The decision from NRG Energy (NYSE:NRG) to pivot the business away from its traditional asset-based power generation model and toward an asset-light retail business model has been controversial to say the least. While the shares have outperformed the broader utility sector since my last update, with more mixed performance relative to closer comps like Constellation Energy (CEG), and Vistra (VST), the performance over the last five years has been far less impressive and many investors remain highly skeptical of the company’s strategic shift.
With the company’s recent Analyst Day in hand, I view NRG’s shift as something of a “take it or leave it” proposition for investors. The company clearly no longer sees its future in asset-based generation and has fully committed to a retail-driven model focused on retail electricity in Texas and smart home technology nationally. Activist investor Elliott Investment Management (“Elliott”) is advocating for change, and I don’t discount their ability to shake up the board and management, but I think counting on a return to something like the prior operating model is risky.
I certainly acknowledge the risks that go with this strategic shift, but I continue to believe that the old model wasn’t attractive as some investors maintain, with low probable returns on assets and capital over the long term. This new strategy could fail, and I see a wider range of outcomes, but I also see greater long-term upside if management can execute on its vision.
All-In On Retail
It was pretty clear with the recent announcement of the sale of the company’s 44% stake in the South Texas Power (or STP) nuclear station to Constellation that management was further committing itself to its transition to a retail-driven model. Management more explicitly confirmed that commitment in its recent Analyst Day, while also unveiling a model that promises a greater focus on returning excess cash to shareholders through dividends and buybacks.
The sale of STP erases about 25% of NRG’s Texas generating capacity, as well as its largest source of carbon-free generation. STP is a base load facility and management will look to replace that capacity through open market purchases – while the Texas power market has seen notable volatility in recent years, sourcing adequate base load power shouldn’t be that challenging for the company.
At the same time, the company is still intending to own generating capacity, but with an increased focus on intermediate/peak needs. Management is looking at adding 1.5GW in brownfield capacity across three sites to strengthen its peak supply capacity, with the TH Wharton site the most advanced (the gas turbine has been purchased).
Estimating the returns from these capacity additions, assuming all go forward, is painfully complicated. There are scenarios where these plants could generate double-digit returns, but that will depend critically on the future of the Performance Credit Mechanism and other changes to the energy market in Texas in the coming years. At a minimum, though, owning more peak capacity will reduce some of the volatility in results, as high peak prices force the company to choose between margins and market share for its retail customer base.
The sale of the STP stake will shift NRG’s earnings base overwhelmingly (90%-plus) to retail, split between retail energy and Vivint. This retail energy business does have attractive competitive advantages and the potential for attractive and relatively stable margins, but “potential” is a tricky word in investing, particularly given the chaos seen in the Texas electricity market in recent years and the controversy over the Performance Credit Mechanism.
Vivint Remains Highly Controversial
While Retail Energy will generate more than half of NRG’s EBITDA for the foreseeable future, the company’s Vivint smart home subsidiary still factors very significantly in management’s vision of the company’s future. Given that the acquisition of Vivint has been highly contentious from the day it was announced, this remains an ongoing challenge to sentiment.
Management has laid out an attractive vision for the business, looking for 9% subscriber growth, high teens revenue growth (on cross-selling and new revenue streams), and service margins around 80%. Management is also looking for improved FCF conversion – from 20% to 55% – on reduced customer acquisition costs and increased operating scale, as well as 30% annualized growth in FCF over the next several years.
When I last wrote about Vivint I mentioned the possibility of expanding the business beyond its core security offerings and its small offerings in solar energy, and to that end management announced a new “smart lighting” business that will include smart light switches, smart bulbs, and a bridge system – a service that will cost about $300 upfront with a $5 monthly service fee.
I don’t see much risk to the general idea of increased adoption of smart home systems over the next decade (and beyond), as there are multiple benefits in the form of convenience, customization and control, and cost savings. It remains to be seen, though, how well Vivint will compete against a host of options, including systems and solutions provided by the likes of Amazon (AMZN) and Alphabet (GOOG) (GOOGL). Customer “stickiness” has been good thus far (an average customer term of over nine years), but these are still early days.
Almost every part of the Vivint model remains a point of controversy with investors, though, including debates over the pace of consumer adoption, how much customers will pay, market share trends, and service profitability at scale. These concerns aren’t helped by factors like a court ruling back in February where a North Carolina court initially awarded a $189M judgement to CPI Security against Vivint in a case where CPI alleged deceptive sales practices on the part of Vivint.
An Increased Focus On Shareholder Returns
In addition to going effectively all-in on its retail power and smart home businesses, as well as talking down the prospects for large-scale near-term M&A, management announced a renewed and increased focus on shareholder returns from the new operating model.
Management is now looking to distribute 80% of excess cash flow (operating cash flow minus maintenance capex) to shareholders, up from 50% previously, while committing 20% to growth projects (versus 50% previously). Those shareholder returns will come in the form of higher dividends and increased share buybacks, with management increasing the buyback authorization to $2.7B (from $1B), while also targeting high single-digit annualized dividend growth. If management’s forecasts pan out, over $8B could go to shareholders over the next five years in addition to $2.5B of debt reduction.
Execution Risk And Activist Discontent Are Relevant Considerations
How well management can execute on this shift to a retail model remains to be seen – the company has been making these intentions clear for some time, but investors remain highly skeptical. I would argue that the returns on “classic” power generation aren’t all that exciting, though, and while I could argue for a strategic plan that sees a shift toward more renewable energy generation, I think there is merit to NRG’s plan.
Many analysts and investors disagree, though, and that includes Elliott Investment Management – a well-known activist investor. Elliott disclosed a 13% stake earlier this year and called for a strategic review/change that included $500M in savings from improved asset reliability and streamlined costs as well as a divestment (sale or spin-out) of Vivint. While NRG and Elliott have had a productive relationship in the past, there have been more recent rumors that Elliott is now more aggressively pushing for changes to both the board and executive management (including replacing CEO Mauricio Gutierrez).
I don’t underestimate Elliott’s ability to affect change in its targets, but there isn’t a lot of time to make big changes. The sale of STP is targeted to close by the end of 2023 and if that deal goes through, I’m not sure how Elliott’s plans will fit the new asset base of the company.
The Outlook
I do expect meaningfully higher EBITDA in FY’23 as NRG benefits from the inclusion of Vivint and the absence of 2022 headwinds like operating issues at Parish and the winter storm. Beyond that, I expect low single-digit EBITDA growth over the next four years (from ’23 to ’27) and close to mid-single-digit adjusted FCF growth. Within these expectations, solid growth at Vivint is a key driver, so execution here is a must-have.
Between discounted cash flow and an EV/EBITDA approach, I believe a fair value around $41 is fair (a 7x multiple to my 12-month EBITDA estimate) and I expect a high single-digit long-term annualized total return on the basis of forecasted FCF.
The Bottom Line
I continue to believe that there are merits to NRG’s strategic shift that are still going underappreciated and undervalued in the market. I also believe that this is a consummate “show me story” where rerating is inextricably linked to management execution; NRG management has to prove that their vision of the Retail Energy and Vivint businesses are valid and that they can execute to the targets they’ve laid out.
By the same token, I have no interest in convincing the skeptics – if you don’t like the shift away from an asset-heavy electricity generation model, you’re not going to like NRG anymore unless Elliott succeeds in its efforts to alter the company’s course. Given that uncertainty, this is only a stock suitable for more risk-tolerant investors, even with above-average return potential relative to the sector here.
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