Callpine Corp. 13134VAA1
December 28, 2004 - 11:47am EST by
2004 2005
Price: 78.25 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 2,105 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Long Calpine Canada Energy Finance 8.5%’s of 2008 vs. short Calpine Corp. 7.875%’s of 2008

This idea is on its face relatively simple, but at the same time somewhat complex and fairly elegant. I recommend buying the Calpine Canada Energy Finance 8.5% notes due 5/1/08 (“the CCEF notes”) versus selling the Calpine Corporation 7.875% notes due 4/1/08 (“the Corp. notes”). My latest quote on the CCEF notes is 78.25, and my latest quote on the Corp. notes is 77.25 (the spread is really what matters). Both sets of notes are senior unsecured obligations of Calpine Corp (CPN).

First, some background on Calpine. Calpine Corp. is an independent power producer that was one of the darlings of the deregulated energy markets from 1998-2000. If you were paying attention to this stuff back then, you may remember the “virtuous circle” argument that was put out by certain equity analysts in favor of investors paying up for CPN stock -- CPN owned power plants that produced megawatts of electricity, which justified a rising stock price. It would then issue stock to fund purchases of more power plants to produce more megawatts of power, which would justify an even higher stock price, which would then be used to buy more megawatts…. It was enough to make your head spin.

When independent energy collapsed and IPPs could no longer rely on the capital markets to fund their liquidity requirements, many IPPs filed for bankruptcy (NRG, Mirant, etc). Calpine, however, was lucky enough to be able to refinance the bulk of its debt just before the market realized what was happening. As a consequence, it weathered the initial storm. It remains a highly levered entity, though, and continues to borrow to produce more power.

I am not planning to argue that it’s more or less likely than not that Calpine will file for bankruptcy in the next four years. I would, however, say that there is some possibility of that happening, and it’s not negligible.

I am also not planning to provide a valuation of Calpine here, because, frankly, I think it’s a very difficult thing to pinpoint. I have seen some very smart people put the “correct” price of a gas-fired combined cycle power plant at $725/kW. I have also seen some very smart people put the price of the same type of plant (in the same geographic market) at as little as $200/kW. What is correct? Well, it depends on how in vogue the power markets are at the time - If there’s another company willing to take a plant off of your hands at $500/kW, well, then that’s sort of what it’s worth, regardless of whether or not the buyer makes an adequate return on his or her investment. I would also argue that the value of a power plant at the time of a company’s liquidity crunch is more important than the value of its portfolio now. I have seen more than enough of the forward power price curves that “independent consultants” provide to investors to know that they are all over the place. I don’t consider myself to be an expert in power supply and demand in the US going forward for the next several years, and so I won’t even try to get there. Basically this has been my long-winded way of justifying my reasoning for not providing you with a valuation. Suffice it to say, though, that I believe that there is a pretty wide range of “reasonable” valuations. I also believe that in a worst case scenario, in the case of a bankruptcy, the market for power assets in the United States may not be nearly enough to allow for the estate of a bankrupt Calpine to cover its bonds.

Back to the trade itself. This trade does not hinge so much on the exact recovery that the bonds receive. It hinges on the structure of the bonds. When financing Canadian activities, U.S. companies often use a structure that allows them to receive a “double-dip”; that is, they are allowed deduct the interest in both the U.S. and Canada. This savings can be meaningful. These structures can get to be very complex; I will give you an overview of them and their requirements, and encourage you to run this by legal counsel to the extent that you feel you need a further explanation.

The double-dip is received through the use of “hybrid entities”, which are taxed differently in the US and in Canada. It works as follows: (i) the U.S. parent company forms a wholly-owned Nova Scotia unlimited liability company. In the U.S., it’s possible to treat this company as a look-through entity like a partnership or a branch, because as a matter of NS corporate law the shareholders are liable for the debts of the company. The NSULC, however, is considered to be a corporation for Canadian tax purposes. (ii) The NSULC borrows money. This is generally done with the backing of a guarantee from the U.S. parent company. While a parent guarantee is not necessary for the structure’s tax purposes, practically speaking it is integral because no lender would lend money to an entity that essentially has, as I will describe, no assets and no income. As such, Calpine has given the CCEF bonds a corporate guarantee. Since the NSULC can be treated as a look-through entity for U.S. tax purposes, the U.S. parent can deduct interest paid by the NSULC on its debt. (iii) The money borrowed by the NSULC is lent to a Canadian operating subsidiary of the U.S. parent pursuant to an inter-company loan. That money is then used to finance the Canadian business operations. (In the case of an acquisition of operations in Canada, the NSULC lends the money to a Canadian AcquisitionCo, which then uses the money to buy the shares of the target. Then the target and AcquisitionCo are merged together into an operating company). (iv) The interest on the inter-company loan is paid in stock of the Canadian operating company. For Canadian tax purposes, the interest paid from OpCo to the NSULC is deducted in Canada, thus providing a second dip. (v) The interest income earned by the NSULC is offset by the interest expense paid by the NSULC to its third-party lenders, so the NSULC has no net income for Canadian tax purposes except for the interest rate spread. (vi) Because the interest on the inter-company debt is paid in stock, the U.S. parent can ignore the payment of the interest by Canada OpCo for U.S. tax purposes, so there is no income recognized in the U.S. for interest paid on the inter-company loan.

