CALPINE CORP CPN
January 27, 2016 - 7:35pm EST by
pathbska
2016 2017
Price: 14.25 EPS 0.49 0.87
Shares Out. (in M): 357 P/E 29.1 16.4
Market Cap (in $M): 5,085 P/FCF 5.8 4.5
Net Debt (in $M): 11,039 EBIT 927 1,058
TEV ($): 16,124 TEV/EBIT 17.4 15.2

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  • Utility
  • Natural gas
  • Replacement Cost
  • California
  • NOLs
 

Description

Overview
 
that thread. The stock is also down 33% on 5% lower 2016 EBITDA estimates and virtually flat 2017
estimates. Just to provide rehash some background, Calpine is an independent power producer (IPP)
that operates in the Northeast (mostly in the “PJM” region), Texas (the “ERCOT region) and California
(the “CAISO” region) in roughly equal parts.
 
Calpine operates a 27,000 MW fleet of primarily combined cycle gas turbine (CCGT) plants that are
amongst the youngest, cleanest, and most efficient amongst its peers. It also has low cost geothermal
plants in California. Given the increased regulatory activity around environmental issues and the
volatility inherent in most other renewable power sources (e.g., solar and wind), we believe Calpine’s
fleet will be a key component of the power mix in each of its markets.
 
 
Why does the opportunity exist?
 
Calpine’s share price declined from $24 in late-2014 to its current level around $14, which implies a
significant discount to the replacement cost of its assets. Applying a reasonable valuation to the
geothermal assets in California, Calpine’s CCGT fleet is valued at ~$350/kW, versus replacement costs of
between $1,000-$1,200/KW.
 
This is being driven by: (i) weak power market prices, (ii) a selloff in the overall commodity complex
(despite limited impact to Calpine’s business), and (iii) anticipation of interest rate increases in the US,
which resulted in weakness for rate sensitive sectors such as Merchant IPPs and Utilities. The current
consensus seems to be that there is no catalyst for the sector and, based on current forward curves,
there will not be much growth, if any, for EBITDA.
 
 
Why do we find this opportunity compelling?
 
As detailed below, we think investors are overlooking significant growth in the company’s per share free
cash flow over the next few years. We have examined numerous situations where companies used
stable cash flows for share buy backs, and have found that many of them were subsequently significant
outperformers.
 
Calpine is a well-run company that is intently focused on share buybacks, against which they compare all
capital allocation decisions. In the past two years they have completed > $1.6b in buybacks,
representing > 30% of the company’s current market cap. The CFO recently summarized the company’s
view saying, “The way I look at us is we are a free cash flow per share growth story”.
 
The two tables below show the power of buybacks, particularly at low share prices. The first table shows
estimated 2019 free cash flow (FCF) per share assuming different level of buybacks as a percentage of
the current market cap and under different stock price assumptions. The second table shows FCF/share
at different average annual levels of EBITDA at different levels of buyback. Note that the lower left hand
corner roughly corresponds to our bear case and the lower right hand our bull case. Even with a flat
EBITDA profile (roughly $2b) we believe Calpine is able to buyback on average of ~16% of the float each
year without changing its leverage ratios.
 
 
2019 Calpine FCF/share at Different Levels of Buyback and Stock Price

         
   
Annual Buyback % Current Market Cap

    5% 10% 15%
Calpine Share Price $14 $3.92 $4.66 $5.52
$18 $3.81 $4.33 $4.90
$22 $3.73 $4.14 $4.56
 
 
 
2019 Calpine FCF/share at Different Levels of EBITDA and Buyback

         
   
Average Annual EBITDA (m$)

    1,800 2,000 2,300
Annual Buyback % Current MC 5% $2.99 $3.63 $5.10
10%

$3.55

$4.32 $6.06
15% $4.06 $4.93 $6.92
 
 
How confident are we about the company’s future earnings power?
 
We believe Calpine’s EBITDA will grow modestly over the next few years as currently depressed power
prices increase (with that said, we don’t need prices to increase in order for the investment to be
successful).
 
