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Standard & Poor's


04/21/14 10:10:18 AM



This week's Focus Stock of the Week is NRG Energy (NRG: $32.21) which carries S&P Capital IQ's highest investment recommendation of 5-STARS, or Strong Buy. NRG Energy is the largest independent power producer (by generating capacity) that operates as an integrated wholesale power generation and retail electricity company. Our Strong Buy recommendation reflects our view of an attractive valuation and our belief that NRG will benefit from cost reduction efforts and savings from recent mergers.

On April 1, 2014, NRG completed the acquisition of Edison Mission Energy (EME), which had been in Chapter 11 bankruptcy, for about $1.6 billion consisting of $400 million in NRG stock and $1.2 billion of cash, net of cash acquired. NRG expects to achieve a total of $70 million in annual cost savings by integrating the EME operations into NRG's platform. EME's 7,967 MW (megawatts) of generation assets are valued at about $400/kW in this deal. We think NRG is acquiring good assets at a relatively low price as it did with its previous acquisition of GenOn Energy. EME's portfolio consists of 1,683 MW of wind, 1,628 MW of gas, 4,314 MW of coal and 345 MW of oil/waste coal capacity. NRG expects that it will be able to transfer 1,598 MW of capacity, consisting of contracted wind assets and the Walnut Creek plant, to its NRG Yield segment.

NRG owns a 65.5% voting interest in NRG Yield (NYLD 42 NR). NYLD owns 100% of the class A units of NRG Yield LLC (representing a 34.5% economic interest in the LLC), while NRG owns 100% of the Class B units (representing the remaining ownership of the LLC). NRG Yield LLC owns 1,324 net MW, and thermal infrastructure assets with an aggregate steam and chilled water capacity of 1,098 net MWt and electric generation capacity of 123 net MW.

We believe NRG has a solid track record of integrating acquired assets and achieving its cost saving synergies. NRG originally planned to achieve $300 million in annual savings and synergies from its GenOn acquisition. Through December 31, 2013, NRG achieved $484 million in annual benefits through both operational savings and balance sheet efficiencies. On a smaller scale, NRG continues to target additional cost savings through operational improvements and capital expenditure efficiencies within its existing operations.

We see revenues, including the EME deal, rising 15% in 2014, but falling 3% in 2015, versus a 34% rise in 2013, which was aided by acquisition of GenOn in late 2012. We believe the continued production of gas from oil wells and from the Marcellus Shale will keep downward pressure on natural gas prices, which adversely impacts peak power prices. However, we see narrowing reserve margins in the Northeast reflecting more stringent environmental rules that are leading to coal plant retirements.

NRG's business strategy includes aggressively positioning itself to meet the market's increasing demand for sustainable and low carbon energy solutions. This strategy is designed to enhance NRG's core business of competitive power generation and mitigate the risk of declining power prices. NRG is focused on operational excellence, optimal hedging of generation assets and retail load operations, repowering of power generation assets at premium sites, investing in alternative energy technologies, pursuing selective acquisitions, joint ventures, divestitures and investments, and returning stockholder capital. In addition, NRG, through its subsidiary, NRG Yield, is focused on providing a more competitive source of equity capital and reducing market exposure with contracted assets.

We forecast gross margin of 40.2% in 2014 and 38.5% in 2015, versus 28.1% in 2013. We expect EBITDA margins of 13.5% in 2014 and 11.3% in 2015, versus 12.2% in 2013. We expect merger savings helping margins in 2014, but see lower revenues hurting margins in 2015. We estimate recurring 2014 EPS of $1.26, up 152% from 2013's $0.50, which excluded net contract amortization, mark-to-market and non-recurring losses of $1.72. Our 2015 EPS estimate is $0.86, down 32%.

NRG recently traded at 25.5X our 2014 EPS forecast, or a 23% premium to its independent power producer and energy trader peers. Our 12-month target price of $37 is 29.4X our 2014 EPS estimate, or a 26% premium to its peers. We believe the valuation is warranted by our view of strong cash flows and strong earnings growth potential driven by merger savings and new projects entering service.

Risks to our recommendation and target price include changes in energy market conditions, economic conditions, and interest rates.

S&P's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.


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