One of the hottest stocks in the power sector could have plenty of sizzle left. Texas Genco ( TGN), which ranked as a top market performer in 2003, has already rocketed another 40% this year. Three-fourths of that gain has come since TheStreet.com first
spotlighted the overlooked stock in early May. But the company has the power -- and will soon have the incentive -- to increase its value even more. For starters, some believe, Genco could finally raise its 2004 earnings guidance -- currently at a range of $3.35 to $3.75 per share -- when it releases quarterly results next month. The company could then boost its value even more, through share buybacks or big dividends, if it falls under new ownership, as expected, just a few months down the road. Right now, parent company CenterPoint ( CNP) owns 81% of Genco. But CenterPoint plans to shed its generation subsidiary in order to comply with Texas deregulation laws and raise money to pay down its huge debt load. In the meantime, however, CenterPoint has done little -- some say too little -- to boost Genco's valuation ahead of a crucial regulatory hearing, now under way, involving both companies. At stake in the so-called true-up hearing are billions of dollars that CenterPoint is hoping to recover from its investment in Genco before it sells the company. Already, however, at least one Wall Street analyst has witnessed clues that Genco's earnings -- and its entire value as a company -- could prove higher than most people think. Steve Fleishman of Merrill Lynch recently pointed to comments made in CenterPoint's true-up hearing as evidence of good things to come. "There was a suggestion that TGN's earnings outlook might be revised upward on the next earnings conference call," Fleishman noted in an industry report published late last month. But "the most noteworthy development thus far seems to have been comments from a CNP executive indicating that CNP had received two bids for its 81% interest in Texas Genco, and the company seemed pleased about the indicative price." Genco's stock, which has more than doubled in a year, fell 19 cents to $46.85 Monday.
Powering AheadBy now, Genco has already taken a series of steps -- including some unrecognized by the market -- to boost its earnings power. But the company is leaving what is arguably the biggest opportunity for its future owner. Down the road, Genco can embrace the same vehicle that actually crushed other players during the merchant energy meltdown. The company can take on debt. "Taking on debt may reduce TGN's cost of capital because the debt would cost less than TGN's equity, depending on dividend policies, and because the debt interest payments are tax-deductible to TGN while stock dividends are not," explained Harry Chernoff, an analyst at Pathfinder Capital Advisors who bought stock in Genco ahead of the recent surge. "TGN's capital structure permits an enormous amount of flexibility in taking on debt at a moderate level of risk." Right now, Chernoff says, Genco has no real need for the debt proceeds because it generates plenty of money to cover its business operations and any necessary capital improvements. But he says that Genco could easily raise $1 billion in the debt market and, if it uses the money to buy back stock, boost earnings per share by nearly 20% beginning next year. Alternatively, he says, Genco could return the cash to stockholders through a very large special dividend of about $12 per share. "The magnitude of this potential event is not fully appreciated by the market," he said.
Gassing UpCenterPoint critics, fighting to prove that the company suppressed Genco's value, argue that Genco should have utilized debt financing already. Still, Genco is now far better positioned to take on debt safely than it was a few years ago, when it was all the rage among competing merchants eager to profit when gas prices were low.
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Genco's continuous rise
Genco is, in essence, a natural gas play because it uses much cheaper fuels to produce electricity in a deregulated Texas market where power prices are determined by gas prices instead. And the company -- which relies on inexpensive coal, lignite and nuclear fuel -- is now in the process of auctioning off future capacity at a particularly opportune time. "While spot gas prices have been $6 before, the 12-, 18- and 24-month gas strips have never been as high as they are right now," Chernoff said of trades on the New York Mercantile Exchange. "This strip pricing makes it likely that TGN will be able to sell capacity well into 2006 at record prices." Earlier this month, Raymond James energy analyst J. Marshall Adkins pointed out that prices on the 24-month gas futures strip had surged nearly 20% so far this year. He noted that long-term expectations for natural gas prices are already "robust" -- but he also predicted that another, largely unexpected, spike could be coming. "We believe the gas market is in for a rude awakening over the next two months," he wrote. "If oil prices hold in the high $30s to low $40s/Bbl range, we believe that gas prices are likely to move into the $8/Mcf range in the coming months." Even without that spike, Genco stands to rake in the dough. Based on current gas strips -- and a debt offering to fund stock repurchases -- Chernoff estimates that Genco could generate profits of more than $5.50 per share in 2005 and $6 in 2006.
RisingChernoff includes a few additional factors, beyond current power auctions and future stock buybacks, in his calculations. For starters, Genco recently announced plans to increase its stake in a highly efficient nuclear station that, Chernoff believes,
But Genco investors could benefit even before that happens. As Fleishman has noted, CenterPoint seems happy with the bids it has received on its interest in Genco so far. And if CenterPoint opts for a secondary offering -- another real possibility -- Genco could bring even more. "The public would probably pay more to get these income streams than would a third-party buyer," Chernoff stated. "TGN could easily sell the company to the public at substantially more than $50 per share." Thus -- even after the big run-up -- Chernoff believes that Genco remains undervalued. "The short story," he concluded, "is that TGN has a lot going for it that is not in the price of the stock."