The catalyst for a more positive power price outlook is supply reduction as a function of generation
retirements. In the Texas market, for example, Calpine and other industry analysts estimate ~25% of
production is cash flow negative at current prices. However, the landscape is changing as a considerable
amount of coal-fired capacity is likely to be shut down, as they are already unprofitable and would
require significant capex in order to meet the state’s Regional Haze mandate in 2018-2020. Retirements
are also being seen in the Northeast, where both nuclear and coal power plants have already begun
shutting down in the face of regulatory and environmental hurdles. Beyond more immediate state
specific regulations, coal capacity also faces longer term impacts from the national Clean Power Plan.
Developments also look to be favorable in California, as solar is pushing out older/marginal gas units and
causing volatility in daily pricing. This is a situation on which Calpine can capitalize given its efficient and
flexible fleet. Beyond these forces, one cold winter or hot summer could easily change the narrative
about how slack power markets are.
 
 
What about natural gas prices and their impact on the company’s earnings?
 
We believe downside to Calpine’s EBITDA versus estimates is limited over the next 3-5 years, even if
natural gas prices were to move lower from here. Coal generators are now trading at the marginal cost
of production, such that when gas prices decline power prices tend to lag that decline. Given the
efficiency of its fleet, in that situation Calpine would be able to take share by increasing volumes at the
expense of coal or inefficient gas plants and at the same time would face lower input costs. This gives
rise to what is known as the “Calpine smile” where at gas prices roughly between $3 and $4, EBITDA
would tend not to change with gas prices. At gas prices < $3, EBITDA would rise as gas declines, and at
prices > $4 rise as gas rises. (Though at these low prices earnings are less sensitive to swings and
higher gas prices would likely be seen positively by the market.) On our numbers, assuming power
prices in-line with today’s lows, EBITDA will be roughly flat with 2015 (give or take 5%). Furthermore,
the nature of the EBITDA will be increasingly tied to capacity payments in the Northeast region,
benefiting from an auction mechanism used in the PJM (and elsewhere) to guarantee capacity. These
PJM payments are already set through H2019 and will rise ~70% from 2015 levels. These payments
and contractual arrangements in California will account for > 50% of EBITDA in 2018.
 
 
Risk/reward?
 
In our base case we assume slight improvement in forward power prices and buybacks equating to 10%
of the current market cap, which would generate ~$4.32 in FCF/share in 2019. (We use the company’s
definition of FCF, which removes growth capex and includes low cash taxes. We view this as reasonable
given that growth capex is typically contracted and debt financed. The company will not be paying
significant cash taxes for a long, long time and with buybacks the NOL/share remains high). At 7x there
would be > 100% upside. In a more bullish scenario with buybacks at 15% of the current market cap,
FCF/share could be ~$7 for > 200% upside. We would not be surprised to see the company divest
another significant asset to buy back shares, as they see the equity as extremely undervalued. Power
assets in Calpine’s markets have transacted at far higher valuations than presently embedded in the
equity. We do not see a lot of downside to current FCF/share. But in our bear case we assume a strong
decline in volumes and further declines in power prices. In 2019 FCF/share with modest buybacks would
still be close to $3.00 but could dip to $1.63 (ex-NOL) in 2017. At 7x that number the associated
downside is ~%20.
 
 
 
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

-Coal, peaker gas and nuclear plant retirements in Calpine's markets

-Stabilization in current and forward gas prices and in turn power prices (despite the smile)

-Asset sales

-Extreme weather events

    sort by    

    Description

    Overview
     
    that thread. The stock is also down 33% on 5% lower 2016 EBITDA estimates and virtually flat 2017
    estimates. Just to provide rehash some background, Calpine is an independent power producer (IPP)
    that operates in the Northeast (mostly in the “PJM” region), Texas (the “ERCOT region) and California
    (the “CAISO” region) in roughly equal parts.
     
    Calpine operates a 27,000 MW fleet of primarily combined cycle gas turbine (CCGT) plants that are
    amongst the youngest, cleanest, and most efficient amongst its peers. It also has low cost geothermal
    plants in California. Given the increased regulatory activity around environmental issues and the
    volatility inherent in most other renewable power sources (e.g., solar and wind), we believe Calpine’s
    fleet will be a key component of the power mix in each of its markets.
     
     
    Why does the opportunity exist?
     
    Calpine’s share price declined from $24 in late-2014 to its current level around $14, which implies a
    significant discount to the replacement cost of its assets. Applying a reasonable valuation to the
    geothermal assets in California, Calpine’s CCGT fleet is valued at ~$350/kW, versus replacement costs of
    between $1,000-$1,200/KW.
     
