IPPs revisit synergies, cost cuts as sector M&A looms

The allure of synergies and cost cuts is heightening an atmosphere within the competitive power sector where a round of large company transactions feels increasingly imminent.

Recent attention paid to the sector rests squarely on unconfirmed reports around a private takeout of Calpine Corp., a takeover bid made by Vistra Energy Corp. to Dynegy Inc. and an ongoing strategic review at NRG Energy Inc., which collectively could see the sector consolidate or lean toward sales through year end.

Drivers of potential deals remain consistent with historical motivations that have helped inspire large M&A deals in the past: synergies, cost cuts and bets by private investors that competitive power assets are undervalued relative to some future commodities price recovery.

And as investors await more clarity, analysts have further fleshed out the foundations for what could move the needle on transactions.

Refreshing its asset valuations, Barclays Research analysts on June 1 noted that strategic processes tied to large transactions could "unlock value" that pegs Calpine's long-term asset value at $15 per share, and NRG, absent its holdings in GenOn Energy Inc., at $19 per share, representing a roughly 10% premium to where share prices ended June 1. For Dynegy, however, Barclays assigned a $13 share price target based on its long-term asset values, a roughly 50% premium against share prices on June 1.

Cost cuts

NRG's proposed restructuring of GenOn would shave off the majority of its holdings in PJM Interconnection, meaning the generator could potentially look to transact with Dynegy, analysts noted, pointing to complementary portfolios that could limit market power issues.

"We believe NRG may consider evaluating transactions in parallel with its conclusion of its [business review committee] in the next few months," Citi Research analyst Praful Mehta said May 24. "While a deal with Vistra clearly doesn't work given market power, in our view, a Dynegy and NRG transaction may work especially if NRG has clear line of sight to lower leverage post the BRC update."

Morgan Stanley Research analysts on May 31 also suggested a potential deal between NRG and Dynegy could make sense, given NRG's contemplated exit from GenOn, centering its primary business around generation and retail in Texas, with less exposure in PJM.

Citi sees cost cutting initiatives at NRG potentially totaling as much as $500 million in reductions, and suggested investors may be only factoring as much as $300 million of reductions into share price valuations. NRG's total operating costs and expenses totaled about $2.71 billion for the three months ending March 31, according to its most recent earnings filing.

Barclays wrote that based on its analysis, every $100 million in cost cuts at NRG would render $1.50 to NRG's share price. UBS Securities LLC analysts in a May 31 note suggested that baseline cost cuts at NRG would be nearly $240 million, expecting NRG management to provide a further update on strategy and cost structure ahead of the Aug. 14 deadline for the business review committee.

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Synergies as prologue

Despite speculation around an NRG-Dynegy tie-up, the potential synergies between Dynegy and Vistra would be more consistent with historical precedent in larger transactions, and potentially too hard to ignore, as CEOs of both companies acknowledged in recent interviews with S&P Global Market Intelligence.

Pointing to historical synergies from "merger of equal" scenarios, Morgan Stanley noted that a Vistra-Dynegy deal could be rationalized by as much as 30% in O&M synergies to the target company, or 15% across a consolidated entity. That latter figure could mean a combined Vistra and Dynegy might save between $250 million and $300 million, equating to roughly $2 billion in shareholder value at current trading multiples.

"While the stock has seen strong performance since the article's posting, we believe the market still underappreciates the synergy potential from such a transaction," Morgan Stanley analyst Stephen Byrd said, referring to The Wall Street Journal article that set off discussions of a potential merger. "If a transaction was announced, we would expect it to be structured as a stock-for-stock basis due to change of control considerations on Dynegy's debt."

Digging into the economics of a potential Vistra-Dynegy merger, Guggenheim Securities LLC analysts on May 31 highlighted synergies between $500 million to $1 billion necessary to justify a deal, while maintaining Vistra's pledge to keep its leverage at 4.0x net debt-to-EBITDA.

Guggenheim further estimates a takeout price between $10 and $14 a share for Dynegy could make sense, equating to a roughly 7.1x to 7.4x multiple relative to Dynegy's enterprise value against its estimated earnings in 2019.

"We are getting incrementally more comfortable with the feasibility of synergies we estimate would be needed to justify a transaction, as cost-saving opportunities that potentially could yield from somewhat aggressive [general and administrative] reduction (60%) alone could be enough, not to mention potential fuel cost savings that could stem from joint dispatch or finance synergies from potential interest expenses savings," Guggenheim analyst Shahriar Pourreza observed, pointing to a combined $850 million in pro forma general and administrative costs.