NRG Bondholders Reject Ratings Firms on GenOn: Corporate Finance
NRG Energy Inc. (NRG) debt investors are rejecting the assertions of ratings firms that the largest independent U.S. electricity generator’s $1.7 billion all-stock takeover of GenOn Energy Inc. (GEN) may diminish its credit quality.
Bonds of NRG rose to records and returned 1.5 percent last week, exceeding the 1.24 percent return of speculative-grade peers, after the Princeton, New Jersey-based utility said it would buy its second-largest competitor. Moody’s Investors Service maintained a “negative” outlook for NRG as Standard & Poor’s and Fitch Ratings said NRG risked a downgrade.
While GenOn has lower ratings and $2.53 billion of bonds that investors can redeem at a premium in a takeover, NRG said it expects to boost free cash flow by $300 million and trim debt by at least $1 billion. The addition of Houston-based GenOn’s assets and cash will add protection for NRG’s creditors.
Bondholders “are picking up a whole bunch more asset coverage and they’re picking up a lot more asset diversity, and there’s no financing requirement, so you’re not adding any more net debt,” Andy DeVries, a New York-based analyst at CreditSights Inc., said in a telephone interview. “By making this acquisition, you improve your financials.”
Lori Neuman, a spokeswoman at NRG, said Chief Financial Officer Kirk Andrews wasn’t available to comment on plans for the new company’s capital structure.
NRG’s most actively traded note, its 7.875 percent bond due in 2021, rose 3.1 cents on the dollar last week to 106.25 cents, pushing its yield down to 6.71 percent, the least since the company issued the $1.2 billion debenture in January, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
The senior unsecured debt is rated B1 by Moody’s; BB-, one step higher, at S&P; and a level above that, BB, by Fitch.
NRG bonds rose today, with the company’s 7.625 percent notes maturing in 2019 gaining 0.6 cent on the dollar at 9:33 a.m. in New York to 104.8 to yield 6.18 percent. Its equal- coupon debt due in 2018 increased 1.5 cents to 106.25 to yield 6.25 percent.
Bonds of the power producer are outperforming the average of its junk-rated industry peers that included an 8.5 percent surge for GenOn debt, according to Bank of America Merrill Lynch’s high-yield electric utility index.
By combining with GenOn, which has about $1.7 billion of cash, NRG said it expects to cut operating costs by $200 million and save $100 million per year with lower interest expenses and collateral requirements, Andrews said on a July 23 conference call. GenOn is rated B2 by Moody’s, B by Fitch and B- by S&P.
“That would be a real plus, and it wouldn’t involve any additional levering up,” Margie Patel, a money manager at Wells Fargo & Co. in Boston who oversees about $1 billion and holds NRG debt, said in a telephone interview. Rising bond prices may signal that investors are “giving the company the benefit of the doubt that the synergies will be realized,” she said.
Cutting borrowings by $1 billion would also decrease the merged company’s ratio of total debt to estimated 2014 earnings before interest, taxes, depreciation and amortization to about 5.15, lower than each firm’s 2011 leverage levels, based on Andrews’s Ebitda estimate of at least $2.6 billion in two years.
While GenOn assets won’t guarantee the debts of NRG in a restructuring, the boost to free cash flow improves the credit of both companies’ obligations, DeVries of CreditSights said.
Credit-default swaps linked to NRG bonds fell to 519 basis points today, the lowest level since August, according to prices compiled by Bloomberg. Protection on GenOn debt plunged 3.6 percentage points last week, to 607.4 on July 27, the lowest since 2010, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.
“The part that people are excited about is the synergies and the cost efficiencies that are going to come from the combination,” Anthony Canale, an analyst at Covenant Review LLC, a New York research firm, said in a telephone interview. Bondholders “are thinking to themselves, ‘What did we give up? No cash left our system. The company issued common equity, which in a liquidation is behind me, and they took in this whole new business,’” he said.
Taking over a lower-rated GenOn, which has lost money for eight of the past 10 years, probably won’t help NRG’s credit rating, and management’s estimated savings aren’t guaranteed, according to S&P’s Aneesh Prabhu. About 70 percent of mergers overstate the expected cost savings, he said.
Independent producers, which sell power in competitive markets where rates aren’t set by local regulators, have been hurt by a more than 30 percent drop in electricity prices since 2008 while also facing higher costs to comply with new environmental rules.
GenOn had lost about 30 percent of its market value this year before its takeover was announced as slumping natural gas dragged down the price of electricity. Natural gas, used to generate power, touched a 10-year low in April and has fallen about 63 percent since the start of 2008.
“If the bondholders of NRG like this deal, they’re basically suggesting that the synergies are realistic,” S&P’s Prabhu said in a telephone interview. “We’re cynical about it. We’ll look at it and see what is really possible. Eventually, a rating agency is relatively more conservative than the market.”
Creditors face an additional risk that NRG’s finances may be stressed if GenOn bondholders decide to redeem as much as $2.5 billion of senior unsecured notes that can be sold back at 101 cents on the dollar in the event of a takeover, according to Shalini Mahajan, a New York-based analyst at Fitch.
By using equity to finance the deal, NRG also boosts the potential size of share buybacks and dividends that deplete cash, she said.
“We do see, overall, despite the $1 billion debt reduction, and giving them full benefit of all the synergies and costs savings that they’ve projected, that by 2015 it would be a slightly weaker entity than on a standalone basis,” Mahajan said in a telephone interview.
NRG said July 22 it would pay its first-ever quarterly dividend of 9 cents a share to holders as of Aug. 1. GenOn’s subordinated debt is trading above the put price, reducing the chance that NRG will need to tap surplus cash and a $1.6 billion bridge loan that Andrews called “ample and sufficient” to cover any redeemed debt.
While the purchase may have financial benefits such as the annual savings and reduced debt, it doesn’t outweigh the economic obstacles for power companies such as low electricity prices that contributed to Moody’s putting NRG’s debt on “negative” outlook May 11, according to William Hunter, an analyst at the New York-based firm.
“The deal does not cure the forces that were already in place that caused us to have a negative outlook,” Hunter said in a telephone interview. GenOn’s $4.2 billion in total debt doesn’t include about $2 billion of other obligations such as leases that increase the company’s leverage, he said.
Though the deal gives NRG creditors a less pronounced benefit than debt holders of GenOn and probably won’t lead to an upgrade for the merged company, its increased size, improved access to capital and cost savings boost credit quality, according to Peter Thornton, an analyst at KDP Investment Advisors Inc.
“It’s a really good fit,” Thornton said in a telephone interview. “Over time, as we work through the trough that we’re in right now, this is going to be a really powerful company.”
NRG was formed in 1989 to invest in independent power projects as a unit of Northern States Power Co., which merged with New Century Energies Inc. to become Xcel Energy Inc. in 2000. NRG filed for bankruptcy as a unit of Xcel in 2003 after Enron Corp.’s collapse two years earlier caused losses for energy generators and traders.
GenOn equity holders will receive 0.1216 share of NRG for each of their common shares under the takeover agreement, a 21 percent premium to the July 20 closing price. GenOn has gained 31 percent to $2.39 and NRG climbed 9.9 percent to $19.84.
“The deal’s positive for NRG,” said Robert Gephardt, a bond analyst at Chicago-based asset manager Neuberger Berman Group LLC, which oversees about $89 billion of fixed-income assets including NRG debt as of May. “This is an industry where greater scale really does provide benefits. You have more resources and more cash flows supporting” the company’s obligations, he said.