To say it's been a difficult period for NRG Energy (NYSE:NRG) would be an understatement. The independent wholesale power producer is the largest in the U.S., but its recent investments in renewable energy put a squeeze on revenue and earnings.
Since the resignation of CEO and visionary leader David Crane, his replacement, Mauricio Gutierrez, is primed to switch the company from a growth model to a business focused on traditional power generation with reliable profitability. And as Crane said in August, "Wall Street has difficulty digesting the idea of a conventional company going green."
As a result, shares have crumbled 60% over the past 12 months to levels not seen since 2004. However, shares appear to be trading at a discount to the company's conservative estimate of intrinsic value. Let's dive into the valuation and see if there is a margin of safety at these levels for long-term investors. A more in-depth analysis of the business can be found here.
Before we get started, it's important to remember that discounted cash flow valuation (DCF) is an imperfect process of valuing a company. In a perfect world, it's how any company should be valued. But as we Fools know, the world we live in is neither perfect nor fair. That's the reason it's so important to be as conservative as possible when using a DCF valuation. Nonetheless, understanding a company's valuation from its future cash flow is an important exercise. Let's dive into the valuation.
In the case of NRG, we will be valuing the business based on its discounted future free cash flows to determine whether there's a margin of safety. Based on low-line management projections, NRG will have cash flow from operations of $1.89 billion in 2016. Maintenance capex and other distributions for the year will be $890 million. The back-of-the-envelope net free cash flow is about $1 billion.
Management projects free cash flow of $1 billion to $1.2 billion in 2016. At an enterprise value of $23.09 billion, the company would be trading at 23 times free cash flow. On a market-cap basis, it currently trades at 3.14 times free cash, an incredibly small multiple given the stability and free cash flow capability of the business.
In keeping with our conservative estimates, instead of using management's low-line projection for free cash flow of $1 billion, I'll use half that amount, which has NRG generating $500 million in free cash flow. This number gives us an even larger margin of safety.
Why did I choose this number?
Call me crazy, but I don't like to lose money.
I suspect the company is closer to a cyclical low in earnings, but I like having as large a margin of safety as possible. I wouldn't be surprised to see the company generate free cash flow in excess of $1 billion in the years to come. If that happens, and I'm buying below a very conservative DCF value, then I should do very well over the long term. If not, hopefully, I bought at a big enough discount to the company's intrinsic value and can escape unharmed. At the very least, I'm getting paid to wait with the healthy dividend being issued to shareholders right now.
I believe management will repurchase shares shortly, based on past history and continued FCF generation, but I'll even assume the company raises capital at these levels and offers shares -- let's say 70 million. So I'll use 400 million shares outstanding in my calculation.
Based on these numbers, and to be very conservative, I come up with three growth scenarios for NRG over the next 10 years. I'll also give a probability weight based on the likelihood of each scenario.
Let's look at the three scenarios using these various assumptions and see how we were able to arrive at a reasonably conservative estimate of intrinsic value using a range of values and probability of how the scenarios would play out:
- Low-range scenario No. 1: 0% growth in FCF for years one through 10.
- Mid-range scenario No. 2: 2.5% growth in FCF for years one through 10.
- High-range scenario No. 3: 5% growth in FCF for years one through 10.
I weighted scenario Nos. 1 and 2 at 40% probability each -- very conservative and possible growth rates. However, I do believe the company can grow more than 5% in the future, as it has in the past. The discounted values of NRG range from $13.11 to $16.01. The stock is trading $13 per share, which gives a relatively large margin of safety to our weighted assumptions.
This calculation provides us with a weighted DCF value of $14.23 per share. In other words, if all of our assumptions come to fruition, an investor buying NRG today could expect a 15% annualized rate of return over the next 10 years. With shares trading at $13 per share, it appears undervalued.
Also, the company is trading at 75% of its tangible book value. Using tangible book of $13.73 as a proxy for liquidation value, this is extremely undervalued, given that the company generates an ample amount of free cash flow. Given the conservative DCF value ranges and the tangible book of the company, a conservative intrinsic value range of NRG likely lies between $13 and $16 per share.
What this Fool believes
In short, there are lots of reasons to believe NRG is on the right track. New CEO Gutierrez sees a path to establishing the company as a "conventional" utility in the coming years, which will keep revenue and earnings stabilized. The company also has the ability to unload non-core assets in the renewable energy segment if worse came to worst. Lastly, low commodity prices haven't hurt the company's free cash flow capability.
The company won't knock your socks off regarding growth, but high barriers to entry, limited competition, and restructuring all bode well for the future. Investors with a long-term horizon should consider investing in this beaten-down utility. If NRG stock falls any further this year, I may pick up a few more shares, too.