Reliant Energy, Inc. Q2 2009 Earnings Call Transcript

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Reliant Energy, Inc. (RRI) Q2 2009 Earnings Call August 3, 2009 10:00 AM ET


Dennis Barber – Vice President Investor Relations

Mark Jacobs – President, Chief Executive Officer

Rick Dobson – Chief Financial Officer


Neel Mitra – Simmons International

Lason Johong – RBC Capital Markets

Michael Lapides – Goldman Sachs

Ameet Thakkar – Duetsche Bank

Brian Russo – Ladenburg Thalmann

[Paul Patterson – Glenrock Associates]


Welcome to the RRI Energy's second quarter 2009 earnings conference call. (Operator Instructions) I will now turn the call over to Mr. Dennis Barber.

Dennis Barber

Good morning and welcome to RRI Energy's second quarter conference call. Leading the call this morning are Mark Jacobs, President and CEO and Rick Dobson, our Chief Financial Officer. Following our prepared remarks, we'll have a question and answer session.

The earnings release as well as a slide presentation we're using today is available on our website at in the investor section. A replay of this call will also be available on the website approximately two hours after the call.

Consistent with our past practice, we're using several non-GAAP measures to provide additional insight into operating results. Reconciliations from the non-GAAP measures to GAAP figures are available on the website.

In conjunction with our investor conference last week, we gave a preview of our second quarter results and updated our outlook using forward commodity prices as of June 26. The information provided today is consistent with that preview.

I would also like to remind you that any projections or forward-looking statements made on this call are subject to cautionary statements on forward-looking information contained in our SEC filings. I'll now turn it over to Mark.

Mark Jacobs

Good morning everyone. Welcome to our second quarter earnings call. As I'm sure most of you are aware, last week we held an investor conference in New York. In conjunction with the conference we pre-released two key results.

This morning we reported our final results, an open EBITDA loss of $10 million and an adjusted EBITDA loss of $78 million. These results reflect the challenging environment we're operating within. Both Rick and I will provide more color in a few minutes, but first I wanted to touch on last week's conference.

I appreciate the positive feedback that many of you have provided. As we shared at the conference, RRI Energy has a set of core beliefs about the industry. Those core beliefs guide our approach to creating long term shareholder value.

Looking forward, we see both opportunities as well as challenges. At the conference, we discussed how we're tackling both of these head on, and we provided our perspective on the key value drivers of the business along with detailed transparent information to allow you to better understand the impact of these factors on our business going forward. We also discussed how we're managing the business in light of challenges in the current economic and market environment.

On Slide 4, I wanted to highlight our five key areas of focus. First is managing risk in the current market environment. There's a reason that it's number one on the list. It's important because while we believe that market conditions will eventually recover, the timing of a recovery and whether we've yet reached the bottom is highly uncertain, and if we don't get this one right, none of the others matter.

Every action we take or contemplate taking is measured by its impact on our balance sheet and liquidity as well as how it positions us for a market recovery. Let me be clear. We are taking actions to ensure that regardless of the timing of a market rebound, the company remains financially strong.

During the second quarter we completed the sale of the retail business. That transaction reduced our debt and improved liquidity but most importantly, it significantly reduced risk; the risk of nearly $3 billion of capital and contingent capital.

We also implemented a modest forward hedging program for 2010 and 2011. This program is designed to ensure that we are free cash flow break even or better even if market conditions substantially worsen, and we made significant progress on realigning corporate support costs; a program that will provide $40 million of annual benefit.

The second area of focus is on operating our assets efficiently and effectively. This priority is aimed at ensuring that we get every nickel of value out of our assets. Let me share with you how I think about efficiency and effectiveness and why they're so important.

There are a number of factors in our business we can't control; factors such as commodity prices, the economic environment and weather, but we can control our performance, and that means efficiency and effectiveness.

You can think about efficiency as what are the cash costs it takes to operate our asset base. Effectiveness relates to how well we capitalized on the opportunities the market presented. Consider the margin each of our plants could earn if it was available 100% of the time. Effectiveness is a measure of what percentage of that margin pool we earned. The more efficient and more effective we are, the higher the return on invested capital and the greater our free cash flow, an especially important point in the trough of the cycle.

