Independent Power Producers Remain Attractive

Faizan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Utility stocks have remained popular due to their attractive dividend yields in a low yield environment. Lately, the Fed’s QE tapering signal and rising treasury yields have resulted in a pullback for utilities, to keep their yield competitive to treasury yields. However, QE tapering is conditional to an improvement in the economy, that’s why volatility is likely to prevail in the utility sector as investors fear the Fed’s measures.

Utilities outperformed the broad market in 2011. Utilities SPDR (NYSEMKT: XLU), an ETF, returned 14.8% in contrast to a flat return for the broad market in 2011. However, since May this year, Utilities SPDR has underperformed the market by 9%, the primary reason has been fear of Fed’s QE tapering.

Independent power producers (IPPs) are attractive

IPPs offer lower dividend yields and are not subjected to high degree of regulations when compared to regulated and diversified electric utilities. Due to lower dividend yield on average offered by IPP’s, I believe Utilities SPDR will underperform the IPP’s in a current rising treasury yield environment. Currently, it offers a dividend yield of 3.7% and the 10-year Treasury yield is 2.48%.

Also, after the recent PJM auction pricing announcement, uncertainty has been addressed that is expected to be positive for the IPPs. Moreover, IPPs generate healthy free cash flow that can be used to boost EPS through share repurchase program. Therefore, I remain bullish on IPPs.

Two IPPs with potential of superior returns

Together with its subsidiaries, NRG Energy (NYSE: NRG) operates as an integrated wholesale power generator and retailer. Following the PJM auction results announcement, NRG's stock was price down 5%, as the company’s margins might be affected in the future due to lower than anticipated long-term capacity pricing. However, NRG offers investors a good investment opportunity and potential for price appreciation.

I am bullish on NRG because of a possible increase in margins from import of capacity into the PJM market, realization of expected synergies from GenOn acquisition, and conversion of coal plants into gas fired units. Also, NRG’s significant exposure to the Texas market, rising natural gas prices, and possible monetization of contracted assets bode well for the company.

NRG has strong cash flow, evident from its current operating cash flow yield of 13%, and is expected to generate healthy cash flow in the future, which could be used to repurchase common shares and boost EPS. Given its strong cash flow position, the company can repay its debt, which will further strengthen its balance sheet and eventually lead to multiple expansion.

Changes in regulations currently faced by NRG in Texas and weak natural gas prices are important sources of risk for NRG and can adversely impact financial performance in the future.

The other IPP on which I am bullish is Calpine (NYSE: CPN). With 92 power plants and approximately 27,000 MW of generation capacity, Calpine operates in twenty states in the U.S. and Canada. Calpine has a potential to offer attractive total return to the investors as the company has a strong balance sheet with excess and growing free cash flow. Also, Calpine’s large exposure to the Texas power market, which is considered to be a market with strong fundamentals, is a positive and an important performance driver for the company.

Moreover, the company is immune to changes in natural gas prices, hence not exposed to changing natural gas prices. Calpine, as mentioned earlier, has strong free cash flow which can be used by it to repurchase portion of its common shares and repay debt that will further increase financial strength and can result in possible price appreciation.

Conclusion

I am bullish on the aforementioned two IPPs, NRG and Calpine. The companies have strong cash flow positions and are expected to maintain the trend in the upcoming years, which can be used to buy back shares and repay debt that will most likely result in potential price appreciation for both of the stocks. Also, in the ongoing environment of rising 10-year treasury yield, IPPs stand a chance to outperform the dividend paying regulated and diversified utilities. 

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Faizan Chudhry has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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