The Mistaken Connection Between Natural Gas and Utilities

As a shareholder in Mirant (see: Is There Significant Value Behind this Coal-Burning Utility?) I've come to follow the movements in their share price on a day to day basis.

Because of this, I'm very interested in determining what influences the movement of the stock price and whether the downward move that the company has experienced recently was caused by outside factors (i.e. changes in commodities prices, the weakening economy) or internal factors such as market distaste with the company or other problem areas that have yet to crop up in tangible news.

Blurbs that I've read, such as Bob Pisani's Stock Talk from March 31st, 2010, point to natural gas as being a big mover for utility companies like Mirant. Commenting on the movement in independent power producers, Pisani notes:

"Natural gas happened. Independent power producers usually work in regulated markets, where the price they can charge is often tied to natural gas prices. Nat gas went from $6 to $4…a disastrous impact on profits, since fixed costs did not change."

So I thought I'd take Pisani's hypothesis to the data and see what the data had to say. I performed a linear regression in STATA to try and see what connection daily returns in natural gas had on energy producers such as Mirant (MIR), AES Corporation (AES), Dynegy (DYN), RRI Energy (RRI) and NRG Energy (NRG).

The short answer: except for Mirant, natural gas has no statistically significant explanatory power for the companies' stock prices for the time period considered. Even the explanatory power of natural gas for Mirant becomes statistically insignificant when a proxy for market performance (i.e. the S&P 500) is added in.

What I Did

To begin, I used Yahoo! Finance to collect historical daily stock price data for all of the companies mentioned above and for the S&P 500 index. The West Texas Natural Gas Wellhead price was used for natural gas and this data was obtained from GFD (Global Financial Data). For further testing, I also used the WTI Crude price, GSCI Energy Index, Moody's Commodity Index and Dow Jones U.S. Electricity index, all obtained from GFD.

All data was converted to percent return, and to try and control for changing correlation and dependency in the data I only looked at the time elapsed since the beginning of 2009 through the 9th of April 2010. The cut off at Apirl 9th was done to correct for the fact that Mirant and RRI just entered in to a merger agreement.

For the first step, I simply performed a linear regression of the daily percent change in natural gas prices on the daily percent change in the company stock price. Below please find the adjusted R-squared values, coefficients on the natural gas variable and corresponding t statistics from my regressions.

To put the coefficient in to perspective, for Mirant, if there is a 1% positive change in natural gas prices we would expect the stock price to go up by 0.04%.

As we can see above, in AES, Dynegy and RRI adding in natural gas rendered a negative adjusted R-squared value, meaning that it'd be better to guess randomly than look to natural gas as an explanatory variable. It is very easy, from the results shown above, to see that natural gas clearly does not have an impact on utility stock prices for the time period considered.

From a Longer Time Horizon

When I used data spanning back to 2006, the answer started to change. Natural gas became statistically significant for all companies except for AES, and this was even when market performance (i.e. the S&P 500) was added in. The negative coefficient of natural gas in the Dynegy instance is somewhat strange, but the coefficient is so low one can essentially assume it is zero. In fact, in all of the companies the impact of natural gas on stock price was far dwarfed by the S&P 500 variable, in all cases by at least a degree of magnitude.


The conclusion from this study would be that while over the long term utility stock returns are more generally tied to natural gas movements this effect absolutely does not exist on a shorter time frame (i.e. 1-1.5 years going back). This could be because most utilities today hedge for inputs, so they probably are not sweating the day to day movement. These hedges typically go out a year in advance, which could explain why data periods over longer time periods, which can take in to account longer trends, show more significance.

The extremely low values on the coefficients for natural gas, in both the longer and shorter term analysis, suggest that Pisani is mistaken is his connection between natural gas prices and stock price moves of power producers.

Whoops.

Mirant Corp (MIR): Is There Significant Value Behind this Coal-Burning Utility?

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As I noted in my write-up for The Pantry (PTRY), my investing strategy focuses on finding value stocks trading at a Price to Book (P/B) of less than one. From these, I try to find seemingly boring and unsexy companies that I think will keep posting positive free cash flows to equity holders long enough for the market to re-evaluate the company, presumably at a P/B of greater than one.

One company that's held my interest for a while now is Mirant Corporation (MIR). Again some basic information:

Market Cap : 2.35B

Enterprise Value: 2.93 B

P/E : 1.99

Forward P/E : 10.23

PEG Ratio : 0.18

P/S : 0.79

P/B : 0.53

Yahoo! Finance description:

"Mirant Corporation produces and sells electricity in the United States. It generates electricity through coal-fired and oil and gas generating facilities. The company'’s operations primarily consist of procuring fuel, dispatching electricity, hedging the production and sale of electricity by its generating facilities, managing fuel oil, and providing logistical support for the operation of its facilities. The company was founded in 1982 and is headquartered in Atlanta, Georgia."

The Crux of It

The main sell for Mirant is that even after taking away intangibles, goodwill, and other non-current assets, the stock still maintains a P/B of less than one. Looking at their balance sheet from their most recent Q3 filings, using today's closing stock price and subtracting the value of intangibles, derivative contracts, deferred income taxes, prepaid rent and other, I get a P/B of 0.87.

From that P/B, Mirant is being priced practically like it's going in to bankruptcy. When all of these values are netted from shareholder's equity as reported on the balance sheet, one essentially arrives at a post-bankruptcy value to shareholders because I would consider these netted assets ones that would only remain valuable to the business were it to remain a going concern. Arguably if the derivative contracts were exchange traded they could probably be easily sold off, however since Mirant noted that they dealt quite significantly in OTC derivatives I subtracted this value to be more conservative.