Compensation for every RRI Energy employee is tied to efficiency and effectiveness. One of the ways efficiency and effectiveness show up is in the way we operate our fleet. Last week, we discussed our approach. It's customized by plant based on the individual value proposition at each of our stations.

It includes factors such as what market the plant is located in, where it sits on the dispatch stack, what environmental controls are in place and how we expect the plant's position to evolve over time. That leads us to operating and investing in each of our plants in an individualized manner that maximizes each of their respective values. At the same time, we're building in flexibility to enable us to modify the operating model at each plant to respond as it's position evolves.

The third point here is positioning RRI for long term value creation. We believe that market conditions will recover over time. The majority of our output is strategically open so that we will benefit when market conditions do improve.

Our fourth area of focus is around how we invest capital in the business. As stewards of your capital, we believe approaching investments with a healthy dose of skepticism is being a highly disciplined investor of capital. This point is based on our core believe that cyclical industries in general, and the power industry in particular under earn their cost of capital.

And the final point on this slide is the focus on supporting the business with a prudent capital structure and liquidity level that reflects the underlying cyclicality of the business. Rick will discuss in greater detail the actions we've taken and are contemplating taking to ensure that our liquidity and debt levels put us in a position to be successful at all points in the cycle.

Taken together, I think this set of priorities puts us in a strong position to deliver long term value to shareholders.

Let me turn to the results for the quarter on Slide 5. Rick will take you through the numbers, but I wanted to share with you my perspective. The bottom line is that 2Q financial results reflect the environment in which we operate. To call it challenging would be an understatement.

Commodity prices have collapsed versus last year. Natural gas prices averaged over $8.00 per mmbtu lower during 2Q 2009 than 2Q last year, and load levels reflected the severe economic recession and extremely mild weather.

These factors show up in a couple of ways. Overall unit margins were less than a third of the level of last year's 2Q. Within our coal fleet, average unit margins per megawatt hour declined from over $37.00 to just over $9.00. Overall load declined significantly. In PJM and MISO, load was off mid single digit percentages. That shows up in our results in the form of lower economic generation.

Quarterly results were also impacted by coal purchases and our results in the form of benefit of coal purchases that were significantly below market prices. This year, it's just the opposite. As we discussed last week, our coal procurement strategy has been successful from an operational perspective, but it has introduced a level of earnings volatility. We're reviewing that strategy to see if there are better ways to address coal procurement.

While market factors were the principal driver of the variance in quarterly results, I also wanted to touch on our operating performance for the quarter. As you know, we made a significant improvement in the performance of our fleet over the last several years. However, unplanned outages at Seward, Keystone and Shawville in May and June resulted in about $6 million of lost margin.

We've done a root cause analysis and we believe these are isolated instances. Fleet performance has improved considerably in July.

We expect to complete the tie in of the Keystone scrubber later this fall and as we discussed last week, we made the decision to defer the tie in of the Cheswick scrubber until next spring based on economics.

Rick will also cover our updated 2009 and 2010 outlook. 2009 reflects the difficult market conditions and the impact of our above market coal purchases. 2010 shows significant improvement with an improved forward curve for commodity prices and a roll off of our coal purchase requirements.

Importantly, if you include cash flow from retail before the close, both 2009 and 2010 are free cash flow positive. I'll now turn the call over to Rick Dobson, our Chief Financial Officer.

Rick Dobson

As Mark said, some of what we're going to cover today is ground we covered last week at the investor conference, so I'm only going to hit the key points today.

Let's turn to Slide 7. In the second quarter of 2009 we experienced very weak commodity prices, mild weather and reduced load driven by poor economic conditions. These factors were the primary drivers of our lower generation output and much lower open energy margins resulting in open EBITDA loss of $10 million in quarter two.

These drivers combined with coal purchases, at prices above the current market result in a second quarter adjusted EBITDA loss of $78 million. These same drivers are the contributing factors to our operating free cash flow loss of $148 million to date, but after considering the retail performance through April this year, we produced $173 million of free cash flow through June 2009.

