CALPINE CORP CPN
April 10, 2015 - 10:06am EST by
Jaysan33
2015 2016
Price: 23.00 EPS 0 0
Shares Out. (in M): 375 P/E 0 0
Market Cap (in $M): 8,619 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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  • Power Producer
 

Description

Long CPN
 
As a merchant power generator/IPP, CPN’s profitability is generally driven by gas prices, as gas
prices set power prices in most power markets and forward power prices are a determinant in
capacity pricing. The sensitivity to gas prices is less than that of a coal or nuclear generator, as
CPN is a gas power plant operator. But the sensitivity is still there since CPN is an efficient gas
generator with operating heat rates below market clearing heat rates. So any thesis on CPN has
to be grounded with a view on gas prices.
 
Even as gas strip pricing has recently collapsed due to an oversupplied market (continued
production growth in the Marcellus and Utica), there are numerous dynamics at play that I
believe make CPN’s cash flow story attractive and sustainable. The dynamics discussed in this
write-up should support continued cash returns to shareholders via stock buybacks, regardless of
further declines in natural gas prices. Furthermore, whenever commodity markets balance, the
balancing is not smooth and production generally over-adjusts. Therefore, I see longer-term
natural gas prices as undervalued, as natural gas markets must balance in the short-term via a
production response.
 
CPN trades at an average ’15, ’16 free cash flow yield of 12% on current Consensus estimates. I
believe the underlying gas market dynamics at play support these cash flow estimates over the
next two years, and when combined with the magnitude of cash flow return to shareholders,
support a minimum 16-22% total return range on the stock over a 12-month horizon.
Importantly, this return estimate assumes no change to CPN’s cash flow multiple (i.e. it
continues trading at a 12% yield).
 
The energy market today is very fluid and uncertain, and finding anything with high conviction
is pretty difficult. But because I view CPN as having limited earnings sensitivity to natural gas
prices: a 12% free cash flow yield and a forecasted return to shareholders of 33% of its market
cap over the next 3 years make it one of the few near-term energy bets that it is palatable.
 
 
Summary:
 
- Northeast natural gas production growth will have to slow down in order to balance an
oversupplied gas market in 2015 and 2016. Even a Consensus slowdown in 2016 L-48
gas production growth to 2.5 Bcf/d from 3.8 this year will still leave Oct’16 storage at
very high levels and will again require incremental YoY C-to-G switching….a lot of
demand elasticity required of the power market
 
- Gas supply/demand models require substantial incremental YoY CtoG switching in ‘15 at
a time when:
1. Gas plant power burn already steals market share when gas is below $4.00
2. Coal is oversupplied and incremental gas demand from power gen needs
to today be done at more competitive PRB coal prices
 
- Oil and NGL prices have driven down well IRR’s and E&P cash flows, meaning break-
 
even gas prices from liquids-rich wells are much higher today. But the slowdown in oil
production (and associated gas production) is taking too long, implying substantial risk
for Oct ’15 storage levels
 
- Even if we get a material slowdown in associated gas production growth, it does not seem
to be enough to balance the market on its own; i.e. NE production growth is too high and
we’re already requiring a lot from CtoG switching.
 
 
 
Conclusion #1: there is meaningful risk that gas prices need to fall to levels that curtail NE gas
production growth in ’15 and ’16.
 
Conclusion #2: Gas production growth needs to slow now in order to balance markets near-term,
at time when gas demand begins to pick-up in 2016+. The production response at the bottom of
a commodity cycle always has risk of overshooting to the downside, meaning long-term gas strip
pricing seems undervalued after the recent correction. This is a positive for merchant power
companies
 
 
 
The problem is the natural gas balancing mechanism
 
According to Bentek estimates, gas-fired power burn for base-load generation reached a record
high of around 23 Bcf/d in Jan and Feb ’15 (when henry hub prices averaged $2.91). But we still
need more switching as total power demand falls in the shoulder season and production growth is
not slowing.
 
