Tag Archives: investing ideas

Is The Calpine Dip An Opportunity?

Summary Calpine one of the largest power generators in the U.S. and Canada, with ~27,000 megawatts of generation capacity. It’s our belief that this best-in-class operator is being unduly punished by the decline in oil & gas prices. We find the shares to be incredibly attractive at current levels, with an FCF yield of 17.33% (low-end adj. FCF 2016) and EV/EBIT of 13.51. The low commodity prices in natural gas have generate negative sentiment around Calpine (NYSE: CPN ). The company has ~27,000 megawatts of generation capacity, with 97% being natural gas-fired. Normally, you’d think this would be a good thing for the company and its customers, but the market doesn’t see it that way. Anything natural gas-related is being sold, regardless of the underlying fundamentals. The continued drop in oil & gas prices dictates that electricity will remain low. Calpine is still able to generate excess free cash in a low electricity price environment; however, it gets better margins on high prices. With that said, we don’t expect oil & natural gas prices to remain at these depressed levels forever. So, is the dip in Calpine an opportunity to back up the truck in this best-in-class utility operator? The largest provider of electricity from natural gas and geothermal Calpine was founded in 1984, and is one of the largest power generators in the U.S. The company has ~27,000 megawatts of generation capacity from 83 power plants in 19 states and Canada. It has a formidable presence in the increasingly competitive wholesale power markets in the northeastern U.S., California, and Texas. In addition, it owns natural gas and geothermal power plants across North America. (click to enlarge) Essentially, the company’s power generation portfolio consists of natural gas combustion turbines and renewable geothermal conventional steam turbines. (1) Calpine is one of the largest owners of cogeneration plants and industrial gas turbines. (2) It also has one of the largest geothermal power portfolios in the U.S. with its Geyser assets in northern California. The company generates ~15% of renewable energy in California. (click to enlarge) Calpine has strong competitive advantages from its scale, low-cost status, and geographic presence. The natural gas shale revolution has certainly driven down the price of natural gas with the glut in supply. In turn, this has helped the company to generate low-cost electricity from its gas-fired generators. An abundant supply of natural gas and the displacement of older or obsolete power technologies has positioned Calpine to deliver low-cost electricity well into the future. The company’s geothermal power plants position it well against environmental liabilities. (click to enlarge) Calpine’s status as a low-cost provider in the power generation space gives it a big competitive advantage versus competition. The company is well positioned for stricter federal and state environmental regulation, as it has substantially less greenhouse gas emissions than its peers. Competition is increasing in this commodity business As natural gas prices continue to make new lows on a weekly basis, Calpine benefits dramatically. It relies on natural gas to fire its plants. But what happens if there is a dramatic increase in prices for a sustained period of time? We wish we had the answer. Certainly, it represents a risk if natural gas continues increasing in price over the long term. Our view is oil & gas prices in the U.S are likely to be capped for the foreseeable future due to the glut of supply in the market. Alternative energy and solar companies are another threat. This threat is likely to be subdued in a low commodity environment, which makes many of the alternative energy sources more expensive. However, over the long term, renewable energy sources could dramatically hurt Calpine’s business if they gain traction and compete on a cost basis. Main competitors include Atlantic Power (NYSE: AT ), Talen Energy (NYSE: TLN ), Ormat (NYSE: ORA ), NRG Energy (NYSE: NRG ), and Duke Energy (NYSE: DUK ). Long wave of growth potential As we have mentioned before, Calpine’s gas-fired plants should benefit from the ample supply of natural gas in the U.S. over the long term. More importantly, the power industry is one of the largest industries in the U.S. We are all impacted by the generative capabilities of utilities. The deregulation of the power industry presented uncertainty in the markets for a period of time. Wholesale power producers increased competition dramatically and decreased Calpine’s geographic advantages. However, utilities bring with them incredibly high barriers to entry. The secular trends of abundant, affordable natural gas, increased environmental regulations, focus on grid reliability and pay-for-performance, and the need for capacity to help intermittent renewable should pave the way for outsized growth in the future. Management is shareholder-friendly and competent The company generates excess free cash in the amount of ~$700-800 million per year. This leaves plenty of excess capital for share buybacks and dividends in the future. Management has a strong track record of capital allocation that is accretive to shareholders. Since 2010, management has bought companies at an average of ~6x EBITDA, while it has sold companies ~14x EBITDA. It continues to monetize non-core assets through sales or contracts, and is firmly committed to returning capital to shareholders with the excess free cash that the company is generating. (click to enlarge) Bottom Line It’s our belief that this best-in-class operator is being unduly punished by the decline in oil & gas prices. The entire sector continues to get beaten up, while Calpine continues to generate excess free cash. The secular trends of abundant, affordable natural gas, increased environmental regulations, focus on grid reliability and pay-for-performance, and the need for capacity to help intermittent renewable should pave the way for outsized growth in the future. In addition, the company has $6.9 billion in NOLs that still need to be worked through. The market appears to be pricing Calpine for dead, as it trades at a substantial discount to its replacement cost. We find the shares to be incredibly attractive at current levels, with an FCF yield of 17.33% (low-end adj. FCF 2016) and EV/EBIT of 13.51. Future dividends and buybacks should prove to be additional catalysts for this heavily undervalued company. While we are not huge fans of the power generation business, Calpine should do very well for investors over time. Notable Shareholders: Bill Miller | Altalis Capital | Rivulet Capital | Addison Clark Please share your thoughts in the comments section below as I learn just as much from you as you do from me. It can be a timely endeavor, but I answer all of your comments and questions myself. Your patience and understanding is greatly appreciated. I will get to your comments as soon as possible. 🙂 (Source of the above figures: Company Presentation )

