NRG Offers All-Stock Buyout for GenOn Energy

On July 22,  NRG Energy (NRG) announced plans to acquire independent power producer  GenOn Energy  in a $1.7 billion all-stock deal that would create the largest U.S. wholesale generator with 47 gigawatts of capacity across much of the Northeast, Mid-Atlantic, Texas, and California markets. NRG is offering 0.1216 shares per GenOn share and GenOn shareholders will own 21% of the combined company after the merger closes. As of market close July 20, the offer values GenOn at $2.19 per share, a 20% premium.

Despite the market-based premium NRG offered, we think the exchange ratio undervalues GenOn by roughly 14%. Based on our $4.50 per share fair value estimate for GenOn and our $31 per share fair value estimate for NRG Energy, we think GenOn shareholders should own about one third of the merged company, not 21%. We plan to cut our fair value estimate for GenOn to reflect a high probability of the deal closing within the next 9-12 months. For NRG, we believe the deal is value-accretive, and we plan to raise our fair value estimate to $33 per share from $31 per share.

In addition, the companies' shareholders will split the $200 million of pretax operating synergies and $100 million in interest cost savings that NRG management has projected. We estimate this could add about $1 per share of value for current NRG shareholders and $0.10 per share of value for current GenOn shareholders. Management's $200 million target seems achievable at 8% of combined recurring operating expenses based on our 2012 forecasts for each company. Management estimates one-time costs to NRG to close the merger of $155 million. The company has committed to retiring roughly $1 billion in debt after deal close, specifically including a $690 million GenOn term loan due in 2017.

Strategically, we think the deal represents NRG's quest to add conventional generation in the Mid-Atlantic region to support its fast-growing Reliant retail operations in that region. NRG has shown some of the benefits from pairing its retail and wholesale generation fleet in its core Texas region, and we think NRG management is aiming to extend that strategy to newly profitable retail markets in the Mid-Atlantic region, where the bulk of GenOn's fleet is located. In addition, the acquisition gives NRG considerably more upside to a rebound in power prices.

The transaction announcement also came on the same day NRG declared its first-ever dividend. It will pay $0.09 per share on Aug. 15, implying a $0.36 per share annual payment and a 2% yield on NRG's stock price as of July 20 market close. NRG management also pre-released second-quarter results, including adjusted EBITDA of $530 million and maintained its full-year EBITDA guidance of $1.8 billion-$2.0 billion. We are reaffirming our full-year estimates, which are at the high end of management's guidance range.

GenOn updated its 2012 EBITDA guidance, increasing it to $467 million from $446 million versus our forecast of $448 million. Guidance for 2013 increased to $687 million from $669 million versus our forecast of $657 million. The increases are mostly mechanical as the majority will come from increased forward natural gas prices. However, GenOn also initiated its first 2014 EBITDA guidance at $730 million, versus our current estimate of $679 million.

NRG Energy CEO David Crane, who will remain CEO and chairman, and GenOn Energy CEO Ed Muller have a history dating back to 2006 when Muller's then-Mirant made a hostile bid worth $8 billion and a 33% premium to NRG's stock price at that time for Crane's NRG that ultimately failed. Mueller will join the combined board as vice chairman along with three other GenOn board members.

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