    This is being driven by: (i) weak power market prices, (ii) a selloff in the overall commodity complex
    (despite limited impact to Calpine’s business), and (iii) anticipation of interest rate increases in the US,
    which resulted in weakness for rate sensitive sectors such as Merchant IPPs and Utilities. The current
    consensus seems to be that there is no catalyst for the sector and, based on current forward curves,
    there will not be much growth, if any, for EBITDA.
     
     
    Why do we find this opportunity compelling?
     
    As detailed below, we think investors are overlooking significant growth in the company’s per share free
    cash flow over the next few years. We have examined numerous situations where companies used
    stable cash flows for share buy backs, and have found that many of them were subsequently significant
    outperformers.
     
    Calpine is a well-run company that is intently focused on share buybacks, against which they compare all
    capital allocation decisions. In the past two years they have completed > $1.6b in buybacks,
    representing > 30% of the company’s current market cap. The CFO recently summarized the company’s
    view saying, “The way I look at us is we are a free cash flow per share growth story”.
     
    The two tables below show the power of buybacks, particularly at low share prices. The first table shows
    estimated 2019 free cash flow (FCF) per share assuming different level of buybacks as a percentage of
    the current market cap and under different stock price assumptions. The second table shows FCF/share
    at different average annual levels of EBITDA at different levels of buyback. Note that the lower left hand
    corner roughly corresponds to our bear case and the lower right hand our bull case. Even with a flat
    EBITDA profile (roughly $2b) we believe Calpine is able to buyback on average of ~16% of the float each
    year without changing its leverage ratios.
     
     
    2019 Calpine FCF/share at Different Levels of Buyback and Stock Price

             
       
    Annual Buyback % Current Market Cap

        5% 10% 15%
    Calpine Share Price $14 $3.92 $4.66 $5.52
    $18 $3.81 $4.33 $4.90
    $22 $3.73 $4.14 $4.56
     
     
     
    2019 Calpine FCF/share at Different Levels of EBITDA and Buyback

             
       
    Average Annual EBITDA (m$)

        1,800 2,000 2,300
    Annual Buyback % Current MC 5% $2.99 $3.63 $5.10
    10%

    $3.55

    $4.32 $6.06
    15% $4.06 $4.93 $6.92
     
     
    How confident are we about the company’s future earnings power?
     
    We believe Calpine’s EBITDA will grow modestly over the next few years as currently depressed power
    prices increase (with that said, we don’t need prices to increase in order for the investment to be
    successful).
     
    The catalyst for a more positive power price outlook is supply reduction as a function of generation
    retirements. In the Texas market, for example, Calpine and other industry analysts estimate ~25% of
    production is cash flow negative at current prices. However, the landscape is changing as a considerable
    amount of coal-fired capacity is likely to be shut down, as they are already unprofitable and would
    require significant capex in order to meet the state’s Regional Haze mandate in 2018-2020. Retirements
    are also being seen in the Northeast, where both nuclear and coal power plants have already begun
    shutting down in the face of regulatory and environmental hurdles. Beyond more immediate state
    specific regulations, coal capacity also faces longer term impacts from the national Clean Power Plan.
    Developments also look to be favorable in California, as solar is pushing out older/marginal gas units and
    causing volatility in daily pricing. This is a situation on which Calpine can capitalize given its efficient and
    flexible fleet. Beyond these forces, one cold winter or hot summer could easily change the narrative
    about how slack power markets are.
     
     
    What about natural gas prices and their impact on the company’s earnings?
     
    We believe downside to Calpine’s EBITDA versus estimates is limited over the next 3-5 years, even if
    natural gas prices were to move lower from here. Coal generators are now trading at the marginal cost
    of production, such that when gas prices decline power prices tend to lag that decline. Given the
    efficiency of its fleet, in that situation Calpine would be able to take share by increasing volumes at the
    expense of coal or inefficient gas plants and at the same time would face lower input costs. This gives
    rise to what is known as the “Calpine smile” where at gas prices roughly between $3 and $4, EBITDA
    would tend not to change with gas prices. At gas prices < $3, EBITDA would rise as gas declines, and at
    prices > $4 rise as gas rises. (Though at these low prices earnings are less sensitive to swings and
    higher gas prices would likely be seen positively by the market.) On our numbers, assuming power
    prices in-line with today’s lows, EBITDA will be roughly flat with 2015 (give or take 5%). Furthermore,
    the nature of the EBITDA will be increasingly tied to capacity payments in the Northeast region,
    benefiting from an auction mechanism used in the PJM (and elsewhere) to guarantee capacity. These
    PJM payments are already set through H2019 and will rise ~70% from 2015 levels. These payments
    and contractual arrangements in California will account for > 50% of EBITDA in 2018.
     