Morgan Stanley’s valid point: The Northeast needs 1.5 Bcf/d YoY incremental CtoG to balance
the regional market this year, and when combined with the fact that infrastructure is tight out-of-
basin, gas will need to find new NE pricing hubs to stimulate demand. But Northeastern coal
prices are already out of the money relative to gas:
 
 
 Source:  Barclays Research
 
 
So where does incremental demand in the NE come from? Coal retirements via MATS is one
area, but at least one sell-side shop has recently revised down its MATS retirement estimates due
to regulatory timeline extensions.
 
 
The graph above from Barclays is an interesting result of strong production growth and higher
power market share from gas via CtoG
 
 
i.e. higher HDD’s can be met by a reversal of CtoG but there is less room from incremental CtoG
when HDDs are very low.
 
 
 
What does this all mean and how should we interpret?
 
1. Because gas markets are oversupplied near-term, gas prices need to fall to a level that
encourages incremental YoY CtoG switching on a U.S.-wide basis.
a. The latest estimate from MS is a total of 2.7 Bcf/d of required incremental
YoY switching nationwide, and 1.5 Bcf/d of that will be needed in the
NE…this is on 5-6 Bcf/d of estimated current CtoG switching
b. Henry Hub will then need to compete with PRB coal prices, implying HH
prices of < $2.60 (see table above)
c. But the NE is take-away constrained near-term, implying prices may need to
fall to shut-in production (at least party via completion deferrals) absent
meaningful incremental CtoG switching in-basin.
i. Apply your own basis to sub $2.60 henry hub
ii. The fact that gas markets require another increase in YoY switching in
2016 should temporarily drive down strips gas pricing even more,
providing the incentive for natural gas E&Ps to slow activity
 
2. Because PJM power prices are set by coal economics, a further downdraft in NE gas
prices means gas power plant operators realize expanding spark spreads and increased
utilization through CtoG switching
a. Meaning as NE gas prices keep falling, PJM spark spreads expand as coal
plants set power prices
b. As this dynamic plays out, further declines in 2016 forward gas pricing may
not lead to tighter spark spreads in the NE because coal pricing will set a floor
on power prices
 
3. Given that Henry Hub prices are already close to $2.60, further declines in power
prices are some-what mitigated by the coal floor; i.e. coal begins at some point to set
power prices in Texas; but importantly, incremental CtoG switching is needed to
balance the market, so gas power plants realize increased utilization via CtoG
switching.
 
4. Bottom line is that gas prices need to force lower natural gas production growth,
particularly in the Northeast, if the needed CtoG doesn’t materialize at a high enough
price level
a. Gas power plants realize expanding spark spreads, where coal begins to set
power prices, and increased utilization via CtoG. Then, as the natural gas
commodity cycle develops (i.e. 2016 expected gas production comes down),
strip gas pricing then rises, which is beneficial for merchant power stocks and
sellside valuation of these stocks.
 
Risks to the above interpretation:
 
1. Oil production growth begins correcting immediately, bringing down associated gas
production growth enough to allow minimal incremental CtoG to balance gas markets
a. Consensus 2015 gas production growth is 4 Bcf/d YoY with associated gas
production growth of 2 Bcf/d, implying that if you took out the 2 Bcf/d of
associated gas growth, you would still need incremental YoY CtoG switching to
balance gas markets this year, albeit a much smaller amount
i. Or, you would need oil production to decline in ’15
ii. Or, you need NE gas production growth to slow
 
2. CtoG switching is sufficient to balance gas markets at a gas price that does not slow
down NE production growth, meaning we never get the upward bias in strip pricing post
2015 shoulder season.
a. This would mean that NE gas finds power demand sensitivity at < $2.60 henry
hub, but in this case, gas turbines get the incremental utilization
 
3. MATS retirements create a tighter power market than anticipated, increasing gas demand
more than expected YoY
a. In this case, a tighter power market means higher power prices and higher spark
spreads
 
4. Spark spreads decline
a. The risk is that coal prices start to come down materially in a short period of time
which requires a lower and lower gas price to displace coal in the power stack.
This drives down power prices and thus drives down spark spreads of efficient
gas plants (see more on this below)
b. However, it may be difficult to realize much lower coal pricing given implied cost
of production.
 
