Talen Energy Is Deeply Undervalued

| About: Talen Energy (TLN)

Summary

There are three possible reasons for a huge drop in stock price in the last half a year.

Valuation Multiples shows the stocks of the company are deeply undervalued.

Relative Valuation to competitors and the industry average also shows that the stocks are cheap.

In December 2015, several executives made purchases of the shares of the company in the open market.

Talen Energy Corporation (NYSE:TLN) is a spinoff from PPL Corporation, operates as a competitive energy and power generation company in the United States. The company has a portfolio of natural gas, coal, nuclear, oil, and other renewable generation assets, generates and sells electricity, capacity and related products from a fleet of power plants that uses diverse fuel sources: carbon-free nuclear, clean and flexibly dispatched natural gas. Talen Energy operates mostly in PJM Mid-Atlantic (83%) and ERCOT Texas (12%) and has approximately 15,000 megawatts of generating capacity from 24 power stations. The company is based in Allentown, Pennsylvania.

Following its spin-off and until recently, the company lost more than 70% of its value. It shouldn't be a surprise since it's well-known that spin-off companies usually lose much of their value in the first several months. Many investors in a parent company are intensively trying to throw off unwanted holdings. Instead of the expected 2-3 month of the price decline, this one's been going on for more than 8 months already. So is this prolonged decline is justified or not?

Possible reasons for the decline

One of the reasons for a big drop in the market price of shares could be the decline in energy prices. Perhaps investors afraid that company's earning would decrease in the nearest future. I've been doing my research on U.S. Energy Information Administration site trying to find more information regarding the electricity prices in the U.S. within the last year and found no evidence for the big decline. Actually, electricity prices a slightly rose for the residential sector and a narrowly dropped for the both commercial and industrial sectors. Their forecast for the coming two years is a slight elevation of price in all the three sectors mentioned above.

On the other side, if we look on the prices for coal, natural gas and dual fuel, we can see the much bigger drop. They are the raw materials that the company uses for generation of power. Thus, the company's costs should decrease in higher pace than its revenue.

The second reason could be the company's last earnings report (Q3 2015). TLN reported a net loss of 401M. However, if you check in their report closer you would find out that the company had about 522M one-time non-cash expense: a non-cash goodwill impairment charge of $466 million pre-tax ($449 million after-tax) and a non-cash, pre-tax asset impairment charge of $122 million ($73 million after-tax). So, if we disregard these one-time non-cash expenses, Talen Energy should see YoY improvement.

The last reason, but not the least, might be the Clean Power Plan imposed by Obama administration. The purpose of this program is to reduce carbon dioxide emissions by 32% below 2005 levels by 2030. Personally, I support the reduction of air pollution. However, I don't think that the company's profits in the near term or the middle term would be affected much by the Clean Power Plan. Besides, the company has enough time to get adjusted to the new reality.

In addition, from the political perspective, it appears to be a very similar situation to what happened with the Obama Care Plan. Therefore, I don't know how long it will take for the Clean Power Plan to be approved and pass all regulations, and what will be included in the final version of this document. Meanwhile, last month, Congress passed resolutions to block the Clean Power Plan and another major EPA energy regulation of new power plants, but President Obama vetoed them.

Valuation Multiples

Let's begin with looking on the value of the company. In 2015, TLN expected to earn more than 1B in Adjusted EBITDA and Adjusted Free Cash Flow about 400M (middle range). Thus, TLN shares trade at just 4.15 times 2015 EV/EBITDA and P/Adjusted Free Cash Flow ratio is only 1.91.

Debt-to-equity ratio equals 0.92. It's important to mention that the big chunk of its debt has to be paid only after July 2019. So, the company will have enough time to invest in growth or/and capital return before the debt burden will bother. If you like P/B ratio, you can find that TLN trades at just 0.17 times to its book value.

The company has 648M in cash and 128.5M of shares. After executing a simple math, we got $5.04 cash per share. When the price per share is about $6, it's incredibly cheap, isn't it?

Here is the summary table for 2015:

Year

2015

EBITDA

1B

EV

4.15B

EV/EBITDA

4.15

Net Debt

3.38B

Equity

4.4B

Shares

128.51M

Fair Value*

$ 19.71

Upside

231%

* Fair value calculated with Adjusted EBITDA for 2016 (only 845M) and an implied multiple of 7.

