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Calpine Beauty: Power-Hungry Gas Generator Steams Ahead

Peter Eavis

You have to admire the gall of independent power producer Calpine (CPN Quote - Cramer on CPN - Stock Picks). It has the hyperbolic growth aspirations of a dot-com and the vast capital needs of an Old Economy industrial behemoth.

So how is Calpine faring in a market that has come to mistrust gaudy growth targets, and which is now wary of providing huge gobs of financing to emerging companies? Very well, it so happens. Though off its highs, its stock is up 150% this year. Meanwhile investors are falling over themselves to throw new money at the company.

Surely, then, this is a perfect time to take a good hard look at Calpine. As mindless euphoria is being drained out of the market like pus from an overripe boil, the San Jose, Calif.-based firm stands out as one of the few companies that has kept its fans enraptured.

The Cross Hairs

And Calpine's goals need to be seen to believed. Its plants can currently produce around 5,000 megawatts of power. In just four years, it aims to expand that eightfold to 40,000 MW. That sort of increase, if executed, would be unprecedented in the independent power sector. Earnings forecasts are equally stunning. The company expects average annual per-share earnings growth of 40% between 1999 and 2004. That works out at a 400%-plus increase in per-share profits over the five years.

Calpine's game plan is unique -- and not without appeal. It's deploying cutting-edge gas-fired turbines to produce power. Power from Calpine's plants may not be cheaper than output from, say, coal-fired stations, due to the higher price of natural gas. But Calpine is focusing on areas where existing less-efficient gas-fired plants determine market prices. And as part of efforts to protect itself against in spikes in natural gas, Calpine is trying to buy companies with gas reserves. The company has cash of about $1 billion, and access to around $3.45 billion in bank loans. Those sums, combined with its expected operating cash generation, should be enough to finance the construction of plants with a combined output of 24,000 MW, the company says.

Calpine appears to have a finely honed strategy and cash to complete 60% of its buildout. So what's not to like?

Plus Ca Change

First, the broader concerns. Anytime a company pledges to grow this quickly, there is the risk that key markets may look a lot different in a couple of years. This is especially so in newly deregulated markets like California. Huge pent-up demand for power exists in the Golden State today. But in two years? And the aim of being situated mostly in areas where gas plants currently set the price may be tough to maintain in the medium- to long-term. About 75% of Calpine's output is currently to such areas.

In addition, growing to 40,000 MW would make Calpine a huge gas consumer come 2004. In fact, it would need about 2.6 trillion cubic feet of natural gas that year, which would represent around 10% of projected annual consumption that year. That's a big chunk for just one company to get hold of.

Natural gas may be cleaner and more efficient than other fuels, but it's getting expensive. Gas prices have risen 170% this year. Sure, Calpine hedges gas prices and tries to have the price it sells power at linked to gas prices. The company also buys gas companies with reserves. Around 20% of its current output can currently be fueled by gas from sources it owns.

But higher gas prices are making gas companies more expensive, which may be putting acquisitions out of Calpine's reach.

Calpine was recently in negotiations to buy an independent gas producer with a stock market worth of over $1 billion, according to a person at the targeted company who requested that he and the company not be named. The deal fell through because Calpine didn't want to pay the asking price. A half-cash, half-stock deal was on the table, meaning Calpine could have forked out over $500 million in cash. Calpine spokesman Rick Barraza declined to comment on specific merger discussions, but he says Calpine can achieve its projected returns even without extra gas ownership.

Where the Money Is

Calpine's accounts also deserve scrutiny. In the third quarter, around two-thirds of the company's interest expense, some $97 million, didn't flow through the income statement. Instead, it was placed on the assets side of the balance sheet, or capitalized, in the property, plant and equipment line.

This is done because this expense is related to power plants that aren't yet in operation. Once these plants are up and running, this expense will be amortized, or gradually written down, over the expected life of the plant -- some 40 years. Make no mistake, in doing this, Calpine is following standard industry practice and generally accepted accounting principles.

However, as kosher as it may be, this approach skews cash-based earnings. Add capitalized interest to the expenses in the third quarter and the company's net income would likely have been 18% lower, at $120 million. In the nine months ended Sept. 30, 2000, including total capitalized interest expense of $120 million could've made net income for the period one-third lower than stated.

What's more, capitalized interest is also a lot higher as a percentage of total interest expense this year than last. In 2000's first nine months, it was equivalent to 68% of the total interest expense, vs. 42% in the same period in 1999. In fact, in dollar terms it's up 314% ($120 million against $29 million). A big jump like that could lead some to wonder whether Calpine is goosing its bottom line by upping the capitalized interest amount.

Then again, such a rise may be justified, since Calpine's capital expenditure bill is ballooning. The problem is that there's no way of checking if the increase is warranted using publicly available numbers. A rough approximation of capital spending can be gotten from the investing activities section of the cash flow statement. That shows spending on property, plant and equipment was 141% higher in the year's first nine months at $1.62 billion. That's a big jump, but it's nowhere near the 300%-plus leap in capitalized interest.

Barraza says this item in the cash-flow statement shouldn't act as a guide, since it also includes acquisition spending, which doesn't qualify for capitalized interest. He declined to break out the non-acquisition part, or provide further guidance on why capitalized interest went up so much.