January 27, 2016 - 7:35pm EST by
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 (in $M): 16,124 TEV/EBIT 17.4 15.2

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


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
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


$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
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.
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.


-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

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