In Q1 2016, TLN expected to sell some of their assets (Ironwood, East Hydro, and C.P. Crane) to comply with the regulatory limits and improve its profitability. Therefore, the Adjusted EBITDA and Adjusted Free Cash Flow will drop to $845 million and $260 million respectively, reflecting the announced asset sales. It gives us EV/EBITDA = 4.91 and P/Adjusted Free Cash Flow ratio equals to 2.94 - still incredibly undervalued.

In addition, the company is looking to purchase new power plants that could increase its profitability. For example, recently Talen Energy acquired MACH Gen LLC, adding 2,500 megawatts of efficient natural gas-fired generation in key markets.

The last thing worth mentioning is synergy. If you are a fan of the word "synergy" you can find it a lot in the company's periodic filings with the Securities and Exchange Commission and on the company's website in the investor presentations. Personally, I am a little skeptic about all kinds of "synergies" that CEOs like to talk about. It seems like "synergy" became a trendy word for them. I think a real synergy is very hard to measure and you need to know at first what kind of synergy your joint business can attain. Is it offensive synergy? Perhaps it's defensive synergy? Maybe it's tax synergy? I don't know it but according to the Investor Presentation, it looks like they're talking a little bit about all the kinds of it. Let's hope they are right, so, it could bring even more value to the company.

Competitors

Now, compare TLN to the main competitors and the industry average. As you can see in the table below, Talen Energy main ratios, like EV/EBITDA, Forward P/E, and P/B ratio, are very low compared to its rivals. It trades on EV/EBITDA of 3.7 against the industry average of 7.65. Forward P/E is 9.49 against the industry average of 14.74. P/B ratio is 0.17 against 1.05. You may think that Talen Energy is a more leveraged and risky company, and, therefore, deserves a lower valuation. No, TLN is less leveraged than its competitors with only 0.92 Debt/Equity ratio against the industry average of 1.70.

Is there any problem with the company? I don't know, just can't find any justifications why the market prices TLN so low. In the last year, the entire energy industry suffered from the low energy prices and many companies lost a significant amount of their market capitalization. Obviously, Talen Energy lost much more than its rivals and I think it's not justified.

Ticker

Company

EV/EBITDA

Market Cap

Fwd P/E

P/S

P/B

P/C

Debt/Eq

TLN

Talen Energy Corporation

3.7

764.57M

9.49

0.14

0.17

1.18

0.92

NRG

NRG Energy, Inc.

6.94

3.18B

20.4

0.2

0.36

1.4

2.17

EXC

Exelon Corporation

5.42

25.25B

10.9

0.84

0.97

3.48

1.04

ETR

Entergy Corporation

6.71

12.15B

13.7

1.03

1.33

11.67

1.54

EIX

Edison International

8.02

19.26B

15.7

1.57

1.66

143.75

1.07

DYN

Dynegy Inc.

10.06

1.36B

-

0.4

0.51

1.46

2.62

DUK

Duke Energy Corporation

10.12

49.61B

15.3

2.09

1.24

36.22

1.07

CPN

Calpine Corp.

8.65

4.86B

16.5

0.7

1.54

7.38

3.7

AEP

American Electric Power Co., Inc.

9.23

28.81B

15.8

1.71

1.63

58.43

1.14

Average

7.65

14.74

0.96

1.05

29.44

1.70

* The data about EV/EBITDA were taken from Yahoo Finance. The rest of the data were taken from finviz.com's Screener.

Insider Activity

At last, I would like to say a few words regarding the company's last month insider activity. In December 2015, several executives made purchases of the shares of the company in the open market. Nobody knows the company's true worth better than the people running the firm. If they are willing to invest their own money in the firm, apparently, it means they think the stock is undervalued and the price will go up.

Conclusion

Due to the large (and disproportionate in my opinion) drop in the price, TLN stocks are looking very attractive. In this environment of the low energy prices, the primary near-term and middle-term challenge for the company is to keep its profitability on the same level or even grow it by smart acquisitions. But, taking into account that commodity prices deflated much more in the last year (a raw material of the company), I see a little downside with a big upside for the company stocks.

I initially saw the investing idea in TLN at Yinon Arieli's site.

Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. The views and information contained herein are the personal views of the author. Every investor must do his/her own due diligence before making any investment decision. Always consult an investment professional before making any investment decision.

Disclosure: I am/we are long TLN.

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.

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