The structure is actually a lot more complex than this, but those are the basics. The CCEF bonds were set up in such a manner.

In the case of a CPN bankruptcy, it is my belief that the CCEF noteholders will also have a double dip, though one of a different sort. They will have a first bite at the CPN pie because their bonds represent a senior unsecured obligation of the U.S. parent. They will also have a second bite at the pie because the CPN corporate guarantee represents the full faith and credit - and a senior unsecured obligation - of the parent. Conversely, in the case of a bankruptcy, the Corp. bonds will have only a single bite. A double dip for the CCEF holders would potentially result in a wide spread in recoveries between the Corp and CCEF bonds.

While I believe that any legitimate read of the indenture will tell you that the CCEF bonds are senior unsecured obligations and also have a corporate guarantee, it is reasonable to expect a legal challenge to a double dip from the Corp. bondholders (all of them, mind you, not just the 7.875%’s), and from the equity holders. Such a challenge would likely point to the identical language in all of Calpine’s indentures and prospectuses regarding its unsecured notes that says that the notes represent senior unsecured obligations of Calpine. That argument would say that it was never Calpine’s intent to provide greater protections to one set of unsecured bondholders than to others. I believe that, even were the guarantee language not considered to be a pretty damn good indication of Calpine’s intentions, the guarantee would not be clawed back. The counterargument that it’s awfully convenient for the Corp. bondholders and shareholders to have shared in the economic benefit afforded to them by the Canadian structure when all was going well, only to scream and moan when the ship started to sink, would blow a wide hole in their claim (this is not to say that a settlement would not ultimately occur; I’m just saying that the CCEF notes would be negotiating from a strong position).

Now to the economics. At a price of 77.25, the Corp. notes have a yield to maturity of 17.24% and a current yield of 10.19%. At a price of 78.25, the CCEF notes have a yield to maturity of 17.30% and a current yield of 10.86%. If you put this trade on at a one to one ratio, you give up a tiny bit in YTM. At the same time, though, you’re being paid in current terms to hold the trade. I view both of these aspects of the trade to be negligible, and, at any rate, they more or less cancel each other out. You essentially put on the trade for free.

If things break right for Calpine, they cruise through to 2008, pay off both sets of bonds, and you’ve had a trade on that used up capital but didn’t really cost you much. If things don’t work out, and CPN files for bankruptcy, the CCEF bonds could potentially receive a much higher recovery than the Corp. bonds due to their double dip. Clearly, the recovery differential will depend on what the value of the estate ultimately is. I personally think that if Calpine is in such trouble that it needs to file, that would imply that the capital markets are ascribing a pretty low value to power assets and that, relatively speaking, the estate’s value would be closer to the worst case scenario than to the best case. As I said, though, I’m not going to get into my valuation of the company, because I think that reasonable people can disagree on that pretty easily.

I would also argue that this trade provides a nice little portfolio overlay. If Calpine (one of the high yield market’s darlings) can’t refinance its debt, then the capital markets have probably dried up to a good extent for a lot of companies. Who knows what leads to that happening? A crappy economy? Another terrorist attack? A war gone bad? These scenarios are unfortunately not so far out of the question. Certainly one doesn’t hope for a disaster, but your investors would probably be happy if some of your investments not only survive but actually make some money in such a case.

The only risk is if somehow the company sputters through to 4/1/08 and pays off the Corp. notes, while meanwhile the market still prices the CCEF notes at a discount to par due to bankruptcy risk, and then CPN files ch. 11 instead of paying off the CCEF notes. That would suck, but I would also view it as highly unlikely. Otherwise, the risk is very small and highly quantifiable - just how I like it.


1. Calpine-specific liquidity event
2. A jolt that rattles the economy.
3. A jolt that rattles the capital markets.
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