Guess The Target: AES, Calpine, Dynegy, NRG?

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Includes: AES, CPN, DYN, FE, NRG, VST
by: Bruder Capital, LLC

Summary

IPPs face overcapacity and lower prices in their markets.

Private equity is circling in pursuit of capacity at the right price.

One or more of the IPPs is likely to be acquired or sell significant assets.

Here’s a stab at which ones might go first and how to play them.

IPP Valuation Comp One of my favorite parlor games is called “Guess the Target.” You may have played this game before. Basically, you win if you buy the next company to get acquired from within a group and get taken out at a premium.

To improve your odds, I suggest you pick a rapidly consolidating sector. Generally, this creates excellent opportunities for event-driven investors. Knowing that each company within the sector will most likely sell part or all of itself makes it possible for you to focus on, analyze and profit from the realization of valuations near-term. Longer term revenue and margin trends remain important, but recede into the background as your IRR becomes more subject to figuring out which company or assets will change hands, at what valuation multiple, and how it will impact their securities. That last part is important too, namely, picking the right security. Pick the wrong one – stock, bond, loan, CDS – and you’ve not done yourself a favor even if you get the company right.

The independent power producers are a case in point. There are five remaining listed public IPPs: AES Corp. (AES), Calpine Corp. (CPN), Dynegy Inc. (DYN), NRG Energy (NRG), and Vistra Energy (VST). VST is a recent addition to the list – it emerged from bankruptcy in October 2016 via a tax-free spinoff from Energy Future Holdings to former Texas Competitive Electric Holdings first lien creditors. Talen Energy fell off the list when it was taken private in December 2016. Riverstone Holdings paid $5.0 billion to buy the other 65% of Talen that it didn’t already own. The transaction effectively valued Talen at 1.24x revenue (or 8.0x EBITDA), setting a recent valuation marker and signaling that private equity firms would likely be the main buyers of IPPs and unregulated power assets going forward.

None of this is secret. CPN confirmed one week ago that it is holding M&A discussions with private equity firm Energy Capital Partners (or ECP) and DYN has been a rumored target since May when The Wall Street Journal reported that it was talking to VST about a potential merger or sale of assets, potentially creating a bigger IPP than NRG. On the other hand, ECP filed last week to sell its 14.9% stake in DYN (19.5 million shares), which may either be a signal that ECP is definitively buying CPN instead or may only reflect ECP’s desire to have a registration statement in place prior to the August 7th expiration of the lock-up period on those common shares.

There’s no problem seeing why the IPPs are looking to sell themselves. Per the graph below, spot wholesale electricity sale prices have generally declined across the US since 2013. For example, consider what has happened in the PJM, the largest of the US power grids. Huge increases in power plant capacity, state subsidization of competing (and otherwise unprofitable) nuclear plants, and lower demand have created a perfect storm of too much utility power chasing too few customer dollars. Over the past 5 years, electricity sale prices dropped 8.4% in the PJM Eastern Hub and 2.5% in the PJM Western Hub. The same reasons for selling apply to unregulated merchant generating portfolios placed on the auction block by hybrid utilities like FirstEnergy (FE):

You may have looked at the graph above and thought that the recent rise in California electricity pricing is a hopeful sign. Perhaps it is. But monthly or quarterly changes can be deceptive. Utilities are often called upon to maintain capacity or produce a much greater amount of electricity in any given month or quarter than the longer-term trend in industrial production suggests. Another major reason why utilities are seeking to dispose of their merchant generation units is that selling electricity into unregulated markets is much less predictable than selling electricity under a regulatory regime.