     
    Risk/reward?
     
    In our base case we assume slight improvement in forward power prices and buybacks equating to 10%
    of the current market cap, which would generate ~$4.32 in FCF/share in 2019. (We use the company’s
    definition of FCF, which removes growth capex and includes low cash taxes. We view this as reasonable
    given that growth capex is typically contracted and debt financed. The company will not be paying
    significant cash taxes for a long, long time and with buybacks the NOL/share remains high). At 7x there
    would be > 100% upside. In a more bullish scenario with buybacks at 15% of the current market cap,
    FCF/share could be ~$7 for > 200% upside. We would not be surprised to see the company divest
    another significant asset to buy back shares, as they see the equity as extremely undervalued. Power
    assets in Calpine’s markets have transacted at far higher valuations than presently embedded in the
    equity. We do not see a lot of downside to current FCF/share. But in our bear case we assume a strong
    decline in volumes and further declines in power prices. In 2019 FCF/share with modest buybacks would
    still be close to $3.00 but could dip to $1.63 (ex-NOL) in 2017. At 7x that number the associated
    downside is ~%20.
     
     
     
    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    -Coal, peaker gas and nuclear plant retirements in Calpine's markets

    -Stabilization in current and forward gas prices and in turn power prices (despite the smile)

    -Asset sales

    -Extreme weather events

    Messages


    SubjectRe: percentage of earnings from peak power prices
    Entry01/29/2016 04:34 PM
    Memberpathbska

    Hi chris815, glad to have posted and thanks for your question.

    If you take Calpine's EBITDA in 9M 2015, 37% came from the West, 25% from ERCOT (Texas) and 38% from the East region. In the West at this point very little of Calpine's earnings, in our estimation, comes from the classic midday peak period. We believe more than a third is from contracted volumes (PPAs) from the geysers and a bit from select peaking type assets. These contracts are long-term in nature and we actually think the geysers contracts will roll to similar if not higher prices when they begin to expire in 2022 since they are key renewable assets for California. For the other California PPAs we know when they reset and account for the lower EBITDA. One rolled off at the start of this year resulting in $40m less EBITDA. Another will not roll until 2019. For the rest of the West, what has actually happened is renewables have created new peak periods where they previously did not exist. Solar has resulted in the so-called duck chart where prices are high in the early morning daylight and in the late daylight period. This period used to be served by peaker units that are retiring. Through nine months, Calpine volume is actually up 2% YoY. Long-term in California we see nuclear retirements and the need for flexible units to allow Calpine to maintain earnings in the market.

    In Texas the issue is wind. Power prices in Texas are so low that solar will not be a major threat to this market for a long-time (though you will see some projects). There are times when wind drives pricing to zero, and those times may or may not be during "peak" hot periods. However, there are times when the wind stops blowing and at those points you get spikes in power prices because traditional baseload coal is often not running full time. Wind has merely shifted the economics. Texas, to be clear, is a depressed market. 9M EBITDA was down 13% in the market. On-peak power prices are down 32% and average spark spreads are down somewhat less. Wind has grown tremendously during this period. So why is EBITDA only down 13%? Because volume is up 28% YoY. Gas may be on the margin in Texas, which is depressing sparks, but lots of coal and peaker units are out of the market.

    In the East we see renewables as a longer tailed threat. There will be solar installations driven by state level renewable mandates, but there will also be retirements. We estimate around 50% of East earnings are from capacity payments. We know what these will be through the first half of 2019. The last auction was very bullish for Calpine as most their PJM capacity is in the constrained EMAAC region, which priced high due to the addition of capacity performance (CP) for 80% of bid units that instituted penalties for units that do not provide the power they bid into auction. This keeps a lot of older peaking type units out of the market. We have also seen limited new supply coming into these auctions as the economics for new build are marginal it is difficult to finance one off units. For the next auction (2019/2020) we see lower pricing, but for the 2020/2021 auction the 80% CP requirement goes to 100%, which should boost pricing. The bulk of the rest of the company's capacity revenue comes from the NE ISO, where capacity auctions have also been strong. Calpine's volume was up approximately 6% in 9M (estimating the contribution from one new plant). Long-term renewables will impact the other 50% of revenue in the East but like with the West will likely present opportunities for efficient CCGTs.

