NRG Energy ($NRG) — Initiation (11/18/21)

Price: $36 Market Cap: $8.8bn Valuation: 7x FCF Category: General

wrote about this in a Quick Value post in June but have added to my position so wanted to dig deeper.

  1. Background
  2. Direct Energy acquisition
  3. Winter Storm Uri
  4. The Turnaround
  5. Market Mispricing
  6. Valuation

Background…

I’ll pick apart some tidbits from the latest 10-K which describe the business well.

This is a similar business to Vistra ($VST) — NRG sells electricity and natural gas to residential, commercial, and industrial customers. They operate an integrated model with 33 power plants generating 23 GW of energy.

The integrated model has the advantage of supplying NRG’s retail customers with electricity from NRG’s power plants so they can avoid having to buy (or sell) electricity from other companies.

Generation portfolio totals ~23 GW broken down by 10 GW in Texas, 9.5 GW in the East, and 3.2 GW in the West. Most of the generation comes from natural gas (43%) with 35% coming from coal — there have been some further asset sales / coal plant retirements that will bring the generation portfolio down to 14 GW in 2021.

NRG generation assets

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NRG’s retail customers across primary markets Texas/East are served partially by the company-owned generation assets and the remainder from market purchases (the integrated model).

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The analyst day in June 2021 gave an excellent overview of the key differences between operational and financial supply of energy. This balance / portfolio management is the key to operating a successful customer-facing energy provider such as NRG…

Operational vs. Financial Supply

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Back in 2014, NRG had a portfolio of some 93 plants producing 47 GW in energy. With half the retail customers too. That business was mostly a wholesale generation company in the business of producing energy and selling it at market rates to other companies.

Since then, new management has come in, they’ve sold generation assets to meet retail customer needs, and acquired more customer-facing businesses. Today’s NRG is very much a retail-focused business.

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Retail customers have grown from 2.9m in 2018 to 6m as of 3Q21 thanks to the addition of Direct Energy.

Not that this business deserves a 20-35x EBITDA multiple but I get what management is trying to do in highlighting the retail nature of their business and dispel the traditional mindset of a volatile merchant power producer…

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Direct Energy acquisition…

In 2021, NRG acquired Direct Energy for $3.6bn to add some 3m retail customers, exposure to natural gas services, and geographic exposure away from the Texas market.

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Direct Energy is a primarily financially-supplied retailer of energy services to business and residential customers nationwide. They also own the Airtron HVAC company generating ~$600m in annual revenue.

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Below were the original pro-forma targets for the combined NRG + DE.

July 2020 Direct Energy targets

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Winter Storm Uri…

A big reason for the current opportunity is due to Winter Storm Uri during Feb 2021. NRG (and Vistra) are the largest electricity providers in the state of Texas and each took a beating (both in share price and fundamentals) from this storm.

Vistra anticipates net losses of $1.6bn and NRG expects $500-700m from this one storm alone! (Compare that to current market caps of $10bn and $9bn apiece.)

But it may not all be bad with the potential for market reforms and smaller competitors going out of business…

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From an earlier WSJ article:

The other silver lining is that these larger companies will likely gain more retail customers, both because customers will organically migrate to larger, more stable retail providers and because there will be opportunities for larger companies such as Vistra and NRG to buy financially weakened ones at bargain prices. The retail side of the power business is highly profitable and has been a target of acquisitions for Texas power companies for some time, notes Aneesh Prabhu, analyst at S&P Global Ratings.

The Turnaround…

Mauricio Gutierrez was brought up to the CEO spot in 2015 after previous CEO David Crane led NRG from its post-bankruptcy days in 2003 up to 2015. Crane went on a spending spree for generation assets ultimately ballooning to a 47 GW generation portfolio.

In 2015, the company had $20bn+ in debt with < $2bn in annual operating cash flow. Asset impairment charges were close to $5bn in 2015 and Crane was axed in favor of then COO Mauricio.

Gutierrez spent 2016-2020 selling assets, trimming debt, repurchasing stock, turning on a meaningful dividend, and then in 2021, making a major acquisition.

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Beyond those financial metrics, he’s positioned the company such that wholesale generation represents a portion of retail load as opposed to being a net seller of energy.

Market Mispricing…

The combination of lower power prices and the Uri impact have investors skeptical on the long-run viability of these businesses. They don’t have guaranteed returns like a regulated utility and the price competitiveness of fossil fuels (gas / coal) is becoming more apparent (see recent PJM auction headlines).

Contrary to that… NRG (and Vistra) are highly cash-generative businesses with low-cost assets to support their retail customers. NRG has been shifting toward a combination of operational / financial supply for their customers and with cheap renewable fuel, this mix might be the right approach.

2016-3Q21 cash flow

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Cumulative cash flow is expected to total $8bn over the next 4 years and management intends to return 50% of that via dividends and buybacks. The remaining 50% is “up for grabs” in opportunistic deployment for more repurchases or other uses meeting their 12-15% return hurdle…

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At the June 2021 investor day, management laid out a path to $12.50/share in FCF by 2025 (from $6.30 in 2020) — 15-20% annual growth from a 2020 starting point.

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Right behind that, 3Q21 results gave us a first look at initial 2022 guidance for EBITDA and FCF. Both metrics saw a pretty big step down from 2021 levels. NRG is expecting:

  • $1.95-2.25bn in EBITDA — from $2.4-2.5bn in 2021 — down 14% YoY
  • $1.14-1.44bn in FCF — from $1.4-1.5bn in 2021 — down 14% YoY

They’ve given us the reasons for the decline in a 2021-2022 EBITDA walk… One portion ($310m) is from asset sales (not yet completed) and plant retirements… The remainder ($220m) is from “transitory” impacts such as supply chain issues and major plant outages…

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Valuation…

Looking at the proxy from the 2018 acquisition of Dynegy by Vistra gives us a glimpse at some historical trading / transaction multiples in this industry…

For starters… simple trading multiples at the time were in the 8-9x neighborhood with Dynegy a bit lower thanks to a massive pile of debt.

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Behind that, transaction multiples for these businesses from 2012-2017 ranged from 6-9x EBITDA.

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Today — NRG and Vistra are essentially the last of the publicly traded independent power companies — and they both trade at ~7x EBITDA. And each have their own reasons for deserving a multiple quite a bit higher than that.

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I expect NRG will be buying significant amounts of stock in 2022-2023 as FCF ramps up following the Direct Energy acquisition. This will happen in tandem with the 2.5-2.75x leverage objective by end of 2023.

They shouldn’t have much trouble retiring another 20% of outstanding shares (they did more than this from 2018-2020. I expect 2023 EBITDA to grow from the $2.1bn 2022 level… call it $2.3bn…

At comparable multiples (above) of 8x with 2.75x leverage nets a share price of $60+ by 2023, a 30% CAGR from today’s price.

NRG is about a 2.5% position right now but could become larger if management becomes impatient with the valuation and steps up the buyback pace (similar to Vistra). Most of the bad news is out of the way at this point, so there should be few surprises left outside of cash flow and shareholder returns. This is a company talking about having $8bn in deployable cash over the next 4 years with a market cap of $9bn — capital deployment is key.