The graph below compares month to month changes in industrial production to the month to month changes in power produced by U.S. utilities for the past 5 years. The percentage ups and downs in industrial production generally pale in comparison to the swings seen in power production by the utilities. In fact, during the last half of 2016 and into this year, the changes in utilities’ power production has become even more volatile relative to changes in overall industrial production:

With average prices and margins on electricity sales drooping for much of the past 4-5 years, one can understand why IPP and merchant generation assets and companies have been put up for sale. That begs the question, why would private equity firms – some of whom are the proximate cause of overcapacity and lower prices in the PJM, for example – why should private equity firms be eager to buy unregulated power production businesses…? The key to the investment rationale is time. The IPPs are rich in the type of hard assets private equity investors prefer to buy and borrow against and also throw off a high level of depreciation that gets added back to cash flow. Private equity buyers are presently better positioned to acquire power capacity at lower cost and profit over a five-year time horizon than strategic acquirers who typically require synergies and costs cuts realizable within four quarters of a purchase date.

Private equity funds usually lock up their investors for multi-year terms, a long enough period in which electricity prices can turn around on power businesses purchased at a discount. Funds active in the power space may take years to get fully invested anyway. Consider for example one of the other funds managed by Riverstone Holdings, the Riverstone Global Energy & Power Fund VI LP. It’s a $4.2 billion private equity fund which set up in 2015 which has been making large-market buyout investments in North American oil, gas, coal and renewable energy industries. Undoubtedly, fund management has no problem locating targets or receiving transaction proposals. However, finding executable transactions at the right price takes time, which is why the fund, now two years old, still has $3.6 billion of dry powder left to invest (i.e., it’s still 86% un-invested).

For the last 3 years private equity shops have been the driving force behind M&A within the merchant power generation sector. You have to go back three or four years, to 2013 and 2014, to find strategic acquirers occupying the lead role. For example, Dynegy acquired merchant power assets from Ameren in 2013 and from Duke Energy in 2014 and NRG acquired merchant power assets from Edison International in 2014. Since then, per the table below, since the main buyers have been private equity firms like Blackstone, Brookfield, Energy Capital Partners, LS Power, and Riverstone:

IPP M&A List To guess which IPP will be next to go private, it helps to get a handle on what cash flows and plant assets are under consideration - how much electricity they produce, their capacity, location, and the type of fuel they use. Generally, buyers will prefer natural gas fueled facilities rather than coal or nuclear plants because gas is presently the cheapest fuel source because of all that excess shale gas thrown off by the fracking revolution. Gas delivered to power generators averaged $5/MMBtu in 2014, dropped to $3.23/MMBtu in 2015 and then to $2.78/MMBtu on average last year. As a consequence, natural gas fueled plants were the source of 32% of total US power produced last year. For the first time in US history, coal fired plants finished second with a 30% share.

IPP valuations are based on Enterprise Value to EBITDA multiples and Price to Book Value multiples. In the first case, EBITDA multiples are a function of revenue growth and profitability and a particular IPP’s growth and margins depends, in turn, on electricity demand within its markets. Like other investors, private equity firms can gauge that demand and assign a multiple to the cash flow it represents. The table below provides a four-year comparison of the four IPPs that might go private. One can assume that VST is more likely to be an acquirer than a target – it emerged from bankruptcy last year with relatively low leverage and double BB ratings. It was initially rumored to be a possible acquirer of DYN, but that would entail leveraging right back up. VST seems more likely to either return monies to shareholders via buybacks or purchase specific assets outside of its home base in Texas where it continues to face low pricing.

That leaves the other four candidates. Of these, as shown below, AES and CPN enjoy the highest EBITDA margins and operating margins. However, private equity will be just as interested in looking at how that higher profitability translates into cash flow and its CPN and DYN that have generated the highest free cash flow yields most recently. Last, CPN is the only one of the four remaining targets to have a consistently positive ROE and ROA:

IP Profitability Comp Private equity investors will consider an IPP’s book value multiple but that’s after taking a much deeper dive into the assets it owns. After all, there is a large amount of excess capacity in the national grid. This is particularly true in the PJM, for example. Much of that excess capacity has, in fact, been put in place by private equity funds. In addition, there are plenty of mothballed plants. To put this in visual perspective, the map below dots the locations of abandoned, dismantled, decommission, retired or otherwise out-of-service coal, diesel, and natural gas plants that are strewn across the country:

NRG is by the largest IPP with 46.4 GW of capacity. While nearly half of that is fueled by attractive low-cost natural gas, its plants are dispersed across more than 15 different states. Diversity is a good thing but too much diversity will be a challenge for a private equity firm that doesn’t already have assets in those locations. There are other reasons why NRG becomes a less logical first choice for a privatization effort which are addressed further down below.