Let's now review the 2009 and 2010 outlook on Slide 8. Many of the same drivers of Q2 performance drive our full year 2009 outlook. Depressed commodity prices, mild weather and lower generation due to the state of the economy result in open EBITDA of $276 million for 2009. Factoring in our coal purchases at prices above the current market, partially offset by our natural gas hedges, our 2009 outlook reflects $158 million of adjusted EBITDA.

We have also continued to experience weak commodity prices and very mild weather in July. Lower 2009 adjusted EBITDA drives operating free cash flow losses from continuing operations of $227 million. Again, re-factor in the retail performance, our free cash flow for 2009 is $94 million. Turning to 2010, we see stronger commodity prices pushing open EBITDA to $499 million and adjusted EBITDA to $464 million.

With the completion of the Keystone scrubber and the bulk of the Cheswick scrubber spend occurring in 2009, our free cash flow outlook is $180 million in 2010.

Moving to Slide 9, the current market environment has been challenging and may continue for the near to mid term. The steps we have taken to reduce our debt, maintain robust cash and liquidity balances combined with our significant capacity in PPA revenue profile and modest 2010 and 2011 hedging, give me a high level of confidence that we can successfully manage through this environment.

Let's turn to Slide 10. Many of you may recall that is was back in February 2008 that we last talked about our balance sheet gross debt aspirations. We talked about having gross debt in the $2 billion to $2.5 billion range which included our retail cash flows.

With the sale of retail, it was intuitive that this range needed to be lower. We derived our current targeted gross debt level of $1.25 billion to $1.75 billion by identifying the level of debit that provided modest free cash flow in this off period. We also believe this level of debt yields reasonable access to the capital markets during high stress capital market conditions.

The other key advantage of this range is that it does leave flex debt capacity in the event the shareholder accretive investment becomes available. In addition, this level of debt will produce significant amounts of free cash flow as market and economic conditions improve.

This slide also provides a picture of our gross debt and liquidity profile as of June 30, 2009 and what we aspire to from a liquidity perspective in the longer term. We have purposely not filled in the details of our targeted gross debt as we have not finalized our plans as to which instrument makes the most sense to hold in our capital structure longer term. Many factors such as maturity profile, interest rates and covenants will be considered as we reduce our debt over the near to medium terms.

Focusing on our longer term liquidity aspirations, you see that our ultimate goal is to have a collateral structure in place for cycle hedging. We realize that cycle hedging may be a way off at this point in time, but we want to begin the market assessment and planning phase well in advance of the need for a facility.

We also realize that our revolver matures in June 2012 and a vein of prudent capital structure management, we strive to have longer term certainty around size and cost and are beginning to plan for this sooner rather than later. In both these cases, we are mindful of meshing these desires with the most cost effective means in the capital markets over the medium term time frame.

Turning to Slide 11, in the near to medium term, we will be focused on converting our strong liquidity position to a strong balance sheet by reducing our long term debt. At this point we have set aside $400 million of our cash for the Orion maturity in May 2010. With projected cash at the end of 2009, our high degree of confidence of being free cash flow neutral even in trough conditions for 2010 and 2011, we believe we have $250 million of cash available for debt reduction in the near term.

We also believe that once the collateral facility and revolver clarity become more transparent, up to $500 million could become available and will put us very near the top of our long term debt range. But, in the end our pace will be measured and prudent as we closely monitor capital and economic market conditions.

With that, let me turn it back to Mark to wrap up.

Mark Jacobs

Let me wrap up on Slide 12. RRI Energy is a well positioned wholesale power company. While current market conditions are severely depressed, we believe the market will eventually recover and our business is highly leveraged to commodity price and economic recovery.

We believe a recovery will lead to substantially higher levels of earnings and free cash flow, but the timing of a recovery is uncertain, and it's possible that things will get worse before they get better.

In that regard, we've taken a number of actions to ensure that we have the wherewithal to persevere even if the economic downturn is deeper and more prolonged than the experts predict. We're operating our business today with a clear understanding of the challenges that lie ahead; increasingly stringent environmental regulations, energy efficiency and renewable portfolio standards are examples of the factors that will redraw supply and demand fundamentals.