If Mirant was going in to bankruptcy, I wouldn't want any part of it. I'm not a lawyer or a vulture and don't want to speculate whether there's going to be more than the current share price left over once senior stakeholders have been paid. The company's large cash reserves and a question regarding whether or not Mirant actually has excess cash from their recent Q3 earnings call have lead me to believe, however, that this company is not being priced because of bankruptcy risk. In light of this, it's necessary to look at other possibilities.

So Why the Discount?

Typically, if something sounds too good to be true, it probably is. That being said, with Mirant I think the reason for the dramatic under-pricing is a market perception that companies like Mirant, generating electricity from coal and gas, are carrying unstated environmental liabilities and could potentially get thrown under the bus as the United States' economy moves toward "green" energy.

If you look at Mirant's competitors, this story is supported. The AES Corporation (AES) and Calpine Corp. (CPN) are both trading at P/B values of over one (2.01 and 1.19, respectively), and in both companies' business descriptions they note being involved in one or more alternative energy generating activities, including geothermal and wind. RRI Energy, Inc. (RRI), however, is only trading at an unadjusted P/B of 0.47. The distinguishing difference of RRI? They're not involved in alternative energies, much like Mirant.

Is this discount warranted? Looking at Mirant, they've had to spend $1.67 B, of which they still have $341 MM to go, on capital expenditures due to the Maryland Healthy Air act. They estimate further capital expenditures to bring them up to other environmental standards to be $12 MM in 2009 and $20 M in 2010.

While environmental liabilities will affect companies that are more heavily involved in the dirtier forms of electricity production more than those that are producing partially from alternative means, both companies are still retaining environmental liabilities were states and/or countries to become more adamant about reducing pollution. AES for example, while utilizing wind energy, only generated $28 MM of their Q3 $3.8 B in revenue from it. So while they may be better poised with operational expertise in this industry as it takes off, they're still generating the bulk of their revenues the old fashioned way.

Stability of Cash Flows

Mirant posted operating cash flows of $727 MM for Q3, with total net CFs of $198 MM. This included capital expenditures of $508 MM, well above depreciation charges of $37MM.

One of my concerns with Mirant's CFs was the amount coming from proprietary trading. Being familiar with Enron, several red flags went up when I read about this element of their business in their most recent 10-Q. However, upon noting that realized trading revenues only accounted for $32 MM (7% of total) and even after subtracting unrealized trading losses of $24 MM that the figure would still be positive at $8 MM, I was much calmer.

Looking forward to upcoming charges, Mirant notes projected capital expenditures of $225 MM in 2009 and $441 MM in 2010. These comprise expenditures for the Maryland Healthy Air Act (60% of 2009 and 46% of 2010), other environmental (5% and 5%), maintenance (26% and 26%), construction (4% and 18%) and other (5% and 5%).

As I understand it, a large chunk of this construction expenditure is going to come from building Marsh Landing, a "760 [Megawatt] natural gas-fired peaking" plant near Antioch, CA. From their Q3 earnings call, Mirant notes: "We expect [Marsh Landing] to begin construction next year, and we expect to have construction completed and go into commercial operation in May 2013". For some perspective, Mirant currently produces 10,112 MW of power, so Marsh Landing would expand production by 7.5%.

In terms of upcoming debt, Mirant has $535 in unsecured LT debt coming due in May 2011 and $374 MM in secured LT debt coming due between 2009 and 2013. Based on their positive net cash flows and large cash reserves ($2.0 B), I don't see Mirant having any issues either retiring the debt or rolling it over, especially as credit markets continue to unfreeze.

In terms of looking at operating revenues for 2010 and beyond, Mirant seems to have a very effective hedging program in place to smooth out volatile commodity movements. Mirant is 86% hedged for 2010 for power prices and 78% for fuel. Looking forward, they're 52% hedged for power and 61% hedged for fuel in 2011, with this hedging level continuing to taper off until effectively reaching zero in 2014. In light of this, I don't see a dramatic threat to Mirant's positive net CFs in the near future.

Outlook for U.S. Energy

While the prospect of the power generating assets of Mirant becoming impaired as environmental standards increase or alternative technologies become cheaper increases the risk of this company, I'm of the persuasion that the United States' need for energy will maintain the necessity for more traditional forms of power generation.

In a slide presentation from Mirant that accompanied their Q3 earnings call, the company included a graph looking at current and predicted reserve margins. For those of you unfamiliar, reserve margin is "the capacity of a producer to generate more energy than the system normally requires".

The earnings call noted:

“I point as I have before to the orange line toward the bottom of the page, which is PJM East, which is our most important market. This trend remains and takes into account all that's going on demand side management and other efforts, and it is for anyone who is responsible for making sure that there is an adequate electric supply to meet the needs of the American public, a worrisome situation. This is not how a system should operate. This is not a good trend. It is a good trend for incumbents. It is a good trend in our own narrow self-interest for Mirant, but this is not good for the system.”

While this is of course using their proprietary research, I think that when it is combined with other research it suggests that the United States and the world will increasingly need more and more energy, of which for the foreseeable future traditional energy generating techniques will remain a large part.

While I don't profess to be an expert on energy generation or utilities, I do feel that Mirant is priced at such a level as to be a very good investment possibility. Especially facing what I perceive to be an improving macro-economic climate, I strongly feel that Mirant possesses strong potential to be positively revalued by the market.

Disclosure: Long MIR

Too see the spreadsheet I used for my analysis, please see below

Mirant