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Texas Genco

( TGN) is arguably the most attractive merchant energy player around, investors continue to treat it like an ugly stepchild.

It is a multibillion-dollar company with surging profits and no debt on its balance sheet. It pays a dividend that, while modest, looks more suited for a hike than a cut. It has already sold most of its power for this year and next. And unlike its peers, it actually benefits significantly when natural gas prices spike.

But it has failed to attract coverage from a single Wall Street analyst. And its stock, with an average daily volume of just 50,000 shares, barely changes hands.

"Right now, this is the most obscure mega-company you could find," said Harry Chernoff, an analyst for Pathfinder Capital Advisors who owns a stake in Genco himself. "It's the Rodney Dangerfield of stocks. It doesn't get any respect."

Genco's stock, down 1.3% to $36.01 on Thursday, has already doubled over the past year. But Chernoff points out that it still trades at a much lower multiple than its struggling peers.

"All other merchants have high debt, weak earnings and either no payout or high payout ratios," Chernoff stated. "This makes Texas Genco the standout performer in the group."

Overprotective Parent

But Genco's largest investor -- parent

CenterPoint Energy


-- may have little motive to tout the company's value.

Instead, CenterPoint is currently portraying Genco as a losing investment that entitles the utility to a multibillion-dollar refund under Texas deregulation laws. Last year, CenterPoint spun off 19% of Genco's stock in an effort to establish a market value for the company's assets. It is now using the stock's recent valuation to show a loss on the Genco assets -- before it actually sells the company to pay down debt.

Leticia Lowe, director of corporate communications for both companies, denies any allegations that CenterPoint has purposely suppressed Genco's stock price. She is quick to point out that Genco was one of the 15 best performers on the

New York Stock Exchange

last year. Genco's shares have actually tripled since its public offering in early 2003.

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"It is a great company," she acknowledged. But "the stock clearly reflects the value in the marketplace."

Critics counter by saying that Genco went public at a depressed price during the merchant energy downturn. And they suspect that the stock could have risen even more than it has. They simply question whether CenterPoint really wanted that to happen.

Texas state law allows utilities to seek "true-up" payments for, among other things, the difference between the book and actual market value of their generation assets. In late March, CenterPoint officially requested $3.8 billion -- plus $631 million in interest -- to recoup its investment in Genco. It now faces crucial public hearings followed by a regulatory decision in late August.

CenterPoint analysts -- and the company itself -- view that outcome as material.

"CenterPoint remains focused on two key events this year that stand to substantially impact the company's profitability, stability and ability to de-leverage over the next few years -- the stranded cost true-up process and the sale of its 81% interest in Texas Genco," wrote Terran Miller, a CenterPoint bond analyst at UBS.

Another fixed income analyst, Brian Schmidt of Citigroup, actually upgraded the value of CenterPoint's bonds after seeing just how much money the company was attempting to recover on its Genco investment. But CenterPoint still faces an outcry from customers who would pay for the refund through higher electricity bills.

The Texas Industrial Energy Consumers (TIEC) -- a group that includes, among others, some of the largest oil companies in the world -- is questioning whether CenterPoint has deliberately relied on consumers to make the company whole. Indeed, the group sees little incentive for CenterPoint to maximize Genco's value until after it collects its big refund and goes on to sell the company for itself.

"You can see there is a potential for mischief," said Lino Mendiola, one of the attorneys representing TIEC. "We have some concerns, subject to further analysis, regarding Genco's dividend policy, use of discretionary profits and capital structure."

Chernoff, for one, stops well short of saying that CenterPoint is actually manipulating Genco's stock price. But he still points to numerous actions that CenterPoint could take that might trigger a jump in the shares.

Cash Cow

For starters, CenterPoint could raise Genco's dividend.

Chernoff points out that Genco pays the same $1 dividend it did when it was generating barely more than that in annual profits and cash flow. The company never raised its payout, which could have also raised its stock price, when it was officially being valued. But Chernoff insists that the company could easily afford to do so. Right now, he said, Genco is forecasting earnings of $3 a share -- and discretionary cash flow of $4 -- for 2004.

