or forward multiples consistently. My guess is that you’re attempting to calculate where Mirant and Dynegy are trading based on trailing numbers and then applying that number to Calpine’s forward EBITDA estimates. That won’t cut it, tough guy.

FYI – There’s something called the futures market. If you look on Bloomberg you can get natural gas prices going way out into the future per this market. That’s a good starting place for estimating future commodity prices. That’s how you calculate a DCF.

I tell you what - show me your calculations and I will tell you where you’re wrong. You seem like a royal jack*ss, but I will do it anyway. And why would I tell you where I work? I've already wasted too much time trying to educate you.