Photographer: Luke Sharett/Bloomberg

Beat-Up Power Generators Turn Best Buys in Wall Street's Eyes

  • Profits, share performance seen topping all business sectors
  • Natural gas recovery is key to merchant generators recovery

Cheap natural gas, tougher regulations, a surge in renewable power and tepid demand growth all conspired to make 2015 a bleak year for independent power producers. Wall Street expects a lot better in 2016.

The group will outperform every sector in the S&P 500 next year after plunging 48 percent in 2015, according to analysts’ estimates compiled by Bloomberg and an index of producers that is set to rise 63 percent. Bears who see flat demand and stiffer competition from new gas-fired power plants aren’t so sure.

A rebound in gas, which sets power prices in wholesale markets, will raise revenue for all generators, according to analysts forecasting the jump in share price for the five companies in the power index, which includes AES Corp. and Calpine Corp. Others say higher prices will be offset by flat demand as new energy efficiency standards take hold, and solar and wind power expand.

“These stocks are cheap at any natural gas price,” Stephen C. Byrd, a New York-based analyst for Morgan Stanley said. “They’re cash cows.”

Natural gas futures have fallen 31 percent this year as supplies of the fuel keeps flowing out of U.S. shale formations, driving stockpiles to a record. The companies’ shares are priced as though investors expect gas to stay under $2 a million British thermal units, Byrd said. The heating fuel closed at a 16-year low of $1.755 on Dec. 17. It added 0.5 percent to $1.993 on Thursday at 12:30 p.m. in New York.

Power Use

“We see compelling value,” Byrd said.  Dynegy Inc., owner of plants that can generate enough to power 21 million average U.S. homes, is Morgan Stanley’s top pick. The stock may almost triple to $37 a share, according to a Dec. 4 note.

Electricity tends to rise and fall with the price of gas because the fuel is burned by plants that start and stop during the day as demand fluctuates. Lower gas prices can shrink margins because plants burning other fuels may operate at a loss or not run at all.

AES of Arlington, Virginia; Calpine and Dynegy of Houston; NRG Energy Inc. of Princeton, New Jersey and Talen Energy Corp. of Allentown, Pennsylvania, make up the five-member Bloomberg Intelligence North American Independent Power Producers Valuation Peer Group. Much of their revenue comes from selling into competitive wholesale markets, in contrast with utilities that earn government-regulated rates.

Dynegy forecast on Nov. 4 free cash flow of as much as $500 million in 2016,
more than double this year’s expectation, with as much as $450 million available for share buybacks or debt reduction.

“Based on our 2016 outlook alone, our equity is meaningfully undervalued,” Calpine Chief Executive Officer Thad Hill told investors on an Oct. 30 conference call. “The built-in quantifiable upside in our business from here is tremendous.”

Higher payouts in PJM Interconnection LLC, the largest U.S. wholesale market, and improved gas supply will benefit Talen’s margins in 2016, Paul Farr, the company’s CEO, said by e-mail Wednesday.

“The recent and dramatic pull back in stock prices doesn’t reflect the
underlying solid fundamentals in the competitive generation sector,” he said.

Calpine is expected to rise 44 percent in the next 12 months, according to data compiled by Bloomberg. Dynegy will almost double, making it the best performer in the group, while NRG Energy will rise 66 percent, Talen 83 percent and AES 28 percent, according to the data.

NRG Energy spokeswoman Marijke Shugrue and Dynegy spokesman Micah Hirschfield declined to comment for this article. A spokeswoman for AES, Amy Ackerman, didn’t immediately respond to a call and e-mail seeking comment.

Doubters

Jay Rhame, who helps manage $2.6 billion at Reaves Asset Management in Jersey City, New Jersey, isn’t convinced. He sees new gas-fueled plants taking a bite out of the group’s sales. Panda Power Funds is building two plants atop the gas-rich Marcellus Shale in Pennsylvania. They’ll feed into PJM.

“The backlog of potential plants coming into PJM is gigantic,” Rhame said. “You have a situation where demand doesn’t really grow and hasn’t grown for a while, and a lot of supply is coming on. It’s a hard market to get excited about.”

Most agree gas will move higher in 2016. How much is the question.

The fuel will average $2.279 units in 2016, 15 percent above current prices, according to the Bloomberg Commodity Fair Value index. Credit Suisse Group AG recently cut its 2016 forecast 31 percent to $2.70. Deutsche Bank AG lowered its outlook 10.8 percent to $2.90.

‘Weak’ Fundamentals

“Supply-demand fundamentals are weak for most of the deregulated power markets,” Moody’s analysts led by Toby Shea wrote in a research note last month that cut the outlook for generators to negative from stable. “We could move our outlook back to stable if gas prices rise 15 percent to 20 percent.”

Meanwhile, power prices have fallen even as coal-fired generators shut down. Power sales will rise 0.4 percent next year, according to the U.S. Energy Information Administration.

“It’s a risky business and it’s a volatile business,” said Paul Patterson, a New York-based utility analyst for Glenrock Associates LLC. “It’s got a murky outlook.”

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