"TGN could double the dividend while remaining below average on payout and coverage ratios," he said. "At $2 a share, the implied yield of 5.7% would likely drive the stock price into at least the mid-40s."

Lowe couldn't say why Genco has failed to raise its dividend. She simply said that Genco's dividend policy is "up to the board of directors," more than half of them CenterPoint executives. Indeed, several key positions -- CFO, general counsel and chief accounting officer -- are filled by the same people at both corporations.

Critics see the potential for conflict in the two closely related companies. They question whether Genco is really being operated the way a public company should. Specifically, they point out that most for-profit companies lay out a clear strategy to reward their shareholders by either reinvesting in their assets or increasing their yield -- and they insist that Genco has done neither.

Instead, Genco continues it hoard its cash. Chernoff estimates that the company's cash balance will surge from $50 million at the end of 2003 to $350 million at the end of this year -- around which time the company is expected to be sold. CenterPoint hopes to first secure its $4 billion payment on the Genco assets after regulators issue a ruling late this summer. But Chernoff expects CenterPoint to reverse course and "pull out all the stops to maximize the value of TGN" after that time.

For now, Genco is fueling CenterPoint's results. Indeed, Genco's recent $108 million jump in first-quarter profits accounted for virtually all of its parent's earnings growth. Michael Worms, an analyst at Harris Nesbitt, predicts that CenterPoint will generate "significantly lower earnings" after selling its Genco division.

Technically, CenterPoint has been marketing Genco since former subsidiary



walked away from an option to buy the company around the first of the year. It has offered few details on the negotiations, however.

"Details around interest and potential bids were scarcely discussed on the company's conference call," noted Miller, "though management did indicate that they are 'pleased with the level of participation and the overall interest in this asset.'"

Chernoff points to Genco's cash balance alone as attractive to potential buyers. Nevertheless, he seriously doubts that CenterPoint -- which needs to slash its massive 86% debt ratio to protect its credit rating -- will keep the Genco assets for itself.

Worms certainly agrees.

"It will not pursue a fire sale," acknowledged Worms, who has a neutral rating on CenterPoint's shares. "But management made it clear that CNP is a regulated business model and Texas Genco is not part of its long-term strategy."

Power Profits

In the meantime, Chernoff believes, CenterPoint could easily raise Genco's guidance.

After swinging to a surprisingly strong first-quarter profit, Genco simply reiterated its full-year profit forecast of $3.35 to $3.75 a share. But Chernoff calculates that Genco will earn $4 -- or more -- both this year and next.

Quite simply, Genco generates more money when other power providers are struggling with high gas prices. It sells "entitlements" to its power -- much of it generated by plants fueled by cheap coal or nuclear energy -- to providers in the giant deregulated market of Texas. Its customers sign "take-or-pay" contracts that require them to pay for the capacity, whether they actually use it or not. Because Genco can produce electricity cheaply -- in a market where power prices are linked to natural gas -- the company has seen customers line up to buy affordable power that, nonetheless, guarantees the company a tidy profit.

So far, Genco has already sold 94% of its 2004 baseload capacity. It has sold 65% of its 2005 baseload capacity as well. But Chernoff says that gas prices -- which have driven power even higher -- will translate into more profitable sales for the company's remaining capacity. He also foresees additional profits from the sale of "interruptible energy." As a result, he is convinced that Genco is issuing lowball guidance that analysts -- at least those who follow the company's parent -- have never thought to question.

"For analysts conversant with power systems concepts ... it is easy to estimate TGN's 2004 EPS, but it appears that the analysts following TGN are either incapable or unwilling to do so," Chernoff stated. Management's guidance "has the effect of suppressing the short-run price of the stock without affecting the long-run value of the company."

Still, Chernoff expects Genco to rally before all the dust settles.

Investors "look at TGN and see a sleepy company with no analyst coverage and a puny dividend," he said. "They don't realize that the value already exists because it is not in CNP's or TGN's interest to say so.

"That will change this summer. The smart money will be there ahead of time."