NRG Continues Strategic Shift

We are reaffirming our $16 fair value estimate and no-moat rating for

Under new CEO Mauricio Gutierrez, NRG continues to pay down debt--it retired $229 million in the first quarter--and move away from the renewable energy businesses that former CEO David Crane built during the past five years. We think this strategy is value neutral for shareholders. However, we think it would be better for shareholders if NRG used its core free cash flow for share repurchases or other accretive capital investments, given that we think the stock is undervalued.

We like the offsetting economics of NRG's retail business and NRG Yield's cash flows, which have protected earnings from the collapse in conventional generation earnings. Those businesses contributed 42% of adjusted EBITDA in the first quarter, one of the highest proportions ever. We expect that share to climb as the conventional generation business continues struggling at least through 2018, based on current commodity market conditions. After our recent cut in midcycle power prices, we now assume midcycle EBITDA reaches only $2.9 billion, of which more than $2 billion will come from NRG Yield, renewable energy, retail, and contracted generation revenue.

Change of Guard Brings Change of Strategy Between leading NRG Energy out of bankruptcy in 2003 and resigning in 2005, Crane diversified the company's business with the acquisitions of Reliant (2009), GenOn Energy (2012), and Edison Mission (2014). By 2017, we estimate two thirds of NRG's earnings will come from its home retail business and NRG Yield, which holds most of its renewable energy assets. Its legacy Texas wholesale generation fleet could be close to break-even based on current market prices.

New CEO Gutierrez now has a mandate from NRG's board to strengthen the company's finances in case Eastern U.S. power and gas prices are stuck at secular lows rather than cyclical lows. Power prices in NRG's primary regions typically track natural gas prices, which have fallen 80% from their mid-2008 peak. Depressed gas and power prices have cut into NRG's core cash flows significantly. Nevertheless, management's diversification has reduced cash flow volatility. Since 2009, the company has bought back about $1.5 billion of stock, and it initiated a dividend in 2012.

NRG remains poised to benefit from what we expect will be a rebound in power markets. Its nuclear, coal, and natural gas wholesale generation fleet is well positioned to expand margins as energy usage rebounds and environmental regulations force plant closures throughout the Eastern United States.

The billions of dollars that NRG has spent on renewable energy development during the past few years, along with its ownership stake in NRG Yield, provide long-term contracted cash flows and attractive risk-adjusted returns. But with the CEO transition, NRG is cutting back on its green investments.

NRG's retail business is benefiting from a low-cost competitive advantage in the retail markets by offsetting its load obligations with its wholesale generation fleet, notably in Texas. We think this advantage will grow alongside its retail business, as NRG remains a long-generation company.

Lacking Foundation for a Moat Few of NRG's power plants maintain a low-cost advantage that would be the foundation for establishing an economic moat in the commodity-sensitive merchant power industry. Shareholder returns for NRG's generation assets and retail businesses remain subject to volatile power and fuel commodity prices as well as electricity demand trends. Many of NRG's plants are subject to intense local competition that can quickly erode any excess shareholder returns.

The stand-alone retail businesses also offer no economic moat. Energy retailers sell a commodity product, either electricity or natural gas, and customers enjoy virtually no switching costs. This makes for intensely competitive markets with tight and volatile margins. However, if a utility can pair its retail supply business with its wholesale generation in a given region, we believe it could establish a low-cost competitive advantage in the retail market. NRG has shown signs that it can capitalize on this low-cost advantage.

Although returns for long-term contracted renewable energy projects are above the projects' very low costs of capital, these rely heavily on government subsidies that might not be available when current power purchase agreements expire. For the most part, solar panels and capital are available at some cost, so competitors with large balance sheets have matched NRG's financing advantage. We also believe the company's battery storage, distributed generation, and electric vehicle charging businesses lack the foundation for a moat.

Long-Term Contracted Cash Flows Offset Some Risk A sustained fall in natural gas prices and electricity demand would severely limit future earnings potential. However, fixed contracted and capacity revenue from NRG's conventional fleet will contribute about 80% of earnings through the trough years in the power markets.

At the retail business, already-thin margins offer little room for error when NRG prices customer contracts to incorporate volume and price risk. However, its ability to serve customers with its diverse generation fleet could make it a relative winner in some markets if power prices become more volatile.

Counter to the high-risk and volatile nature of its wholesale and retail energy businesses, NRG's renewable energy business and stake in NRG Yield offers long-term contracted cash flows that can support its dividend and additional share buybacks. NRG Yield is highly dependent on capital markets. A sustained negative perception of the yieldco structure would make it costly to issue equity to sustain cash flow growth and support distributions.

NRG's balance sheet requires careful inspection. Of the $19.5 billion of consolidated gross long-term debt, only $8.6 billion is directly recourse to the parent. Of the $11 billion of nonrecourse debt consolidated on NRG's balance sheet, $6 billion is at GenOn or renewable projects, and $5 billion is at NRG Yield. NRG Energy owns a 46.7% economic interest in NRG Yield, which is more highly leveraged than NRG Energy.

This debt mix could change significantly beyond 2016. Management has committed to $1 billion of debt reduction in 2016, and we expect it will offload another $3 billion of renewable project-level debt through drop-downs to NRG Yield in 2016-17. This debt will remain on the balance sheet consolidated as NRG Yield debt but will simplify NRG Energy's capital structure.

Management is addressing NRG's leverage in anticipation of a sustained power market downturn in 2017-18 that could stress the balance sheet. Excluding its project-level renewable energy and NRG Yield debt, we estimate trough EBITDA in 2017 will cover parent recourse and GenOn interest expense 2.2 times, while debt/EBITDA will rise to 7 times, even after the planned $1 billion debt reduction. NRG has about $3 billion of cash and revolver capacity as at year-end 2015 at the parent. NRG Yield and the renewable projects are much more highly leveraged but come with contracted cash flows and low-cost debt that supports the extra leverage. NRG should easily cover its new dividend, which management cut to $0.12 per share annualized in 2016 from $0.58 per share, reducing the cash outlay to just $40 million.