 
 
 
 
 
 
 
 
 
 
Historical coal prices:
 
 
 Source for coal data/graphs:  Howard Weil
 
 
 
The thrid graph abovce is the Supply response.
 
 Coal is generally priced on contracts with fixed pricing for a term, making it
difficult of power plants to get competitive pricing in the short-term
 
 
Finally, the $53 per ton Appalachian coal price in the table above is very close to cost of production support levels (based on current coal demand):
 
 
 
 
 
 
 
 
 
Why play CPN here?
 
CPN is the perfect fit for the gas and power market dynamic discussed above:
 
CPN is a high-efficiency gas power plant company with merchant exposure in PJM and Texas.
In PJM, we have sustained spark spreads driven by coal prices setting power prices, and so
further drops in NE gas prices are all margin to CPN. In Texas, we have more power price
exposure due to more competitive coal prices (PRB), but gas prices have already corrected to
low levels and there is not much further for gas to go to start competing with Coal. The
necessity of CtoG to balance the market means higher utilization for CPN plants in Texas,
offsetting lower spark spreads; and if gas prices fall enough, CPN realizes the same margin
impact as in PJM, creating a floor on earnings downside.
 
While CPN is realizing increased utilization and higher spark spreads in PJM, offsetting some
margin pressure in ERCOT (Texas), the anticipated gas production response eventually lifts
longer-term gas strip pricing, which is beneficial to any power producer (where gas sets power
pricing). In other words, CPN has short-term earnings tailwinds at time when gas prices are
dropping. Then eventual strip revaluation driving long-term earnings estimates higher because
CPN has a below-market-clearing heat-rate (meaning is still long gas prices).
 
The attractiveness of CPN is not really earnings though: The macro dynamics simply make me
comfortable with the sustainability of cash flow generation that will support continued cash  return to shareholders.
 
The bottom line here is that we can have a high degree of confidence in CPN’s 2015 guidance
range (the bias is upwards in my opinion given the above dynamics). But the more important
aspect is that we can have a high degree of confidence in CPN’s free cash flow yield.
 
CPN trades at an 11% free cash flow yield this year (free cash flow is CFO minus total capex),
but importantly has a policy of returning excess cash to shareholders via stock buybacks.
Therefore, Free cash flow per share is growing at 16% this year and 22% next year based on
Consensus EBITDA.
 
The way I view valuation is that the fundamental dynamics support free cash flow generation,
and the return of free cash flow generation leads to a higher growth rate in free cash flow per
share.
 
So applying an 11% yield to forward year free cash flow per share that is growing 16-22% means
a 16-22% total return potential (alternatively, the company is shrinking EV while growing
EBITDA). The idea that CPN still trades at an 11% yield (at least) is based on the fundamental
factors discussed above.
 
 
 
 
CPN Summary ($mm)
 
 
Current Market Cap   8,212
Current Debt   11,282
Current Cash   717 
 
Leverage   5.31x
Current share price $22.00 
 
 
 
                                                  Low    Mid    High
CPN guided 2015 EBITDA             1,900  2,000  2,100
 
 
 
                                           2014        2015       2016      2017
 
Consensus CPN EBITDA                       1,990       2,014    2,102
 
Consensus Capex                               (497)       (423)     (306)
Interest expense                                (645)       (645)     (645)
Working capital                                  (50)         (75)       (75)
Free Cash Flow to Equity                     798          871        1,076
 
Cash Balance                       717         715         786        862
 
Stock Buybacks                                 (800)        (800)      (1,000)
Cumulative buybacks as % of mkt cap                              31.7%
 
Shares outstanding                375        339         303         257
Free cash flow per share        $2.03      $2.35      $2.88      $4.18
Growth                                                16%       22.3%    45.3%
 
Free cash flow yield                             10.7%     13.1%    19%
 
 
 
 
 
 
                                                                     
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

The catalyst here is the realization of cash flow return to shareholders made possible by visibility and realization in actual earnings.  The stock price cannot ignore actual cash returns to sharedholder of this magnitude without drastically decreasing the fair EBITDA multiple at which the stock trades  (i.e. EV will decline materially while EBITDA grows).