    We are not dismissive of the renewables threat but see Calpine's fleet as a relative beneficiary of the inherent intermittency of them. 


    SubjectRe: Re: percentage of earnings from peak power prices
    Entry08/16/2016 06:09 PM
    MemberValue1929

    Hi Pathbska, thank you for the write-up.  

    I'm having trouble reconciling that mgmt. will aggressively use FCF for buybacks, especially after the lowered adj. EBITDA guidance. In the most recent slide deck, pg 15. they discuss an "opportunity" to de-lever to 4.5x, which seems to be the focus. While they have bought back ~ 130m shares since 2011, almost all that can be attributed to cash draws and proportional increases in debt.  I guess what I find intriguing is the outsized Capex spends during the past 2 years, assuming the majority of that is growth Capex? Curious what assumptions you used to account for maintenance Capex (I believe mgmt. had ~25%?) going forward? and assumptions on growth Capex till 2020.

    Thanks! 


    SubjectRe: Re: Re: percentage of earnings from peak power prices
    Entry08/17/2016 03:04 AM
    Memberpathbska

    Value1929, thank you for the important question.

    The picture has been a bit more complicated the past five years. Between 2010 and 2015 the company bought back $2.8 billion in stock while increasing net debt by $1.7b and spending $3.1b in growth capex and $2.1b on maintenance and major maintenance capex. They accomplished all this by effectively swapping their position in the Southeast with a position in the Northeast. It's hard to say in what type of portfolio management they will engage, but as they say they are aways looking on both the buy and sell side.

    Growth capex needs at the moment are limited. They will complete their only large project York 2 (in PJM) next year, which will require $200m in 2017 capex. They have two additonal smaller projects to complete over the next 3 years. One is a Mankato exansion in MN, which has a 20 year contract. The second is an expansion at their Guadalupe Energy Center in Texas were they have a captive customer (who will purchase a 50% share upon completion). Together these two will cost approximately $400m. We don't see any obvious growth capex requirements. You cannot build in CA, the returns in TX are not sufficient (projects with captive customers like at Guadalupe and rare), and the company has not cleared any new capacity in the NE or PJM into 2020.

    They have spoken about the goal of getting to 4.5x levered since Q4 of last year. During that time they extended their maturity schedule dramatically and other than project debt have no maturities until 2022. They will likely repay some of the expensive 7 7/8% 2023 debt, but they do not have to do that by delevering. They have capacity in the 2023 revolver and/or could issue new debt. They are also due in Q1 2017 roughly $250m from the sale of Osprey to Duke in Florida and South Point in Nevada to Berkshire. Ex these proceeds we see growth capex of $166m in 2017 down to $100m total between 2018 and 2019. We assume $400-$450m in maintenance and major maintenance capex per year.

    The company could buyback 6+% of the float per year and be around 4.8-4.9x levered by 2019. We think this is consistent with getting to 4.5x levered "over time", but also think they will be more aggressive than that either by being more levered (now that they have extended their debt) or by selling assets. The CCGTs within Calpine are trading at < $400 per kW when we think the market could pay up to $800 per kW for them. That provides a lot of fexibility in our estimation. 

        


    SubjectRe: Re: Re: Re: percentage of earnings from peak power prices
    Entry08/17/2016 02:59 PM
    MemberValue1929

    Pathbska,

    Thank you very much for the timely clarification around growth/maintenance capex b/w '10-15 (and forward looking), this is very helpful. I guess the point I was trying to get at was for the past 18-24 months it appeared that growth capex was extraordinarily high and was likely to come in substantially, therefore freeing up excess capital potentially for buybacks. The 6%->HSD makes sense to me, not sure about 10%+, but the math works out quite well even in the lower tier.

    There definitely appears to be an opportunity here. The market is not giving any credit to some of CPN's long-term strategic advantages. This one has certainly caught our eye with the market pinging around all-time highs. Thanks again!

     

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