Assessing The Utility Of Wall Street’s Annual Forecasts

It’s that time of year when everyone starts preparing for the New Year and Wall Street makes its 2016 predictions. I’ll get right to the point here – these annual predictions are largely useless. But it’s still helpful to put these predictions in perspective, because it highlights a good deal of behavioral bias and some of the mistakes investors make when analyzing their portfolios. The 2016 annual stock market predictions are reliably bullish. Of the analysts that Barrons surveyed, they found no bears and an expected average return of 10%. This is pretty much what we should expect. After all, predicting a negative return is a fool’s errand given that the S&P 500 is positive about 80% of the time on an annual basis. And the S&P 500 has averaged about a 12.74% return in the post-war era. So, that 10% expected return isn’t far off from what a smart analyst might guess, if they’re at all familiar with probabilities. There is a chorus of boos (and some cheers) every year when this is done. No analyst will get the exact figure right, and there will tend to be many pundits who ridicule these predictions despite the fact that expecting a positive return of about 10% is the smart probabilistic prediction. In fact, if most investors actually listened to these analysts and their permabullish views, they’d have been far better off buying and holding stocks based on these predictions than most investors who constantly flip their portfolios in and out of stocks and bonds. But that’s the reason why these predictions exist in the first place. Because every year, investors perform their annual check-ups and evaluate the last 12 months’ performance before deciding to make changes. And of course, Wall Street encourages you to do exactly that, because turning over your portfolio means increasing the fees paid to the people who promote these annual predictions. But when we put this analysis in the right perspective, it becomes clear that this mentality is misleading at best and highly destructive at worst. Stocks and bonds are relatively long-term instruments. The average lifespan of a public company in the USA is about 15 years.¹ And the average effective maturity of the aggregate bond index is about 8 years.² This means an investor who holds a portfolio of balanced stocks and bonds holds instruments with a lifespan of about 11.5 years. When viewed through this lens, it becomes clear that evaluating a portfolio of long-term instruments on a 12-month basis makes very little sense. What we do on an annual basis with these portfolios is a lot like owning a 12-month CD that pays a one-time 1% coupon at maturity and getting mad that the CD hasn’t generated a return every month. But this annual perspective makes even less sense from a probabilistic perspective. As I’ve described previously , great investors think in terms of probabilities. When we look at the returns of the S&P 500, we know that returns tend to become more predictable as we extend time frames. And the probability of being able to predict the market’s returns increases as you increase the duration of the holding period. While the probability of positive returns becomes increasingly skewed as you extend the time frame, there is still far too much randomness inside of a 1-year return for us to place any faith in these predictions. The number of negative data points is only a bit lower than the number of positive data points, even though the average return is positively skewed: (click to enlarge) So, at what point do returns become reliably positive? If we look at the historical data, we don’t have reliably positive returns from the stock market until we look about 5 years into the future, when the average 5-year returns become positively skewed. A 50/50 stock/bond portfolio has a purely positive skew, with an average rolling return of 3 years. Interestingly, this stock market data is just as random even though it’s positively skewed. So, trying to pinpoint what the 5-year average returns will be is probably a fool’s errand (even though stocks will be reliably positive, on average, over a 5-year period). (click to enlarge) All of this provides us with some good insights into the relevancy of making forecasts about future returns. When it comes to stocks and bonds, we really shouldn’t bother listening to or analyzing predictions made inside of a 12-month period. The data is simply too random. As we extend our time horizons, the data becomes increasingly reliable with a positive skew. But it still remains a very imprecise science. The bottom line – If you’re going to hold stocks and bonds, it’s almost certainly best to plan on having at least a 3-5 year+ time horizon. Any analysis and prediction inside of this time horizon is likely to resemble gambling. As Blaise Pascal once said, “All of human unhappiness comes from a single thing: not knowing how to remain at rest in a room”. The urge to be excessively “active” in the financial markets is strong; however, the investor who can take a reasonable temporal perspective will very likely increase their odds of making smarter decisions, leading to higher odds of a happy ending. Sources: ¹ – Can a company live forever? ² – Vanguard Total Bond Market ETF, Morningstar