Per the table below, AES has the smallest capacity but it’s heavily concentrated in California where 4.1 GW of its total 6.3 GW are located. In addition, coal is its merchant power unit’s largest fuel source, not natural gas. For the two remaining targets, assets are more evenly spread across California, Texas and at least one additional state – for CPN, it’s Pennsylvania and, for DYN, it’s Illinois. Nearly all of CPN’s power is produced using gas. DYN’s power is 68% gas-fueled but there’s still a hefty 32% share of its production coming from coal fired plants:

IPP Assets Comp With NRG’s assets too geographically spread out and AES’s plants mostly fueled by a combination of either coal or hydro, the list of top candidates for privatization gets winnowed down to two – CPN and DYN. Although CPN’s exposure to Texas (ERCOT) is higher, CPN’s capacity is 97% gas-fueled. DYN is predominantly gas, but the other 32% is coal.

At this point, if you were preliminarily ordering the group based on profitability, capacity, fuel source, and geography, you might place CPN as your top pick for privatization followed by DYN, AES, and then NRG. A look at their relative valuation multiples is a logical next step. The top part of the graph below looks at Enterprise Value to LTM EBITDA multiples over the past 5 years for each of the four main candidates and the bottom part shows their Price to Book Ratio during the same time period. CPN runs in 2nd place behind AES based on its Enterprise Value to EBITDA multiple. CPN runs in 2nd place behind DYN based on Price to Book multiples. Part of that can be ascribed to the fact that it’s been no secret that CPN is in discussions to be acquired by Energy Capital Partners:

Pulling all of this information together, on balance, it looks like CPN is the most logical top pick and ECP appears to be fairly close to pulling the trigger on a deal to buy it in a single transaction. DYN, on the other hand, seems more likely to sell coal-fired assets and use the proceeds to expand its portfolio of gas-fired assets. In February DYN formed a 65/35 JV with ECP to buy Engie’s 9.1 GW gas-fired plants for $3.3 billion. The downside was the location of those assets within Texas and the lower margins in ERCOT. DYN subsequently sold two PJM plants to LS Power for $480 million and last month agreed to sell two combined-cycle gas-fired plants to Starwood Energy Group for $119 million and a gas distribution business to Rockland Capital for $180 million.

If CPN and DYN are the two most likely transaction candidates, with the first expected to change hands in a corporate acquisition and the other expected to be buying and selling assets, then there should be two different strategies for positioning in their securities. The scenario for CPN argues in favor of owning its common stock in anticipation of achieving multiples more in line with its peers. Per the table below, CPN trades as an Enterprise Value to EBITDA multiple discount to its fellow IPPs of 19% and a Price to Book Value per Share multiple discount to its peers of 55%. One can picture a takeout price per share somewhere between $18 and $20 per share based on that assessment:

IPP Valuation Comp The assets transactions scenario for DYN argues in favor of positioning in DYN’s debt instruments rather than in its equity right now as management focuses more on reducing leverage incurred to pay for the Engie plants. The midpoint of management’s guidance for Adjusted EBITDA this year is $1.3 billion and DYN just closed Q2’17 with $9.3 billion of total debt on its balance sheet. Getting leverage back down from over 7x will be a priority, as management demonstrated by making the two July asset sale announcements. DYN’s bond issues provide a way to profit from that information. The most frequently traded of DYN’s outstanding bond issues are the $1.25 billion DYN 7⅝ Senior Unsecured Notes due ’24 rated B3/B+. At 99 cents on the dollar, their last trade price, those notes yield 7.64% with a Z-spread of 566 basis points. Comparable bonds in the space yield 6.58% on average and run 104 basis points richer in terms of Z-spread.

Disclosure: I am/we are long CPN.

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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