We believe our portfolio is positioned to deliver value in this environment. We bring a cyclical industry mindset to the power industry. That means we're highly disciplined investors.

And finally, I describe our views on size, scale and diversity. While RRI Energy has a solid financial and asset foundation, I believe size, scale and diversity matter in delivering shareholder value through the cycles. It's our job to identify all of the avenues to achieve that objective in a manner that creates value.

With that, let's open the line for questions.

Question-and-Answer Session


(Operator Instructions) Your first question comes from Neel Mitra – Simmons International.

Neel Mitra – Simmons International

Could you give any color on much the capacity payments are moving relative to rest of pool capacity payments? Is there any linkage since it seems that MISO capacity payments are set for a shorter term? It also seems like the guidance for the MISO coal capacity payments at your plants came down from the start of the year.

Mark Jacobs

Let me give you a little color on that. MISO as you know does not have a forward traded capacity market that capacity payments are done in a bi-lateral fashion. In general, we have seen very modest capacity value in the MISO fleet so I really don't see as I said; there's not been a big value driver for us.

One of the things I might point here that could be of interest going forward is First Energy had filed on Friday to move into PJM for MISO, and that's something that will take FERC approval, they've indicated a desire to do that by 2011.

Based off of our quick read of that situation, if that were to occur, we would likely have three of our plants, Avon Lake, Newcastle and Niles that would move from MISO into PJM, and that would probably provide us some benefit given the forward traded capacity market in PJM.

Neel Mitra – Simmons International

On Page 16 of your presentation, the PJM weighted average plant to west hub bases has come down significantly for 2009, 2010 versus past years. Is this due to less congestion, lower demand or do you see any longer term structural changes in that basis?

Mark Jacobs

I don't really see any structural changes in the bases. What you're really seeing there is the impact of gas prices and there's a number of plants on the eastern side of the constraint that get into the west hub average pricing, so when you see higher gas prices, generally you see higher bases differentials from our fleet into PJM web hub.

So again, what you're really seeing there in the results and in the outlook going forward is just the effective lower gas prices.


Your next question comes from Lason Johong – RBC Capital Markets.

Lason Johong – RBC Capital Markets

Out of curiosity, any chance you want to increase your 2010 hedging levels in case the forward market is wrong and natural gas prices collapse?

Mark Jacobs

Just to bring everybody back for the benefit, we have implemented a modest hedging program in 2010 and 2011. In 2010, it represents about 25% of our expected output. We look at a log of different commodity price scenarios and measure the earnings and cash flow of the business under those various scenarios.

The hedge that we have put in place to date gives us a very high confidence level of free cash flow break even, even if market conditions continue to deteriorate. But we're obviously going to keep a very close eye on that and if we saw further deterioration in the markets, it's certainly possible that we might adjust those hedge levels going forward.

Lason Johong – RBC Capital Markets

This is a speculative question to some degree, but as you move towards the peak levels, how much debt do you think you can sustain? It looks like your minimum $1.5 billion or your base is about $1.5 billion, but how much max debt do you think in the current portfolio do you think RRI could actually handle as a percentage of EV or just a raw number?

Rick Dobson

The way we look at it, we look at our targeted gross debt range at the trough. And how we think about this from a cap structure perspective is, we don't get caught up in how much leverage we could have at the top of the cycle. We look at what we would have in the trough, and how I would look at it is, obviously at the top of our range is $1.75 billion.

So we would set it at $1.75 billion. All of the rest of the capital that then would become available at the top of the cycle, we would look to deploy it, whether that's in accretive investments or share buy backs or dividends, that's how we would look at it.

We wouldn't look at it adding a lot of extra debt to the cap structure, and if we ended up coming back off the top back into the trough rather quickly which happened last year, we wouldn't want to be in a distress situation.

Lason Johong – RBC Capital Markets

That suggests to me that if you see investments that return a positive MPV, that the level of debt itself is not going to absolutely concern you.

Rick Dobson

No. As we grow the company, then the thing I would focus on is how we focus on it is, interest and maintenance CapEx coverage ratios. So we focus on, depending on the size of the company, we want to be free cash flow positive in the trough, so if we double our megawatts, and double our like profile, we carry twice as much debt.