How To Think About M&A When It Comes To Your Portfolio

What do mergers and acquisitions have to do with your portfolio? A lot, says BlackRock’s Mark McKenna – especially in today’s market. It’s been a remarkable year for financial markets, highlighted by extreme volatility, severe weakness in commodities and a raging debate about interest rates, among other things. But there’s another ongoing market trend of great importance to investors, one that could offer substantial opportunity: M&A. Merger and acquisition activity has been on a torrid pace in 2015, on track to surpass 2007’s record levels. Through November, more than $4.5 trillion worth of mergers have been announced year-to-date, and the activity in the third quarter was the strongest on record for that period, according to Citi. The flurry of deals is a reflection primarily of three factors: low interest rates, robust corporate balance sheets and a global economy that remains sluggish. Low rates make funding acquisitions more affordable, and companies that have a difficult time growing their earnings when the economy is soft often look for attractive merger candidates to help spur their growth. Mergers, Acquisitions and Your Portfolio So how can investors take advantage of this trend? Well, for starters let’s quickly cover what not to do. Simply guessing at which companies might be takeover targets and buying as much stock as you can is not a good idea. Investors should never buy a stock based simply on a hunch that the company may someday be a buyout target. Instead, investors might consider employing what we call an “event-driven” strategy. Event-driven investing focuses on capturing the value gap created when companies undergo transformative events, or “catalysts.” The idea behind the strategy is to invest in a company undergoing a material change that is expected to impact shareholder value. We define catalysts as either “hard” or “soft.” A hard catalyst, such as an announced merger, tends to have a defined outcome, which creates a more predictable return. A soft catalyst, perhaps a company undergoing a senior management change, can have a range of outcomes. One advantage of these investments is that, because they are focused on company-specific developments and not broader market events, they are less correlated with day-to-day market movements. By extension, such event-driven strategies have the potential to generate positive returns regardless of overall market moves. (click to enlarge) From my perspective, the record M&A activity that we’ve seen this year has created the most attractive opportunity we’ve seen in the last 10 years, with merger spread investments near all-time high rates of returns. When compared to other yield asset classes, including high yield bonds, Real Estate Investment Trusts (REITs) and even many illiquid yield investments, merger spreads may offer higher returns with much less duration risk. As a result, merger investments can potentially provide investors equity-like returns with volatility usually associated with stocks, according to data from Bloomberg and Hedge Fund Research Inc. With the stock market both volatile and near all-time highs, and fixed income yields hovering near historic lows, investors should consider different ways to diversify their portfolios. Event-driven strategies are one way to do that, offering not only the potential for positive returns in both up and down markets, but also potentially reducing portfolio risk. Mark McKenna is Global Head of Event-Driven equity and a Managing Director at BlackRock. This post originally appeared on the BlackRock Blog.