Calpine Can't Be Counted Out

In a notable change from recent trends -- and a welcome one for those long -- stock proxies were able to sustain midday strength today, although trading volume remains muted.

Stocks were inspired by a combination of stronger-than-expected retail sales data, hopeful comments from Applied Materials ( AMAT), better-than-expected earnings from Office Depot ( ODP) and a buyback announcement by Johnson & Johnson ( JNJ).

In addition to the above, stocks proxies were also buoyed as accounting issues took a reprieve, although Qwest Communication ( Q) fell 6.7% after The Wall Street Journal took a critical look at its accounting practices.

Thinking of firms under an accounting glare brings us back to Brett Gallagher, who oversees about $3.5 billion as head of U.S. equities at Julius Baer Asset Management.

As noted Monday night, Julius Baer has long positions in two firms that have been caught in the accounting maelstrom, Calpine ( CPN) and Tyco ( TYC).

Regarding Calpine, an independent power producer whose shares have been battered in the wake of Enron's implosion and concerns about its cash flow, Gallagher said Julius Baer began buying at about $16 a share and bought more at $11. Today, Calpine fell 6.8% to $7.98.

Despite the ongoing weakness in Calpine shares, and a recently announced SEC inquiry into the firm's disclosure practices, "we're definitely still positively biased toward the stock," Gallagher said. "This is a situation where the market has allowed panic to set in."

Gallagher's optimism is based mainly on the following factors:
  • The company's existing power purchase contracts were valued at $6.5 billion at the end of the fourth quarter;
  • The company has about $16 billion in power generating assets either in operation or under construction;
  • Following its $1.2 billion sale of convertible notes in December, the company had $1.5 billion of cash on hand at year-end 2001;
  • Although the company is heavily indebted, none of its $11.5 billion of long-term debt outstanding at the end of 2001 is due this year or next. Furthermore, proceeds from the convertible offering will more than cover the more than $800 million in putable bonds, which are likely to be exercised in April.
  • The company's accounts receivable and inventory are worth $969 million in a forced liquidation, even assuming a 40% discount.
  • "The only way we're wrong is if it's a fraud a la Enron," he said, arguing the company's breakup value exceeds $20 a share. "Given the simplicity of Calpine's business relative to Enron and the fact you can see the assets, the probability of that is pretty minimal."

    Gallagher also noted the company can afford to curtail its power building plans until market conditions -- and market perceptions -- improve. Last month the company put 34 projects on hold and cut its 2002 capital spending plan by as much as $2 billion.

    In that light, Calpine is starkly different than Tyco, which "has had the split thrust upon them" by the market's skittishness and resultant rise in its financing costs, he said. Today, Tyco fell 5.3% to $28.90 after warning its second-quarter estimates may not meet consensus expectations, due in part to those higher borrowing costs.

    Julius Baer was still long Tyco when we spoke on Monday, but Gallagher said he had bought Tyco because he believed in the "growth through acquisition" strategy, and he expressed skepticism about the breakup plan. Tyco shareholders who've been venting their frustrations on journalists would be better served using that energy to similarly consider why they bought the stock in the first place, and whether they still want to own it given the change in strategy.

    Value in the Eye of the Beholder

    But as the stock's performance indicates, the Calpine story is more controversial than Gallagher contends.

    One analyst, who doesn't formally follow Calpine and thus requested anonymity, estimated the company's breakup value is between $3 and $19.60 a share.

    That "huge variance" is "too large to have any meaning," the analyst admitted. The spread is due mainly to varying assumptions on the price of kilowatts per hour Calpine can garner.

    For generating in operation, the analyst used low/high estimates of $500/kw hour to $600/kw hour for combined cycle (peak and nonpeak hours) and $300/kw hour to $400/kw hour for peak-only generation. For generation under construction, he used $250/$350 for combined cycle and $150/$200 for peak cycle.

    Calpine "hasn't disclosed information on the contracts, so I don't know how you determine true value," he said.

    At deadline time, a Calpine spokesman hadn't returned a call seeking comment on the issue.

    I ran this by Gallagher, who countered that Calpine has recently made open market purchases of generating capacity at between $678 and $770/kw hour and that new construction is going for $600 to $700/kw hour.

    "In a forced breakup, full market value may not be realized, but I think $600/kw hour is a pretty solid number," the fund manager argued.

    Clearly, this isn't a simple story, and there are plenty of reasons for Calpine shareholders to remain concerned.

    But I will note that Gallagher is far from a wide-eyed optimist, as faithful readers of this column will recall. For example, he made a prescient sell call on J.P. Morgan Chase ( JPM), whose shares fell another 3.9% amid ongoing worries about the firm's internal controls, about which Gallagher expressed concerns in this column on Dec. 20.

    Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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