Mark Jacobs

The other point I would make to that is, Rick also talked last week at the investor conference about the concept of flex debt for the right opportunity. We would increase our debt levels above that targeted range if we had a clear plan to get debt levels back in line over time.

Rick Dobson

We constantly reassess where we would be at a trough perspective based on our asset profile.

Lason Johong – RBC Capital Markets

But no estimation of how much max debt you would be able to carry?

Mark Jacobs

No. Again, I think it's really situation dependant, depending on the opportunity we were looking at. Again, Rick made the important point which is, we certainly don't think we're going to be smart enough to know exactly when the trough is coming, so while as market conditions improve, you could certainly lull yourself into believing you could carry more debt.

And I think as Rick just pointed out, the challenge we see with that approach is when the market conditions change and they can change very quickly, you may not have an opportunity to get you balance sheet resized. So we really feel that carrying a debt level on a target basis that's sized for the trough of the cycle makes sense, and then again we might for the right opportunity go above that if we have a clear plan to bring that debt level back down to the target levels.

Lason Johong – RBC Capital Markets

With the $1 billion of commodity loans that you're looking to get, what does that cover in terms of your liquidity exposure to potential future hedges? In other words, does it cover 50% of your potential output, 75% of your potential output? I know it's commodity price dependent but can you give us a ball park figure of what that will allow you to do?

Mark Jacobs

I can't. I think I probably even alluded to it at the conference last week, but we size that, three to four year look, three or four year hedge profile with up to about 50% to 60% of our generation, and that's under reasonable stress scenarios of $3.00 to $4.00 to $5.00 per mbu gas move.

Again, like I said last week, that seems a long, long way off that we would be putting a three or four year top of cycle hedge on that half of our generation, but that's how we think about it.

Lason Johong – RBC Capital Markets

On Page 11 of the presentation, am I to interpret some of these things as code word for buying back debt and/or equity? Financial market availability cost $500 million. It sounds to me like code word for buying back debt and/or equity.

Rick Dobson

We try not to speak in code here, but I think it's more a discussion around when we see, we get more clarity on where this financial and economic market is going, when we have clarity around how our revolver will look longer term beyond 2012, and when we have a clear view on the collateral structure we would use for cycle hedging, I think that clearly would free up another $500 million primarily in debt reduction.

Lason Johong – RBC Capital Markets

Where does the sale of the retail business show up on your cash flow statements? I can't figure out where it is.

Mark Jacobs

That will be in discontinued operations. You'll see that in the financial statements in the 10-Q and again the way we've shown it on the outlook and cash flow statement.


Your next question comes from Michael Lapides – Goldman Sachs.

Michael Lapides – Goldman Sachs

Could you give us a status update both on the contracting if any of your assets in California and what you're seeing in general both in the MISO and PJM in terms of quota gas switching in July?

Mark Jacobs

On the California contracting basis, as you know most of those agreements are covered by confidentiality agreements so we can't get into a whole of detail, but the general comment that I would make is typically we've seen the load bearing utilities go out on a fairly regular annual basis to contract for capacity needs out four or five years in advance, and that's been very much an ongoing process that they've gone through. We do include in our outlook the financial impact of capacity contracts that we have signed up.

With respect to the question on coal to gas switching, I guess the best evidence we could provide you with that is anecdotally what we're seeing in our fleet, we've seen significantly more run hours at our Hunterstown plant, and if you just look at the economic generation at Hunterstown in Q2, 2009 versus 2Q 2008, that was up over 60% here.

And then if you look at the mid merit part of our coal fleet, you see economic generation being down significantly. That would show up really the Niles Newcastle, Titus part of our fleet.

Michael Lapides – Goldman Sachs

I noticed that Seward for the quarter in terms of output, raw output. Just curious, was that outage driven or something else there or was that economic driven?

Mark Jacobs

As I mentioned in my prepared comments, we had an unplanned outage in Seward in May that carried into part of June. And that is again, we've done a root cause analysis on that. We believe it's an isolated incident and since that time we've had that plant up, and I think in fact in the month of July, the commercial capacity factor at Seward is 100%.


