The headline disclosure at VST’s Analyst Day this morning (06/12/18) was the authorization of a $500M share repurchase plan, as the company has $1B in excess cash available after hitting its 2.5x Net Debt / EBITDA target by year-end 2019. This is only just the beginning of management’s focus on returning capital to shareholders. Over the long-term, VST is confident in its ability to generate at least $3B/year in EBITDA and convert that into $1.8B in Free Cash Flow. This should allow for the initiation of a dividend policy (~3% yield) likely sometime next year with still ample room for further share repurchases. In total, VST is projecting over $6B of cash available for allocation by 2022. Relative to a market cap of $12.6B, this is an attractive proposition. This is particularly important as a means to combat shareholder rotation given legacy distressed debt ownership positions. We’ve now added the initial buyback to our model, which boosts our Price Target to $29 (from $28). Every $500M in additional repurchases is worth $0.60/sh. Outperform.
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Several weeks ago (5/23), our Transports team held its annual conference that once again featured a Coal Outlook panel. Participants included executives from SO and VST. The key takeaway is that coal usage in the sector continues to trend downward, as companies transition their fleets towards natural gas and renewables. That said, this is now progressing at a relatively more modest pace than in recent years. At Southern, the company’s primarily regulated fleet is now only 27% coal-fired, down from about 70% a decade ago. At Vistra, the company is now about one-third coal-fired following the merger with Dynegy and the retirement of 4.2 GW of capacity in ERCOT. Previously, almost half of Vistra’s fleet was coal. Further, VST is currently evaluating the legacy DYN fleet (particularly in Illinois) where there may eventually be more coal shutdowns to come. This is consistent with the broader industry, with coal accounting for roughly 30% of total U.S. generation right now. By the same token, the electric power sector is expected to see a 4% drop in coal consumption in 2018 (25M tons). While in recent weeks the chatter around Trump/DoE support for coal/nuclear has started to heat up, both our panel participants appeared to think the shrinking of these fuel sources was inevitable.
Our utilities pension review, with help from the Wolfe Research Accounting and Tax Policy team and their comprehensive report, takes a look at the state of pensions and other post-retirement plans in the sector using year-end 2017 data. Utilities remain underfunded for their pensions/OPEB, though the gap narrowed when compared to last year. There is still wide disparity in funding levels and accounting assumptions within the sector.
Late last week, the press began to report on a draft Department of Energy memo that provided some detail on the latest attempt to subsidize troubled coal and nuclear. The plan is to exercise power under the previously referenced Section 202 and Defense Production Act. The government would direct RTOs to purchase power or capacity for 2 years from a designated list of facilities to stunt plant shutdowns. The DoE would also establish a “Strategic Electric Generation Reserve” to promote national defense and maximize domestic energy supplies. During the 2-year program, the DoE will conduct a study on the vulnerabilities of the grid. Trump / DoE have not yet taken official action and we expect challenges from generators and RTOs. PJM reiterated that it is not facing a reliability crisis and is pursuing its own study on resilience. Ultimately, it will come down to what plants are bailed out and if it holds up in courts. Further, two years from now we will be in another presidential election and the political dynamic could be very different. There are still a lot of uncertainties. FES creditors would appear to be beneficiaries, while retailers may be most at risk.
In last month’s Utility Trader, we highlighted that bond yields had jumped 52bps YTD but utilities had only underperformed by 120bps. Short interest had collapsed and a lot of equity issuance was coming. Utilities were either signaling a market problem or the utility rally would prove to be a head fake. We leaned head fake and so far that has been correct. Utilities underperformed the market by 390bps in May and now trail by over 500bps YTD. They lost another 250bps on the first day of June on Friday. Bond yields actually ended the month down a little so we think the big problem was really equity issuance. The large PPL and NI deals seemed to suck the life out of the entire sector. There are still a few more large deals to come – ETR, CNP and ED – but we are starting to get line of sight to the end of mega equity issuance.
As we wrote in our PJM postview note (link), we found the auction results to be a big positive relative to expectations. Zonal premiums were maintained and the $140 RTO price most benefitted VST. Most notable was the dramatic slowdown in new build to just 1.4 GW. FE’s decision to clear zero nuclear capacity was another key driver. The other big change was the shift in volumes amongst fuel types. While total cleared volumes were only down 1.5 GW, nuclear saw a 7.4 GW decline in capacity cleared. Meanwhile, coal and gas volumes were actually up 0.5/1.0 GW respectively. This dynamic seemed to garner a lot of the headlines coming out of the auction. Overall, we saw VST as the big winner, NRG/PEG less so, and EXC a relative loser.
The PJM capacity auction for the period June 2021 – May 2022 cleared at a headline RTO price of $140/MW-day. This was a big positive relative to our/consensus expectations. Zonal premium pricing was also maintained (including a few new areas like PS, ATSI, and BGE). New build shrinking meaningfully was another positive. For the first time in several years this event was not a big letdown. Overall this is a big positive for the generation market. Capacity revenues are now locked in through 2021 and generally show stability over 2019-2021. Amongst companies, VST was the clear winner given outsized exposure to RTO pricing. EXC was a relative loser, as ComEd / EMAAC retained premiums, but the data implies lesser volumes.
Last week, VST filed a Form 144 that indicated Oaktree has the option to sell 20M shares. Oaktree was the second biggest shareholder as of quarter-end, with 52.6M (10% of total) shares held as of its 04/09/18 filing (DYN merger close). The Form 144 was dated as of 05/08/18, which means that some of this selling could have already occurred. That said, this is a big stake to sell and could occur over just a few months. Separately, Elliott filed that they no longer own any NRG shares – this was not a surprise as the stock has nearly tripled from their entry point in early 2017.
The PJM capacity auction results for June 2021 – May 2022 will be released post-close on 5/23. As the power sector continues to transform, the number of publicly-traded companies exposed to the auction is at a record low. VST and NRG are the lone IPPs, with EXC and PEG the remaining Integrateds. Investor focus has also been muted. The common question we’ve gotten is “does anyone care?” The prior two years have seen very low RTO pricing, while ComEd and EMAAC have continued to separate higher. We believe this sets up a dynamic where the bar is relatively low for RTO, which would benefit VST most meaningfully. That said, we are conservatively forecasting only a slight improvement to $90/MW-day. The other zones are actually where the vast majority of our coverage has the most capacity. We see EMAAC/ComEd slightly weaker, with improvement in PS zone – see below.
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