Why Howard Marks Of Oaktree Capital Management Is Buying More Dynegy

Author's Avatar
Jun 29, 2015

Dynegy (DYN, Financial) is utility located in the Midwest, the Northeast and the West. The company generates power (26 gigawatts of capacity) through natural gas and coal plants and is the third-largest independent power producer after NRG Energy (NRG, Financial) and Calpine (CPN, Financial). Dynegy's capacity includes baseload, intermediate, and peak power plants. Several years ago Dynegy entered Chapter 11 after a severe decline in power prices left it unable to service its excessive debt. After exiting from Chapter 11 the company started acquiring assets at value prices and building out its operations again. Most recently it acquired 9.0 GW in PJM and 3.4 GW in New England from Duke Energy (DUK, Financial) and Energy Capital Partners. Since exiting Chapter 11 total Mw capacity has increased by ~2,5x.

Robert C. Flexon, whose contract was recently extended to 2018 and who bought shares at the end of 2014, and his team did a remarkable job with their PRIDE program to cut costs and increase efficiency. The Ameren acquisition got integrated much more smoothly than I expected. I have been following the company for a couple of years now, and the company tends to beat the long-term guidance. The recent acquisition in New England is likely to yield additional benefits over the next few years and powers management's EBITDA guidance for 2016 of $1.6 billon. With its current Enterprise value of $9.64 billon the company trades at roughly 6x forward EV/Ebitda. That is an attractive valuation by itself, but with management guidance generally being conservative and the company’s $3.5 billon of NOLs this is a great opportunity. It is no surprise Howard Marks (Trades, Portfolio) Oaktree Capital Management LLC is increasing its stake and now holding over 8% of shares.

03May20171055071493826907.jpg

Source: Investor relations presentation

Financial position

Long-term debt and lease obligations were restructured during 2012 through the Chapter 11 process, and the new leverage profile is designed to withstand long periods of low energy price environments and provide the necessary liquidity capacity to support daily operations. The company is ready to deal with seasonal liquidity requirement swings and can handle its interest payments:

03May20171055071493826907.jpg

Source: Investor presentation

The company has about $7 billion of long-term debt on its balance sheet and $1.73 billion in cash. The debt load is significant but as the latest acquisition gets integrated the EBITDA to Debt ratio will fall. Meanwhile the company benefits from staggered maturities and no near-term obligations.

Management

Management sounds very optimistic on the latest investor presentation while management's guidance up to now has consistently been conservative. Under CEO Flexon’s guidance operating cost per megawatt has declined by 70%. This was accomplished by achieving economies of scale, starting a retail operation and cost cutting. According to Morningstar, insiders hold a combined $28 million worth of shares and have been buying more recently. Flexon holds approximately 2x his annual compensation in shares. I wish it was more, but given the company has been in business for only a couple of years it is not a bad number. The short but impressive track record of the new management team is inspiring. From various communications; earnings calls, K-10 and investor presentations I also have the impression the team knows what it is doing and is highly cognizant of the importance of shareholder value creation.

Risk

Probably the greatest risk for the company is climate change regulation. Washington or state legislators can make life difficult for Dynegy. Regulatory changes intended to slow or prevent climate change can affect the business and increase required CapEx spending. Currently. all of the companies plants are compliant with the air regulations (MATS, CSAPR, consent decrees, etc) and the company has charted CapEx required to update the plants to comply with federal 316(b), ELG and CCR rules that are related to coal combustion and water outfalls.

Valuation

Management guides to an EBITDA of $1,6 billion in 2016. Over the 2016-2018 period Dynegy thinks to be able to generate a FCF yield of 9%-16%. Guidance tells us that Dynegy is a very attractive investment at its current share price on a stand-alone basis. How does its valuation compare with competitors? Could it be cheap just because of a cloudy industry outlook?

Company EV/Ebitda P/E P/E (forward) P/B
Dynegy 29 n/a 12.8 1.6
Calpine n/a 7.68 20.5 2.21
NRG Energy 9 745 126 0.85

Depending on which metric you look at Dynegy looks cheap or somewhat expensive. The forward estimates (Reuters analyst averages) favor Dynegy. This confirms managements assertion it is cheap on relative basis when taking into consideration future Ebitda against Enterprise/Value. The industry does appear to be pressured, and it is not wise to expect the company to trade at elevated EV/Ebitda multiples in the future but the stock still looks attractive, because Ebitda is expected to expand signficantly. On a valuation basis I like the stock.

Outlook

Over the next few years approximately $2 billion of capital becomes available for management to allocate. Flexon stresses the team will allocate with the goal of generating the best returns for shareholders. He repeatedly stated buybacks are definitely an option and the benchmark against which other capital allocation options are weighed. A dividend is not in the cards for now.

Dynegy is pretty well positioned with its portfolio of power-generating assets because significant capacity is leaving the markets where it is active (coal plants of competitors are shutting down). On the slide below you'll see in the right-side diagram how much capacity in MW's is retired in 2015 due to regulation in the company's various markets:

03May20171055071493826907.jpg

Source: Investor presentation

The company will likely benefit from its solid positioning because the ceiling for peak demand is lowered which means the company will receive higher prices more often, if energy demand does not fall. All considered with Dynegy trading at roughly 6x forward EV/Ebitda and $3 billion of unused NOLs, I have a hard time passing up this opportunity.