Your next question comes from Ameet Thakkar – Duetsche Bank.

Ameet Thakkar – Duetsche Bank

I know you've had some members of your Board of Directors have left. Do you have any plans to repopulate the Board or replace them? It looks like the overall size of the Board is less than what we've seen in the past.

Mark Jacobs

Our Board has traditionally been on the smaller side in general. We did have several of our Directors that chose not to stand for re-election at our annual meeting. A point I'd make now is the company today has five directors. Each of them has substantial experience.

Steve Miller, who became our Chairman here effective at the annual meeting, brings a great deal of experience and a successful track record. Steve was the former President, CEO and Chairman of Shell Oil Company.

That being said, the nominating governs committee the Board is looking to add some directors here to the Board over time. And again, there's not a time table I could put on that process here, but my expectation is that we will be adding a couple of directors here looking forward.


Your next question comes from Brian Russo – Ladenburg Thalmann.

Brian Russo – Ladenburg Thalmann

You mentioned earlier that you're evaluating your coal procurement strategy given the volatility that it creates. Could you elaborate on that a little bit?

Mark Jacobs

If I just step back, in 2007 we implemented a coal procurement strategy that effectively had us buying coal one year in advance, and really that is in response to what is the convention in the coal market in terms of forward procurement. One of the things as I said, we want to make sure that we've got the availability of the specific kinds of coal we need at each of our generating stations and again, that was the way we went about doing that.

Some years that works for you if commodity prices go up. Other years it works against you. Again, a big, big positive for us in 2008, a big, big drag on earnings in 2009, so one of the things that we're looking at, is there a way to reduce some of that fixed price exposure that we take on through the coal procurement.

And then the other point that we're very much focused on is, particularly in light of some of the economic challenges we have and I think the environmental regulations going forward, my guess is we may see more variability in the burn levels of coal, particularly at some of the mid merit plants. So that coal procurement strategy was really designed at addressing how can we build more flexibility from a procurement side in there and do it in a way that we minimize the fixed price exposure we take.

Brian Russo – Ladenburg Thalmann

On the contracts that you have on your California assets, can you give us a sense of the time line of those contracts and how might the proposed once through cooling regulation impact the economics of those plants.

Mark Jacobs

The contract on the plants, as I mentioned before, those typically, the utilities in California the contract on a four or five year, six year ahead of time basis, they don't do all of their contracting for capacity in one year at one point in time, but really leg into that over a period of time. So what you see now as I said is we're starting to add capacity contracts going out into the next decade here.

In terms of the once through cooling aspect, the California Water Board, the staff issued a draft rule here last month. Our expectation is that is going to take many, many years to play out. We're not expecting that that's going to get finalized probably some time over the next several years. So I think there's a long way to go on that and it's probably premature to assess what exactly the impact would be on the Ormond facilities.


Your next question comes from [Paul Patterson – Glenrock Associates]

[Paul Patterson – Glenrock Associates]

On the first energy announcement, how do you see that impacting supply and demand for RPM if at all? How does the demand supply change or is it pretty much a wash do you think?

Mark Jacobs

I think it's probably again, given that they've just made that announcement, we've taken a quick look at that in terms of assessing how the impact would be on our fleet. I think in general in terms of if you look at the load that would be moving over relative to the generation that it would move over, there's probably a little bit more on the load side that moves over to PJM than on the generation side.

[Paul Patterson – Glenrock Associates]

Mechanically, base residual auctions have already happened. Do you think it would be the value would show up in the incremental auctions or do you think it would be done in some bi-lateral way? Any sense for that?

Mark Jacobs

I don't have a crystal ball. I think that they would plan from what I understand having this transaction approved to participate in the next forward PJM auction that will occur in May of 2010 and then again, I mentioned that they plan to be in PJM effective mid 2011. So they would have to through residual auction or in the market be able to buy that capacity.

In the last couple of auctions, we had a couple of our facilities that did not clear, so again that would be an opportunity as well.

Well thank you for participating in our call today. A replay of the webcast will be available on our website in approximately two hours.

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