Capturing an Economic Rebound With IPPs
Power producers have yet to benefit from a cyclical economic rebound.
Although they officially fall within the utility sector, the small group of publicly traded independent power producers are far from "granny" stocks. The IPPs are highly cyclical, volatile, closely tied to commodity markets, typically have no economic moat, and don't pay dividends. None of these are characteristics one expects from a company in the utility sector. But that does not mean investors should write IPPs off. In fact, we think this is just the place to turn for investors seeking deep cyclicals that have yet to price in an economic recovery.
First, a brief history: Prior to mid-1990s United States deregulation, all utilities charged customers regulated rates based on set returns. This certainty allowed utilities to pay out large, steady dividends. But deregulation brought competition to the power generation segment and companies--most notably, Enron--poured into this new space. The subsequent industry shakeout--and Enron's bankruptcy--reduced the field substantially. Morningstar's coverage universe now includes just four publicly traded IPPs: Mirant (MIR), NRG Energy (NRG), RRI Energy (RRI), and Dynegy (DYN). Several large diversified utilities such as Exelon (EXC), Entergy (ETR), FirstEnergy (FE), PPL Corporation (PPL), FPL Group (FPL), Constellation Energy (CEG), and Public Service Enterprise Group (PEG) earn a significant share of profits from merchant power generation in addition to regulated delivery operations.
At a high level, IPPs are fairly simple businesses. They own power plants that use fuel (typically coal or natural gas) to produce electricity that they sell to utilities, which distribute that electricity to homes and businesses. Utilities have a regulatory mandate to buy the cheapest power possible to meet demand. Typically, they do so through auctions which set the price that all power producers receive. Because bidders often bid up to their marginal costs, IPPs that have the most efficient plants and the lowest costs run their plants most often and earn the largest profits. Changes in electricity demand from hour to hour in a given region also determine the "winning" bid.
Thus, the cyclicality is immediately apparent. If commodity prices rise, so do marginal costs for power plants rise, and bids as well. For low-cost, efficient operators this means margin expansion. For high-cost, marginal plants this means profit margins tighten. Likewise, rising demand means utilities must take higher-priced bids to satisfy all demand, expanding margins for all lower-cost producers. IPPs that keep costs low experience huge operating leverage when demand rises or when costs at other plants go higher. Stock returns since 2006 show how this leverage drove huge returns during the 2006-07 commodity boom but a similar collapse occurred since then as the recession drove commodity prices down 70% from mid-2008 highs, and U.S. power demand fell 5% from 2007.
If a resurgent economy drives more electricity demand and higher commodity prices, the low-cost IPPs could once again realize record profits. Futures markets for power in 2011 and beyond incorporate virtually no rebound in demand and no rise in commodity prices. We think this is overly bearish and is weighing on the sector, offering a buying opportunity for risk-tolerant investors hoping to capture cyclical upside in an improving economy. Also, all four IPPs we feature below are sitting on large cash stashes that could either be used in today's trough markets to pick up undervalued assets, or returned to shareholders through what we think would be value-accretive share buybacks at current market prices.
Although we think Mirant and NRG Energy are the most attractive options for investors, all four IPPs we cover were trading below our fair value estimates as of late March. In addition, all of the large diversified utilities mentioned above except for Constellation Energy were trading below our fair value estimates as of late March. Exelon, FirstEnergy, and Public Service Enterprise Group are our favorite diversified utilities. We use current three-year futures commodity prices; a $7.50 per million BTU natural gas price and a $70 per ton coal price in 2014; and a moderate power demand boost to drive our regional power price assumptions for all of these firms.
Although we think Mirant represents the most attractive value in the group, there are substantial risks given its reliance on a few key coal-fired plants in the Washington, D.C. area. The plants represent more than half of the company's total generating capacity, up to 80% of annual production and as much as 85% of profits. These plants are large, low-cost and highly efficient in a region with high, stable demand and high-cost competitors. This means Mirant often realizes prices that reflect other plants' much higher marginal costs, primarily tied to natural gas. As natural gas prices rise faster than coal prices (Mirant's primary cost), Mirant benefits. Strong international demand has kept coal prices relatively high while domestic natural gas prices have plummeted the last two years on concerns pertaining to oversupply (see our latest Outlook for Energy Stocks). But as that relationship reverses, Mirant's leverage is substantial. We estimate that a $1 per million BTU increase in 2012 natural gas prices from March 2010 levels could translate into a 30% boost in 2012 operating profit. Using our midcycle commodity prices and assuming a moderate rebound in Mid-Atlantic power demand, Mirant should be able to regain 2009 operating profit levels by 2013 even as high-priced legacy hedges roll off. Our fair value estimate implies a multiple of 10 on our 2013 earnings estimate while the current stock price implies only a multiple of 5. The company's $1.9 billion cash position and only $700 million of net debt gives it flexibility to acquire assets, invest in new plants or return capital to shareholders. On a net asset value basis, we think the current $11 stock price undervalues even the Mid-Atlantic coal fleet and ignores the optionlike value of its California and New York power plants.
