Court Decision's Impact on Dynegy Overblown

This week, the U.S. Supreme Court issued a 6-2 decision effectively supporting the Federal Energy Regulatory Commission's Order No. 745, which said that when a demand response provider in an organized wholesale energy market has the capability to balance supply and demand as an alternative to a generation resource, and when that is cost-effective, the provider must be compensated for its service to the energy market at the locational marginal price. With this, the FERC aimed to ensure the competitiveness of organized wholesale energy markets and see that demand response providers were paid the same as power producers.

The decision on its face appears to be a win for demand response providers and a loss for power producers like

Despite the Supreme Court win, demand response faces other challenges. Mid-Atlantic grid operator PJM is implementing rule changes that hurt the economics of demand response and should boost margins for conventional generators. We expect little change in the amount of demand response that clears the 2019-20 base capacity auction and maintain our long-term outlook. Demand response participation might even drop if PJM continues to make rule changes recommended by the market monitor. This would be a benefit for conventional generators.

Ultimately, we think demand response market saturation will be the limiting factor. As demand response gains market share, capacity values will go down. This will erode profitability for new demand response entrants, since demand response providers typically receive more than 90% of their revenue from capacity payments.

The Supreme Court's ruling has no material impact on our long-term thesis for independent power producers and diversified utilities. We believe the market reaction was overly pessimistic to the ruling and presents a buying opportunity for those with the appropriate risk appetite.

Acquisitions Past and Future Should Create Value With the $6.25 billion acquisition of 12.4 gigawatts of gas and coal generation in 2015, Dynegy nearly doubled its generation capacity. We think this was a good deal for shareholders, given the 9 GW the company will add in the Mid-Atlantic region and the 3.4 GW it will add in New England. We think both markets have attractive long-term fundamentals supporting incumbent generation. In addition, management has proved its ability to manage large acquisitions, successfully integrating and creating value from its recent Ameren acquisition.

In 2013, the company added the 4.1-gigawatt Illinois Power Holdings coal plant fleet to its legacy coal unit's 3.0 GW capacity. Dynegy has improved IPH's operating performance through higher capacity factors and lower forced outage rates, enhancing plant economics. Given management's ability to turn around IPH, we are optimistic that Dynegy's recent acquisitions will create value.

The coal fleet operates in the Midwest regional transmission organization MISO, where 9.1 GW of coal generation capacity is expected to retire soon, with additional aging units at risk. This is affecting MISO's new capacity market prices. The 2014-15 planning year auction cleared at $16.75/megawatt-day and the 2015-16 planning year auction cleared at $150/megawatt-day in Dynegy's primary Illinois zone. Dynegy's Midwest coal plants would realize the most upside from our forecast rebound in power prices. Additionally, given the significant amount of coal in its operating regions, the coal unit's fleet is less vulnerable to coal-to-gas switching than in other regions of the country.

The gas unit operates 6.8 GW of natural gas generation in Illinois, California, and the Northeast, of which 4.4 GW is efficient natural gas-fired combined-cycle generation. The unit currently benefits from low natural gas prices, resulting in significantly higher year-over-year capacity factors and expanding margins. A rebound in power prices and correspondingly higher natural gas prices, would lower capacity factors but still allow the unit to capture margin during peak usage times.

Subject to Commodity-Sensitive Power Prices Dynegy lacks the foundation for an economic moat. Its returns on capital depend on commodity prices for electricity, natural gas, and coal. Many of Dynegy's plants are subject to local competition, which could erode excess shareholder returns. As power grid operators explore more ways to encourage new-build power generation, Dynegy could see its competitive advantage as an incumbent power producer erode. None of Dynegy's independent power producer peers have economic moats. We consider low-cost nuclear generation the only source of economic moats in deregulated power markets.

All else equal, sustained low natural gas prices would damp Dynegy's earnings potential and reduce overall generation levels. Besides the exposure to energy commodity prices, the company faces considerable regulatory risk. The company must also maintain strong relationships in the financial markets, as it will need access to credit to fund growth investments and cover collateral and trading costs in highly volatile power markets.

Dynegy has one of the stronger balance sheets of the independent power producers after emerging from bankruptcy. As of Sept. 30, it had $1.9 billion in total liquidity. We forecast nearly $600 million in capital expenditures for 2015-17, which we expect the company will be able to meet from cash flow generation. We forecast debt/EBITDA will decline to approximately 4.0 times through 2019. The company pays no dividend and recently initiated a $250 million share-repurchase program.