CenterPoint Energy (CNP) closed Thursday at $10.79, up 12% from 5 Jan 04 when I first recommended it to anyone (at a dividends-adjusted price of $9.66) and up 13% so far this year. Hasn't changed much since my last note back on 18 March (posted here on TMF RRI board), but I still think it is a potentially great mid-term play. Become a Complete Fool
First a little history. CNP is one of three descendants of Houston Lighting & Power. When the government of Texas decided to deregulate their power industry, in the Houston market, the utility company was split two ways: CenterPoint Energy got the electricity generation and natural gas (NG) and power distribution network assets as well as the NG customers and Reliant Energy (RRI) got the retail power business. In addition, RRI got lion's share of the assets outside of Texas and emerged with an aggressive "cowboy" style business plan to compete in the merchant power business; CNP in contrast planned to sell off all their non-core assets and focus on becoming a conservative "homesteader" style dividend-paying utility serving Texas.
The main obstacle that threatened CNP's ability to meet their strategic goal was the huge ($11B+) debt the company was saddled with coming out of deregulation. As part of the 1999 deregulation legislation, the legislature provided a mechanism ("trueup") by which the company could get out from under 40% of this debt by recovering so-called "stranded costs" via rate increases over spread out over several years. The exact numbers were to be worked out later, but the general outline of the process are clear: CNP comes up with a number around $4B (this occurred 31 March: $3.8 billion plus $600 million in interest) and the Public Utility Commission of Texas (PUCT) ensures that CNP has followed the law and done their arithmetic correctly and approves either CNP's number or an adjusted (presumably lower) number (this is expected to happen in late August), at which point the company issues low interest bonds to raise cash equal to the trueup amount. The bonds principle plus interest are repaid by CNP from funds collected from ratepayers via a trueup surcharge added to their utility bills for the next several years.
But that only covers part of CNP's debt. The rest of the plan for paying it down was for CNP to divest itself of their generation assets, and use apply the proceeds to their debt. To that end, 19% of a new company, Texas Genco (TGN), was spun off in an IPO in January 2003, primarily to establish a market value. This new company owns and runs the Houston area power generation assets. The plan was for RRI -- who had a strategic need for baseload generation assets to buttress their Houston retail franchise -- to purchase the remaining 81% of TGN from CNP in January 2004 at a fair price determined by the market. Unfortunately, in 1999 no one foresaw the secular shortage of NG in the USA that hit home last year...or, at least, no one foresaw the effect this would have on the price of TGN stock.
Texas Genco has lots of coal- and nuke-fired baseload generation assets in a market (Houston) where due to the huge summer peak demand relating to air-conditioning, the regulated retail price of electricity is strongly affected by the price of natural gas, as all the peaker plants these days are NG-fired. The current electric power rate RRI charges, which was set last year, is based on a $6.10 NG price. (According to the deregulation rules set up by the Texas legislature, RRI is not allowed to charge less than this rate while their putative retail competitors in the Houston market can.) Thus, TGN -- whose production costs for the lion's share their power, coming as it does from coal- and nuke-powered generators, are much, much cheaper -- has been making a mint! And their stock reflects this value, having more than quintupled since the IPO!! (While we were heavy into RRI and did quite well, thanks, you could be complaining that I did not recommend TGN instead, which was by far the best Houston Lighting & Power descendant play in 2003!)
Essentially, this is why RRI decided to pass on the option (which could have been exercised at a price of around $32/share) despite their long-term strategic need to score some baseload generation to protect their Houston retail business -- they felt it was too much of a risk that they would be overpaying due to the historically high price of NG, and, presumably, that the assets would be available cheaper in the future.
So now CNP is stuck with a high-priced TGN for the foreseeable future...if RRI is not willing to pay market price, perhaps the company is not worth that much to anyone else, unless they are considering going into competition with RRI for the Houston retail market. This has the banks and rating agencies nervous, as they don't see CNP getting their money out of TGN (and paying down their debt) anytime soon. They are currently paying over $700MM in interest payments annually and the concern is if they cannot pay down the debt soon, interest rates will rise and the cost of carrying the debt along with it. With their base EBIT (that is, not counting their dividend income from TGN) around $900MM per year, the margin for error seems small.
Analysts also worry that the trueup process may hit a snag. Various public interest group types are beating the drums saying CNP should not get the full trueup request (or -- in the opinion of a few -- any!). (Amusingly, some of these same advocates were all in favor of the deregulation legislation that detailed the trueup process back in 1999.) It seems likely that the PUCT will approve some level of trueup but no matter what they do, lawsuits seem likely and some folks are wondering if this will delay CNP's receipt of *any* funds.
These concerns have certainly depressed CNP's market value. Consider CNP as compared to fellow Texas competitor TXU Corp, and the industry average:
.................. CNP................... TXU............IndustryCNP has average margins, excellent revenue growth, healthy earnings and free cash flow numbers, and yet is starkly undervalued compared to the industry average (P/E of 8 compared to 15). But wait...there's more. CNP owns 81% of TGN, a company with no debt and a market value of $3.3B (at today's close of $41.75/share). Back out the portion of TGN's value that CNP owns from CNP's market value and we are left with a market value for CNP's own operations of $637MM! This for a profitable business with annual revenue of nearly $10 billion! The market is very heavily discounting both the value of TGN and CNP's forthcoming trueup payment. If CNP's own business (not counting the $65MM/year they get in TGN dividends) were valued in line with industry averages, and then you added in the value of the 81% of TGN they own, you would expect a market cap of something like $7.8B, which equates to a share price of around $25! There are some convertible preferred issues that will result in 70MM shares worth of dilution before the pps hits $13, so that brings us back down to a pps of around $20.50 or so...still, we are looking at a nearly 50% discount from where the share price "should" be.
Market Cap:......... 3.31B...............11.99B............2.33B
Rev. Growth (ttm):. 23.20%................9.70%............7.70%
Rev. (ttm):......... 9.82B...............11.24B............2.96B
Gross Margin (ttm): 26.34%...............40.73%...........27.98%
EBITDA (ttm):....... 2.21B................2.98B..........490.0MM
Oper. Margins (ttm): 16.07%.............. 18.53%...........14.18%
Net Income (ttm):.. 411.8MM............ 801.0MM...........72.6MM
FCF (ttm):......... 663.7MM................1.26B..........109.4MM
P/E (ttm):........... 8.05................16.50............14.88
P/S (ttm):........... 0.33.................1.06.............0.87
Is such harsh pessimism justified?
Well, let's take the value of TGN. Is it justified, and can CNP realize it? IMO, TGN is *still* undervalued. They have just exercised their option to increase their ownership percentage of the STP nuke generation facility which, in adding 330 megawatts of the cheapest possible power to their capacity, will be accretive to earnings and most likely push them close to $4/share annually. Assuming the shares maintain a modestly-below-industry-average P/E ratio of, say, 13, we should be seeing a share value of $45-50 once these earnings are confirmed.
Whether CNP can find a buyer willing to pay $45-to-$50 a share for the rest of the company is another question. Actually, with the incredible profits that TGN are producing, I am hoping that CNP management change their tune and decide to hold onto it! The 81% of TGN's earnings "owned" by CNP amount to close to $500MM annually at present NG price levels. If they sold that 81% for $50/share, they would net $3.24B that they could use to pay down debt...which would save them $195MM a year in interest assuming an average of 6% on the retired debt. Does it make sense to give up $500MM a year to save $200MM? I am not certain whether management agree with this analysis of the value of holding onto TGN or not; certainly it is not widely understood this way by the market. I am hoping that the reason management keeps restating their intention to sell TGN is because they do not want to muddy the water by changing their strategy until after the PUCT rules on their trueup application.
Speaking of which, what about the trueup process? Are CNP really likely to get the $4.4B they seek? Well, the Texas legislature are not in session this year which helps reduce the political pressure. IMO, CNP are being fairly reasonable in their interpretation and analysis and what they are asking for is evidently within range of what was expected and agreed to by everyone back in 1999. Of course in a political situation, that may not count for much. And even if the PUCT agrees with CNP, or approves a lower but acceptable-to-the-company number, there could be legal challenges from public interest groups.
But the reality is that CNP are in much better shape than they appear to be.
First of all, most of their debt is fixed-rate and thus they are not in much danger from higher interest rates when the Fed discount rate is raised.
Second of all, even if the PUCT even allows them as little as $3B in trueup moneys, they can use the funds to pay down $1.7B in bank loans and $1.3B in a 12.75% note held by Warren Buffett. This will cut their annual interest nut from $700MM to well below $500MM. If they get the full $4.4B and use all of it to pay down debt, the interest drops to around $350M annually.
But wait, there's more!
The price of NG is unlikely to fall much below $4.50-to-$5, IMO, given the secular USA shortage of supply that cannot be corrected for several years. In this environment, feeding the Houston market with cheap baseload-generated power, TGN will be raking in huge profits for the foreseeable future...and paying out hefty dividends, 81% of which go directly to CNP's bottom line. If CNP uses the dividend proceeds (currently $65MM/year but they certainly could/should go up) to pay down debt, they will make good progress there, and all the while they will still own 81% of TGN. In the worst case -- the credit rating entities insist that more of the debt be retired -- CNP could sell up to 30% more of TGN to the public (thus retaining control in the long run) and retire another $800-900MM of debt, which would knock their interest payments down almost to $300MM ($400MM if the PUCT grants them only $3B in stranded costs reimbursement).
CNP is likely to end up ahead of the game, profitable in their own right, with a manageable debt level and strong credit rating plus bonus dividends from TGN and the prospect of another bonanza down the road when they eventually do sell it off...or, potentially, the opportunity to rethink their strategy and hold onto the TGN assets and enjoy the profits...or potentially, to steal the lucrative Houston retail market away from RRI! CPN already have the customer service and billing mechanism in place because of their NG retail business, so such a move would be easier for them compared to the task for any outsider starting from scratch...and with no baseload generation capacity of their own, RRI is a sitting duck for a price war.
But that is a topic for another day.
The bottom line here is that I consider CNP to be seriously undervalued, in that sum of the parts (CNP plus 81% of TGN) is far greater than the whole ($3.3B market cap) that The Street has pegged the company at. But even if you don't agree that CNP deserves to be priced at a premium, even if you think it is just average, or maybe a little below average, the company is a screaming buy here! Check out these current P/Es of the companies that comprise the DOW Utilities index (which CNP is in):
.....Avg..........16.26 (excluding CNP, DUK, WMB)
Even if CNP is just an average utility, the stock should double from here once The Street and the credit rating agencies figure out what I believe we already know -- that the company has a handle on their debt.
Once they figure out that CNP actually has potential far beyond the average utility, a P/E ratio in the mid-20s is very doable.
Of course, there are risks. The PUCT (or a legal challenge from ratepayers) could reduce CNP's stranded cost recovery. The price of NG could come down and TGN's concomitant value decline. Interest rates could go up a lot faster than we think increasing the weight of CNP's debt burden. Or potentially CNP's management could do something dumb, such as get rid of TGN at a firesale price. (If CNP sells TGN at any price, it is likely to send CNP stock up, so the only "risk" in that case is that further upside might be too limited to hold onto the stock.)
For my part, these risks look small to me compared to the potential reward.
Brad Hessel (long CNP and RRI)
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CenterPoint Energy (CNP) closed Thursday at $10.79, up 12% from 5 Jan 04 when I first recommended it to anyone (at a dividends-adjusted price of $9.66) and up 13% so far this year. Hasn't changed much since my last note back on 18 March (posted here on TMF RRI board), but I still think it is a potentially great mid-term play.