We don't think NRG Energy's valuation is as attractive as Mirant's right now, but we do think it has the top IPP management team and the best business portfolio. For investors hoping to dip their toes into IPPs, we recommend starting with a look at NRG. Its power plants in Texas and the Northeast are well-operated and primarily use low-cost fuels such as coal and even uranium (at its South Texas Project nuclear plant). NRG is the only IPP with nuclear exposure and is a leading contender to build one of the first new nuclear plants in the U.S. in three decades. Similar to Mirant, its low-cost, highly efficient plants benefit when costs rise for less-efficient natural gas plants. We estimate a $1 per million BTU increase in 2012 natural gas prices (as of March 2010) would translate into a 20% boost in 2012 operating profits. NRG also has the most leverage to a rebound in power demand. On a net asset value basis, we think NRG's current stock price ignores the value of its large fleet of natural gas plants, primarily in the Northeast. Although its Texas plants are its primary value and earnings drivers, these natural gas plants have significant option value that pays off when power demand is high. After one of the coolest summers in many years in the Northeast, we think investors are incorrectly assuming hot summers never return and these plants are never needed to meet peak demand. Finally, its recently acquired Texas retail operations provide an earnings hedge against its Texas generation fleet. Typically as generation margins contract, retail margins expand, and vice versa. NRG captures value for shareholders with this pairing by minimizing its trading and hedging costs (explicit and implicit), allowing NRG to operate as the low-cost retailer.
RRI Energy is now trimmer after selling its retail business to NRG in 2009 due to untenable collateral requirements. RRI also violated a key EBITDA covenant in 2009 as a cool summer and a collapse in power prices crushed profits at its unhedged Mid-Atlantic coal fleet, its primary earnings driver. We see two major near-term issues facing the company. First, only 20% of RRI's forecasted generation was hedged for 2010 and 2011 at the end of 2009. This could allow RRI significant upside to its peers during a hot summer or gas price rally, but also leaves the company exposed to persistent weak power markets. This uncertainty also constrains management's ability to make long-term investments in environmental upgrades, especially at its smaller, higher-cost plants. Second, RRI has significantly higher exposure to potential plant shutdowns if regulators mandate tougher non-carbon emissions caps. We expect RRI has some 1,000 MW of coal plant capacity that likely would close and another nearly 2,000 MW of coal plant capacity that could be in jeopardy. Carbon caps would almost certainly force these plants to close, accounting for nearly 50% of the company's total EBITDA. Fortunately for RRI, its debt burden is relatively light, at just under 36% of capital at year-end 2009. That said, we think RRI is trading at a discount to its fair value. Our fair value estimate implies a 7.8 times enterprise-value multiple on our 2012 EBITDA forecast, in line with our net asset value calculation. With the environmental uncertainty and its large open position, we would demand a 40% discount to fair value to provide a sufficient margin of safety. We also think RRI is a likely candidate for M&A activity if power prices improve given its $943 million cash balance at year-end. Still, buyers could remain skeptical of its smaller coal plants.
Dynegy barely survived 2009 when a collapse in Midwestern power demand combined with a bullish open hedging position and nearly led to bankruptcy. While a substantial asset sale kept the company alive, the same fundamental negatives persist. First, its geographical footprint is unfavorable. Dynegy's big earners are all coal plants in Illinois, where an abundance of cheap coal and nuclear plants combine with sluggish regional economies to keep power prices well below most other regions. Shorter term, Dynegy's debt covenants are still a concern, especially moving into 2011. It is well-hedged for the next two years, but it entered into many of those hedges after the collapse in power prices in 2008-09, offering investors little comfort. With cost controls, strong plant operations and a hot summer, Dynegy could pull through. But with its precarious position and the potential for a reduction in revolver capacity, Dynegy is ill-prepared for a serious contingency. The market seems well aware of Dynegy's challenges. Our fair value estimate implies a 7.8 times enterprise-value multiple on our 2012 EBITDA forecast assuming an improving economy and rising power prices. Still, we maintain an extreme uncertainty rating on the company. With near-term upside capped due to 85% of output hedged in 2011 and the covenant worries, however, we think investors would be best served to look elsewhere for leverage to a recovery in power prices.
Travis Miller does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.