First, the disclaimer
"The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function." -- F. Scott Fitzgerald

Before you send me any emails, please know that I shared the quote above for a reason. It is not to blow my own horn, but to let you know that I can make the case for and against Calpine (NYSE:CPN). There's a lot of bad mojo surrounding the company, but there are also some very solid assets making up the base of the business.

So to tell the story, I'll cover the bad stuff first and make the argument against purchasing. Then, I'll estimate Calpine's net asset value (NAV), compare that to its current market cap, and make the case to buy. I'll wrap up by giving you some keys for success going forward. Hopefully, I won't be a blathering idiot at the end and will prove Mr. Fitzgerald's theory correct.

The business
Based in San Jose, Calif., Calpine is one of the most technologically advanced and environmentally friendly merchant energy companies in the world today. With 26,200 megawatts (MW) of generating capacity through 72 natural gas-fired Combined Cycle Gas Turbine (CCGT) plants (these produce 97% of the output) and 19 Geothermal plants, Calpine ranks in the top five of the largest merchant energy companies in the world.

Calpine has two major lines of business -- power generation and oil and gas production. Power generation is its core business and generates 78% of its revenue. Blah, blah, blah... enough about the basics, you can get the rest from

Dead man walking
Where should I start? There are so many negatives surrounding the company that I am surprised it has been able to avoid bankruptcy. It has a junk credit rating and more than $18 billion of total debt. It has a baseload capacity factor (actual generation divided by potential generation) of 47%, and yet it plans to bring 5,400 MW of additional supply on line in 2005, according to its second-quarter 10-Q. Spark spreads are low because the pricing environment is bad and natural gas prices are high. Not the most stellar time to be bringing on additional supply.

Calpine is selling assets to remain liquid. It continues to restructure its debt and is willing to accept dilution to do so. And some people question its accounting. I'm tempted to put my tail between my legs and run the other way. But I promised both sides of the story.

The question is what's going to happen first? Will Calpine be able to capitalize its assets or will it implode under its debt burden? AES (NYSE:AES) faced the same problem a few years ago and came out smelling like a rose. Of course, AES had contracts to sell more than 75% of its power (compared to 46% for Calpine), so that made it much easier.

To give you an example, Level 3 (NASDAQ:LVLT) is doing the same thing. It raised lots of debt and equity capital to build out its state-of-the-art fiber optic network. The idea was to capture the pent-up and growing demand for data transmission. Unfortunately, revenues are not coming in as fast as management hoped. However, Bill Miller and Mason Hawkins of Legg Mason and Southeastern Asset Management, respectively, have made some big bets, thinking capitalization is inevitable for Level 3. Can we say the same for Calpine?

Like a moth to flame
I keep coming back to Calpine's underlying assets. They are real and they are technologically advanced. They work and they work well. (Calpine's availability is more than 90%, meaning they are very reliable when they are up and running.) Too bad they are idle.

But let's look at a best-case scenario. Yes, best case because I want to see just how optimistic the market is right now. The table below uses the simple rule that assets minus liabilities equals equity. There's no rocket science there, just basic accounting. All figures are in billions of dollars unless otherwise noted.

Best-Case Scenario
Generating assets (MW) 31,600 Total debt $18.07
Value ($/KW) $620 Cash $0.84
$19.59 $17.23
Gas reserves (Tcf) 0.7 Accounts receivable $1.17
Value ($/mcf) $1.85 $16.06
$1.85 Accounts payable $1.16
Asset value - Net debt = Equity


$17.22 $3.67

You're Foolish, so I know you will ask, "where did the assumptions come from?" OK, I'll lay them out for you like Bernard Hopkins recently laid out Oscar de la Hoya.

I valued the current assets and those under construction at a cost of $620/kW. That number comes from a report by analyst Christopher Ellinghaus of Williams Capital. He had 5,554 MW of supply under construction at a cost of $3,440 million.

I got $1.85/mcf of natural gas reserves from a recent sale of same natural gas assets.

The numbers come from the second-quarter 10-Q.

The market is not overly optimistic
On Thursday, Calpine closed at $3.43, giving it a market capitalization of $1.52 billion. That's less than half of my rosy forecast. So, the market is not completely jazzed about Calpine's prospects, especially considering it is issuing debt to retire debt. But the market is certainly not as pessimistic as it once was, considering the low is around $1.50 per share.

But is that enough of a margin of safety? Is the market compensating you enough for taking the risk that Calpine is going to survive long enough to capitalize its assets? One of things I keep reminding myself is that energy is a necessity. There will always be demand for it, and it will increase over time. I just do not know if that demand will materialize quickly enough for Calpine. It could be a few years before spark spreads begin to rise again and Calpine gets more and more generation under long-term contracts.

The keys to success
I mentioned them in the previous paragraph. But I will be explicit here. Higher spark spreads are a key to Calpine's future success. Higher spark spreads mean more contribution margin to pay for fixed costs and that's good. Unfortunately, spark spreads are out of management's control and that's bad.

So the real key is getting its assets working more, and that means more generating contracts, like the one with Wisconsin Public Service. And that means pumping the sales guys up. The question is, are you willing to bet that they can pull it off in time? If you can maintain nerves of steel for a few years, Calpine is a speculative buy. If not, there's no harm in keeping an eye on its progress.

What do you think about Calpine ? You can talk about this and other merchant energy companies on the Fool discussion boards.

I wonder what Philip Durell would think about Calpine? I know this is the type of opportunity he looks for in his Inside Value newsletter. Give it a try for 30 days, and see where he's finding bargains.

Fool contributor David Meier owns shares of AES. He does not own shares in any of the companies mentioned. The Motley Fool is Fools writing for Fools.