TEXAS GENCO (TGN)

 

To:                   The Speculators

From:               Jackal

Subject:            TGN

Date:                1/06/2003

 

Here are some notes on a spinoff that will begin trading the regular way on Jan. 6. The company is called Texas Genco (TGN).  I own 200K shares and see the stock going to $14 - $19 in the next three months.

 

 

 

The positives are that book is $35, the dividend $1 and the company is debt-free. Moreover, RRI has an option to buy 81% of TGN from CNP in early 2004 for a 10% premium to market. (If RRI doesn't exercise the option, CNP will likely sell TGN to anyone else, if they can find someone interested. Presumably, RRI or a third party buyer would be interested in buying the TGN shares that are being now spun off to CNP shareholders.)

 

 

The negative is that TGN is not making money and with over-capacity in the industry, it is expected not to make any for the next several years.

  

 

In terms of buying TGN now, at a discount to where it will likely trade after it is fully distributed, the history of the RRI spin-off is not

encouraging of a short term trade since that stock traded in line with its peers for the first  two months following the spin off. However, in the

third month (beginning 12/1) RRI out performed both CPN and MIR by 80% and 47%. As to flow back, it shouldn't be as great as it was in RRI; the $1 dividend (which at current when-issued prices for TGN is a 10.5% dividend yield) might discourage individuals (owners of 54% of CNP shares) from selling out. However, CNP is in the S&P so roughly 1.2M shares of TGN will be coming out on 1/6.

 

 

With the dividend secure (until at least the RRI option expires), the shares on a dividend yield basis likely trade no worse than 12% or $8.33. This is

the downside.

 

 

On the metric of Price/Book, my gut tells me TGN trades fully distributed at least at 28% - 38% of book or $9.8 - $13.3.

 

Combining the dividend and Price/Book approach, TGN shares are like a bond with warrants attached. The bond should be worth somewhere between 9% - 13% or $11.11 - $7.69. The value of the warrant would be some fraction of the future value of TGN; the future value would be the value of TGN at a point in time when much of the excess capacity in the electric business has been absorbed, when new generating plants will need to be built and when presumably the rate of return on existing plants allow share prices to rise above book values. The business model is similar to the commodity chemicals business. In that business, when capacity is tight, share prices easily rise beyond 1.5X Book. Assuming the future value of TGN reaches 1.5X Book or $52.5, one would want a payback of 4X - 7X; that would make the combined value of the bond and warrant $14 - $21. Because TGN is debt-free, the warrant is arguably less risky than generally and the payback should be at the lower end. Abandoning payback and using DCF, assuming 8 years to future value and an 18% p.a. return, the combined value is $19.6.

 

  

Another Price/Book approach would reference other similar companies. CPN is trading at 50% of its net tangible assets. That valuation presumably

reflects a discount for the bankruptcy reorganization (implied by the trading prices of its senior bonds) CPN will need to work thru at some

point. But the CPN Enterprise Value/Book valuation should be higher than that of TGN because CPN has power sales contracts in place that will allow it to be profitable in 2003-4. Moreover, CPN has a portfolio of new plants while TGN'S plants are very old and presumably less efficient. (However, on the other hand, 43% of TGN'S capacity is coal and nuclear - which in the current market are profitable - while gas - all of CPN'S plants - is not.) On balance, relative to CPN, TGN should arguably trade not worse than 35% - 40% of book or $12.25 - $14.

 

  

(Among the unique attractions of TGN is that it is debt-free, an "investment grade" stock. This is unusual in that most spin-offs are non-investment

grade. Currently, all independent power producers are non-investment grade and likely need to reorganize through bankruptcy proceedings. Thus, TGN is a "safe" way of playing the power producing sector.

 

  

In terms of Price/Book, a screen on Bloomberg for stocks having an Enterprise Value of $200+M and Total Debt of 30% or less than Enterprise

Value identifies 1,368 companies. Of these, seven trade at less than 70% of Book. TGN'S comps (ILA, MIR, RRI, DYN, WMB, CPN, EP and AES) trade on average at 32% of Book. However, these are very leveraged animals.

 

  

As to Street analysts I have not yet seen an opinion published. However, on 9/4/02, Baylock & Partners issued a SELL recommendation on RRI in which they said TGN could be worth about $28.75 to RRI on a "fair market value basis."

  

 

David Silverstein (High Yield, Merrill) values coal plants at $500 - $600/MW, nuclear at $400/NW, and gas at $150 - $300/MW. TGN has 5,273MW of coal, 770MW nuclear, and 8,132MW gas/oil. As such, TGN is worth $36.8 with no value attributed to the gas plants. At the low end of valuation, the gas plants increase the valuation by $15.25 to $52 or 1.48X Book.

 

  

While the coal and nuclear plants are profitable (perhaps generating $400M in EBITDA, according to Silverman) their profitability is hidden by losses

from the gas plants. Presumably, a mothballing of the gas plants could unveil the underlying profitability of TGN. If that was to happen, the

shares could trade at 5X EBITDA or $25/share.

 

 

All considering, I expect TGN to trade at $15+ fully distributed. As to timing, based on the trading in RRI and SJM (which traded at a 10% premium

to its prior to spin-off price in the third month following the spin-off), we should buy TGN below $10 and close the position in March.

 

 

 

1/4/03

 

 

Just received a spread sheet on CNP and TGN (prepared by Deutsche Banc. Alex Brown) that is projecting TGN to have 2003 EBITDA of $259M and EPS of $0.81. The EPS number indicates a turnaround from 2002 when TGN lost $1.01/share. Revenues in 2003 are expected to rise 37%, which is still 37% below 2001 revenues (when TGN earned $1.6/share.). While there is no accompanying text, the midpoint of their valuation matrix is 3.5X EBITDA which works out to $10.42/share. At the high end of their matrix, the valuation is 5X or $15.28. Also of note, they show a regulatory equity book value of $40 and expect 2003 cash flow after CAPEX and dividends to be break-even. They don't project into 2004.

  

 

Their numbers make all sorts of assumptions about costs of fuel and electricity pricing which only a very sophisticated analyst of the

electricity business could judge. I tend to doubt the market will price TGN based on such an analysis (which ultimately could vary, I would guess

significantly, as reality unfolds differently than the assumptions made). On balance the analysis is quite bullish to me in that it shows TGN will in

2003 have sufficient cash flow to cover the dividend and have a meaningful level of EPS; as well, the projected turnaround in the 2003 numbers coupled with the results of years past (when TGN was regulated and earned $2.81 (1999)) allow for some level of fantasizing about how well things might be a couple of years down the road.

  

 

Taken together, at current levels ($9.4) TGN offers a terrific risk/reward.