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    Description

    Long CPN
     
    As a merchant power generator/IPP, CPN’s profitability is generally driven by gas prices, as gas
    prices set power prices in most power markets and forward power prices are a determinant in
    capacity pricing. The sensitivity to gas prices is less than that of a coal or nuclear generator, as
    CPN is a gas power plant operator. But the sensitivity is still there since CPN is an efficient gas
    generator with operating heat rates below market clearing heat rates. So any thesis on CPN has
    to be grounded with a view on gas prices.
     
    Even as gas strip pricing has recently collapsed due to an oversupplied market (continued
    production growth in the Marcellus and Utica), there are numerous dynamics at play that I
    believe make CPN’s cash flow story attractive and sustainable. The dynamics discussed in this
    write-up should support continued cash returns to shareholders via stock buybacks, regardless of
    further declines in natural gas prices. Furthermore, whenever commodity markets balance, the
    balancing is not smooth and production generally over-adjusts. Therefore, I see longer-term
    natural gas prices as undervalued, as natural gas markets must balance in the short-term via a
    production response.
     
    CPN trades at an average ’15, ’16 free cash flow yield of 12% on current Consensus estimates. I
    believe the underlying gas market dynamics at play support these cash flow estimates over the
    next two years, and when combined with the magnitude of cash flow return to shareholders,
    support a minimum 16-22% total return range on the stock over a 12-month horizon.
    Importantly, this return estimate assumes no change to CPN’s cash flow multiple (i.e. it
    continues trading at a 12% yield).
     
    The energy market today is very fluid and uncertain, and finding anything with high conviction
    is pretty difficult. But because I view CPN as having limited earnings sensitivity to natural gas
    prices: a 12% free cash flow yield and a forecasted return to shareholders of 33% of its market
    cap over the next 3 years make it one of the few near-term energy bets that it is palatable.
     
     
    Summary:
     
    - Northeast natural gas production growth will have to slow down in order to balance an
    oversupplied gas market in 2015 and 2016. Even a Consensus slowdown in 2016 L-48
    gas production growth to 2.5 Bcf/d from 3.8 this year will still leave Oct’16 storage at
    very high levels and will again require incremental YoY C-to-G switching….a lot of
    demand elasticity required of the power market
     
    - Gas supply/demand models require substantial incremental YoY CtoG switching in ‘15 at
    a time when:
    1. Gas plant power burn already steals market share when gas is below $4.00
    2. Coal is oversupplied and incremental gas demand from power gen needs
    to today be done at more competitive PRB coal prices
     
    - Oil and NGL prices have driven down well IRR’s and E&P cash flows, meaning break-
     
    even gas prices from liquids-rich wells are much higher today. But the slowdown in oil
    production (and associated gas production) is taking too long, implying substantial risk
    for Oct ’15 storage levels
     
    - Even if we get a material slowdown in associated gas production growth, it does not seem
    to be enough to balance the market on its own; i.e. NE production growth is too high and
    we’re already requiring a lot from CtoG switching.
     
     
     
    Conclusion #1: there is meaningful risk that gas prices need to fall to levels that curtail NE gas
    production growth in ’15 and ’16.
     
    Conclusion #2: Gas production growth needs to slow now in order to balance markets near-term,
    at time when gas demand begins to pick-up in 2016+. The production response at the bottom of
    a commodity cycle always has risk of overshooting to the downside, meaning long-term gas strip
    pricing seems undervalued after the recent correction. This is a positive for merchant power
    companies
     
     
     
    The problem is the natural gas balancing mechanism
     
    According to Bentek estimates, gas-fired power burn for base-load generation reached a record
    high of around 23 Bcf/d in Jan and Feb ’15 (when henry hub prices averaged $2.91). But we still
    need more switching as total power demand falls in the shoulder season and production growth is
    not slowing.
     
    Morgan Stanley’s valid point: The Northeast needs 1.5 Bcf/d YoY incremental CtoG to balance
    the regional market this year, and when combined with the fact that infrastructure is tight out-of-
    basin, gas will need to find new NE pricing hubs to stimulate demand. But Northeastern coal
    prices are already out of the money relative to gas: