Kirk Andrews - CFO of NRG Energy (NRG) Part II

Participants

Kirk Andrews, CFO at NRG Energy (NRG)

Nate Abercrombie, The Stock Podcast

Interview Transcript

Nate:         You mentioned the social motivations, as well as the economic motivations for doing what NRG did. Obviously you had a different CEO at the time, but at a certain point, the market was overreacting to some of the volatility in commodity prices, and the market wasn’t rewarding NRG for the shareholder return story, it wasn’t rewarding NRG for a lot of the different efforts that you were making to sort of simplify business. And then there was a change in management, and then there was a new emphasis, which was reduce cost, improve margins, reduce debt. Could you talk about kind of that catalyst, and then if you would like to talk about the activist investor.

Kirk:           Sure, what you’re referring to is first of all, with that pretty significant success we had from an [owner magnitude 00:36:15] standpoint, largely around those large renewable projects that I referred to before. Those types of projects, because of their different return profile, they aren’t exposed to the fluctuations and commodity prices, they have a different valuation multiple associated with them for good reason. They were good value and they still are. But the multiple that they command, that is perfectly justified from a value standpoint, is higher than the way the typical investor in a commodity exposed company like a traditional independent power producer like NRG still was, and is at it’s core commands.

Kirk:           And what happens when that takes place is, markets tend to apply more or less a one size fits all value to the whole company. So if I’ve got a certain part of the business that should be valued at a 10, or 11, or a 12 multiple, but the average investor, understandably, thinks about me as being an industry that’s a seven to eight times multiple. Then if my whole company is given a seven to eight times multiple, I’m not realizing the value for that big piece of the company. And that big piece of the company was the renewables business.

Kirk:           We took an interim step to try to remediate that by taking that part of the business public to a company called NRG Yield. That helped, but didn’t solve the issue because we also hadn’t had the one you referred to before, which is lower commodity prices on the rest of the business, placing greater pressure on the company. So after the CEO change in 2015, the new CEO and I saw a light about picking some of the low hanging fruit and addressed some of those issues, got out in 2016, beginning to reduce our costs, beginning to simplify our balance sheet.

Kirk:           I say simplify because even through that period of time, I think we managed the balance sheet very well. But we did take advantage and do what I call “leave no doubt,” to do some additional de-levering to improve our balance sheet ratios so our investors had greater confidence. We did that over the course of the first year after the change in the CEO. And I would say we were kind of in the middle innings of that game, focusing on streamlining the cost, doing away with some of the cost structure that was designed to go after a lot of different initiatives and different businesses that were addressing where the power markets were going, and focusing more on the core business.

Kirk:           And then in the throws of that, as you referred to, as is often the case for a company that’s going through an evolutional change, and has pressure on its stock price, and some things that aren’t resonating in the stock price, like the renewables business I spoke about before. It was around that time that we found ourselves, like a lot of companies in that situation, with an activist investor in our stock. And fortunately for us, I would say that, that activist investor was both well timed and had the right perspectives to bring about a relatively swift and relatively amicable resolution, and that was, we agreed to continue down the path that we were going down. And that was simplifying the company, streamlining the cost, but it allowed us to step on the accelerator in that process.

Kirk:           So what you’re referring to is, in early 2017, off the backup after the first year we’d gotten through after the regime change, we announced as a part of our settlement, if you recall that with the activist; that the next phase of our approach to that simplification was significantly selling off those businesses whose value was not resonating in the whole company along the lines of what I described before. Continuing down the path towards reducing costs, and also improving even further, the margins of our retail business, which had its beginnings in that Reliant acquisition that I spoke about earlier.

Nate:         Yeah, and all this resulted in something that you called “The Transformation Plan” back in mid 2017. So you mentioned high level, selling off assets whose value isn’t being recognized in the NRG share price, and reducing costs, and improving margins with the retail business. Could you talk about the asset sale number, what you plan on doing in order to achieve cost reductions? And I’ll just leave it there for right now.

Kirk:           Sure. So, and this has evolved since that breakdown, but I will go back through the entire history. The cornerstone of that three prong transformation plan, that you correctly referred, to was the asset sale piece. The other two component pieces being cost savings and improving the margins of the retail business. We are in the middle to kind of late innings of an asset divestiture program that, in total, amounts to about a little more than three billion dollars worth of asset sales. About half of that number is the sale of our renewables platform, which is what created those big renewable projects I referred to before. And in our remain stake in the renewable plants that we own today, that we’d previously taken public like I referred to that before.

Kirk:           Because that IPO of that company helped highlight the differentiated value of that business I often refer to. It was necessary, but not sufficient to solve the problem. So we concluded that the best way to solve that problem was to sell it completely and turn it into cash. If the market price is not giving you the fair price, then if the third party asset sale market does, you can take that capital and deploy it elsewhere to benefit the shareholders.

Nate:         Yeah.

Kirk:           That, I would say, is the cornerstone of that asset sale program. And about half of that three billion plus is that business, and then it’s rounded out by some other businesses that conform to the same definition, but it’s anchored by that part of the business. That basically puts us on a path to almost three billion dollars plus. That’s a lot of capital for a company. To put that in perspective, that’s 10 dollars a share for a company basically is recently, at the end of 2015, at a share price of less than 10 dollars a share, just to put it in perspective.

Kirk:           We’re turning a part, but certainly by no means all of our business, into cash. It’s about 10 dollars a share. That gives you a lot of degrees of freedom to either return that cash back to the shareholders, because it’s obviously their money, or to find ways to acquire that cash to create more value than just 10 dollars a share. So that’s really the cornerstone of that program.

Nate:         So your target was somewhere between two and a half and four billion dollars in asset sale proceeds. And you hit the mid point, and now with an equity value of call it roughly 10 billion dollars, 30 percent of that is coming back in cash, which is pretty phenomenal. Could you talk about the balance sheet as well? So, in a previous episode, having Mike Garland on the program to talk about investor concerns around leverage levels and the total amount of debt. By divesting the renewables business, you’re shedding a lot of debt off of the balance sheet, correct?

Kirk:           That’s correct, and since you mentioned Mike Garland, Mike’s company has an element of this, more or less exclusive to the challenge that we face that was a part of our challenge from a balance sheet standpoint. I mentioned before that the renewables business that we had, most all of our renewables assets were all under long-term contract. They were all selling their output over, in many cases, as much as 20 years plus over the long run.

Kirk:           That’s a pretty levelized stream of cash flow that just allows itself to be financed at the individual project level at a pretty high order of magnitude, and at a pretty low cost, because low risk means low cost to the debt. So think of that just as a bunch of, almost like mortgages, each one of which is right next to that power plant, the renewable power plant, and it’s generating all those cash flows. That’s a great benefit. It allows you to generate a lot of equity return. The downside of that is, that level of debt, relative to the EBITDA, is a high level of debt, and understandably so because that cash flow is not fluctuating around, so it naturally lends itself to higher levels of leverage.

Kirk:           So, we really face two challenges, one of which we probably had some degree in common with Mike Garland, but I won’t certainly speak for him in that regard. And that was, on the face of our balance sheet, which included all of those highly levered, albeit, highly contracted, low volatility in cash flow, power plants; as well as the traditional debt we had on the balance sheet to finance the traditional part of the company. When you looked at that relative to the cash flow of the overall company, it looked disproportionately high.

Kirk:           Now obviously you’d understand that, that was true if you unpacked that a little further, but the average investor only had so much time. And as we often said, “On the face of the Bloomberg screen, we looked like we had way too much debt.” It didn’t matter whether you got down below that and you could explain why that was there. Sometimes you have to recognize that perception is reality. So, part of that divestiture, aside from generating the three billion plus in cash, the other benefit of it is, it solves a good part of that face of the Bloomberg problem, right?

Nate:         Yeah.

Kirk:           If you’re selling off all the assets that have a higher degree of leverage that is impairing the optics, for lack of a better term, of the company, that takes you a long way towards the average investor understanding the capital structure better. And that took us a big step in the right direction. And in addition, off of the back of two things: one as I said, leave no doubt as to the integrity of the balance sheet. We elected to take an incremental step to …

PART 2 OF 3 ENDS [00:46:04]

Kirk:           The integrity of the balance sheet, we elected to take an incremental step to even further de-lever by taking Sullivan, for example, that three billion dollars worth of cash and reducing our debt. One, that reduces our overall debt, makes us look less financially and makes us be less financially risky. But of equal importance, we at NRG, we have a lot of net operating losses, or tax shield that we can use. Which means we’re not making the most of the interest deduction that we generate from all that debt. So our debt is less valuable to us as a company that doesn’t currently pay taxes. So that was another motivation behind reducing our target leverage ratio which is now only three times as a ratio of our net debt, which is our total debt minus our cash divided by our EBITDA, which is basically just a proxy for our cashflow.

Kirk:           So, our debt, net of our cash in representing no more than three times our annual cash flow, that’s simplified ratio.

Nate:         Yeah and so at the peak, debt was what? 23 billion? And the debt will be close to eight billion by the end of the year?

Kirk:           It’s actually lower than that, it should be under six by the end of this year.

Nate:         So, if I were to just summarize at a very high level, and probably butcher it, but early 2000s, there was a lot of supply in the market, commodity prices were low, there were bankruptcies, there was probably concern around the viability of the business model. NRG comes out of bankruptcy, there are, as we said, social and economic motivations that led to call it a renewable build-out. You acquired more generation. You acquired some retail assets. Then, capacity markets also come along, stabilize the business a little bit, but then there’s all this concern around renewables, the returns for renewable growth, investments that NRG was making. Everyone’s concerned about- so again, going back to capacity markets, commodity prices, the economics for renewables- you had these targets to reduce cost and to improve the balance sheet. Could you talk a little bit about the one missing piece, which is stable business model, so in terms of cash flows, revenues. How is the business different today versus, just call it, early 2000s, mid 2000s?

Kirk:           I would say, aside from the simplicity and the enhanced integrity of the balance sheet, which we just talked about. Focusing on the business model itself, I think that the biggest different is A, I think from a power generation part of the business, we are in the right markets that we would like to be in going forward. And that’s primarily, obviously, Texas for the Ercot market. Reason for that is, the Ercot market is probably one of the tightest markets if not the tightest market in the country in terms of supply and demand. That means robust prices and also is the one market for power in the United States whose demand is still growing. So those are both good fundamental dynamics and we’re fortunate enough to have a pretty significant presence there, which we’re pleased with. Partially for those fundamental reasons, and partially because most of our three million retail customers, and I’ll go the back of the story I told much earlier is, they’re also in Texas. So we have the generation that supplies our retail business. That’s important.

Kirk:           And the rest of our power clients in the North East and we have, what I call, an insurgent presence in the North East from a retail perspective, but we have aspirations to grow. Number one, that’s a much easier to tell, much more simplified, much more focused investment story. And one of the things you always have to be mindful of as a public company is your elevator speech. It can’t take a hundred story building to tell it and I think we’ve gotten this down to a manageable number of floors on the elevator to tell our story.

Kirk:           The benefit of that, also, in addition to simplicity is, the right level of retail. Because, even though retail power prices are certainly tied to the underlying cost of the commodity you’re selling, which is subject to fluctuations. Retail margins themselves, the difference between revenues and costs have proved to be relatively stable and there’s a myriad of reasons why that’s the case. That means the retail part of our business, in addition to being a natural sales channel, for our gross product, whih is, we make electricity, provides a really stable base. It’s a big component of our earnings, more than 60 percent.

Kirk:           Then it’s relatively stable, but still you get that stability at the core but on top of that, provided you’re in the right markets with the right assets. For example, our biggest power plant presence in Ercot, and Ercot is a market that is poised for higher prices because you’ve got a growth and demand, you’ve got a relatively fixed amount of supply, the current power prices, even though they’re higher than they were a year ago and much more so, still haven’t gotten to the level that over the long run, they incent more supply coming in the markets. So in the near term, you’ve got the makings for robust prices and upsides. So, stability of cash flows from retail, supplemented by upside for the fundamentals in the markets are it. We think that’s good recipe, which when buoyed with, as you pointed out, three billion dollars worth of excess capital, that gives you a lot of flexibility and you got that off the back of a now eaten, further improved, and simplified balance sheet. I think that’s the right recipe for us as a public company to better appeal to our investors and deliver value. And I think it’s really as simple as that.

Nate:         Yeah. No, that’s a good way to frame it up. So with the amount of cash that you’ve been able to realize, or you will be able to realize from all of the asset sales, and because your company, just call it run rate of anywhere between 1 to 1.3 billion dollars of free cash flow over the next several years? You’re going to generate an enormous amount of cash and I’m curious what you plan on doing with that cash.

Kirk:           Yup. So, what I’m telling you has been, and it’s a relatively simple version, the numbers that you just described are, obviously, accurate. So, the asset sales and the cost improvements we’re doing is really a program, it’s kind of a three year program. 2018, 2019, 2020. So by 2020 we’ll be through that phase of it. So, a little simple math will tel you, you’re right about billion dollars plus, 1.3 is roughly the average. 1.3 billion is, through cash flow, supplemented by another 3 billion dollars of asset sales, even setting aside some of our fixed commitments, that’s the sort of path could generate about 5 billion dollars of excess cash for 2020. And if you extrapolate that out a couple of years forward, it’s not had to get to a number that approaches 8 billion.

Kirk:           Well, you know, that number, eight billion dollars of excess cash, is about 80 percent of NRG’s market cap. In that there’s few companies I can think of that you look at and say, “Do I get an 80 percent pay back over the next five years of my entire investment?” Which means everything’s modular. You buy lunch here at stock, 80 percent of that cash I’ve just invested in stock comes back over the course of the next five years, that’s a pretty compelling story. Now one way to make that manifest itself is just return all that cash to the shareholders, but you can return some of that cash to the shareholders and you apply the portion that you don’t to buying assets for a dollar that are really worth $1.10, then you can create even more value than 80 percent of your market cap. Either way you slice it, at a bare minimum, 80 percent is a pretty compelling number.

Kirk:           This is where I would say, for me as the CFO, the most compelling aspect of A, the regime change that went through and B, the discipline that we’ve catalyzed from our transformation plan, is our approach to what we call cap allocation. Which is the term of art we use to- how do we decide what we do with that five billion through 2020? And to me it’s as simple as this, it’s really a two part equation that really has three parts. The first one is, I want to make sure I’ve got the right balance sheet or I can tell you we’ve already gotten that there. That five billion through 2020 is after we’ve satisfied that. So now the question is, what are you going to do with that money? And the discipline is as simple as this, you need to find ways, if you’re gonna reinvest that money, to reinvest it at a greater return than your investor expects.

Kirk:           Now, you can do the math on the back of the envelope and figure out what your cost of capital is, and as I often put it, many times that’s necessary and sufficient to make sure that you’ve found the right investments. But it isn’t always sufficient. What makes it sufficient is, you also have to look at your own stock price. Said differently, if I’m going to say, “Hey, in order to create value for a shareholder off the back of what the calculator would tell me I’d need to invest at, I’ve gotta generate a 13 percent return pre-tax; un-levered.” But if I look, I know my stock price, the total value of the company including the debt, and I know how much cash flow the company trims off. That’s a simple equation to say, what does that imply the company itself, anchored by the stock prices return? And if that return is greater than that, call it 13 percent, then not only is that where I should really be thinking about putting the money, is that a more compelling investment than that hurdle rate?

Kirk:           If I’m going to look at an investment, it not only has to beat that hurdle rate, it has to beat what I call the new hurdle rate, or the more important hurdle rate, which is whatever the return is implied by my stock, that’s higher, say hello to your no hurdle rate. That’s the approach that we’re going to take. I other words, if we can’t find, let’s use that five billion, five billion dollars worth of investments that not only exceed our cost and capital, our hurdle rate, but the opportunity cost that’s represented by our stock, then we’re going to default to buying back the stock.

Kirk:           And that’s basically, where we are at this five minutes, because in the minds of investors, I think the right way to translate this for our internal discipline is, if the return on your stock price is as compelling as ours even is today, and you were choosing to invest that capital in a new investment, that might be the right decision, I’m not saying it’s wrong, but you need to think about that decision on reinvestment, under those set of circumstances. Would I still make that investment if I had to raise stock to make it at the current stock price? Because if the answer to that question is no, you should not make the investment. Even if it meets your own internal purpose.

Nate:         Yeah.

Kirk:           Because there you’re thinking like an owner, you’re thinking like an investor. Because in substance, you have the opportunity to buy back that stock by choosing to take that capital and invest it elsewhere, it’s in substance, that’s the same thing as issuing stock. And that is the big difference, I think, in the discipline and the luxury that I have as the CFO because my CEO and I see alike on that discipline that I feel passionate about and so does our board. And I think the beneficiaries of that consistent discipline are our shareholders.

Nate:         Yeah, so if you could indeed repurchase close to 80 percent of your shares over the next several years, clearly, the stock is under priced. Would you consider shopping the company to pull some of that value forward?

Kirk:           Well, that is always, as you know from your experience, sometimes a dangerous question to ask and a more dangerous question to answer.

Nate:         Yeah.

Kirk:           The yearbook answer from anybody, I’m going to give it to you, is we don’t speculate about M&A. We have not made a determination that now is the time to seek to sell the company, but we are always focused on doing the right and optimal thing by our shareholders. So, said differently, circumstances and facts matter, right? But if that circumstance is the best means to create value for shareholders, that’s not something we should ever look the other way at. But I would tell you right now in the current context, having said that, our focus is on driving our stock price higher so that it does represent the true fundamental value of the company. And to me, the best way of doing that is the path that we’re on right now. When the market is not rewarding you for that fundamental value, you can create that reality by doing one thing which has two benefits.

Kirk:           One, every time you buy a share of stock for less than what it’s worth, the shareholders that don’t sell back to you reap the benefit in that value being spread over a lower number of shares. That’s value enhancement for those remaining shareholders and that should drive the stock price higher. But there’s no substitute, right? There’s one thing if I’m like every other CFO in the world saying, “My stock is cheap, my stock is cheap, my stock is cheap,” right? Well that’s just talk, at the end of the day. If I’m then taking the action to say, “Not only do I believe my stock is cheap, I’m gonna put my money where my mouth is.” To me, that should instill confidence in the market above and beyond just that arithmetic benefit I talked about for demonstrating that by taking advantage of that opportunity that you’re articulating. Those are the two things that we’re focused on right now. We want to have the luxury, said differently, that when it comes to that capital allocation decision, that that hurdle rate increasingly becomes not only necessary but sufficient, and the only way that’s gonna take place is if we get that stock price closer to fundamental value. So that’s the mandate we’re focused on in the near term. Never foreclosing any and all alternatives to bring that value forward.

Nate:         Yeah. I appreciate that, especially from a current shareholder’s perspective. If you were a potential NRG investor, what do you think you would need to do, because you know so much about the business, what do you think is most important for you to do to get more comfortable with the NRG investment thesis?

Kirk:           Well, I think the most important thing is really self-imposed back on us and that is that, let’s go back to that three billion dollars of asset tills. We’ve already signed the contracts for the vast majority, almost all of those have already been inked, we’re just waiting for them to close. We need to close those asset tills because one of the ways to close that value gap, and I think one of the ways I would speculate is the reason why we haven’t gotten all the way there yet, is simple. It’s execution risk, right? And as an investor, I get it. I’m not willing to value 100 cents on the dollar of that three billion and so you’ve got it in your bank account. And the best way to erode that execution discount, if you will, is to turn those contracts into cash and that’s what we’re focused on right now. That not only benefits from the standpoint of- when I put the cash in the balance sheet, it’s easier to value, but going back to what I said before, at least one of those asset tills meaningfully simplifies the face of the balance sheet, which I think is another issue.

Kirk:           So, I think that’s really incumbent upon us. And the other thing that I would say is, that gives us the ability to tell that more simplified story and as long as I believe, we continue to comport our actions from a capital allocations strategy standpoint, with our words that we’ve consistently articulated and most comprehensively articulated at an investor day presentation that we gave at the end of March. Then I think that that’s the best means by which to instill confidence in our shareholders, because what I would say is, that’s our credibility and credibility’s a currency just like anything else. And just like any other currency, it’s challenging enough to come by, but it’s twice as challenging to get back once you’ve lost it.

Nate:         No, I can appreciate that. So, very last question. A funny story, and this is something I try to ask all management teams, a funny story or question from a sell side conference or an investor meeting that you think is worth mentioning.

Kirk:           Well, I have no doubt that I’m probably forgetting, in the course of my almost seven years here, I’ve seen a lot come and go. But what comes to mind since I just mentioned investor day, it’s both a lesson and a funny story.

Kirk:           But, we have these investor days, is where we sort of roll out the whole company and present the strategy, and all the different businesses, in a full day, at a far more detailed level than we do on a quarterly by quarterly basis. I mentioned we just did that at the end of March, the last time we’d done that is I think January of 2015. And it’s not only the source of my anecdote, but it reinforces what I said before about the elevator speech, right? You need a reasonably simple and far less than a hundred story building to tell it.

Kirk:           Back in January 2015, we still had the platform, the complexity, the balance sheet, a lot more be all things to all people in terms of our different business initiatives. That takes a lot of story telling to get there and as is always the case, at investor day tends to be case at the financial part of the presentation comes last. That’s me. And we had this investor day down in Houston and the investor day, I think, was scheduled to end at like, 1:00 or 2:00. Well, it’s different if you have it in New York, it’s not the same problem, it’s not really a problem, but it’s a lot more challenging in Houston, because what do you know, right? 95 percent of the investors that came down to see you speak don’t live in Houston and when you tell them something’s ending at 1:00 or 2:00, they’re on the flight that they’re able to get to.

Kirk:           And as I watched the time go by, we had well eked into the time that I was supposed to begin and so, not only was I past with telling the financial story behind this hundred story building, I had to tell it in about half the time. So I date myself by saying this, I feel like I was either a speed reader like that guy you see on the TV commercials, or in the literary context, I was, like, going to an Evelyn Wood class, that was the old speed reading course.

Nate:         Yeah.

Kirk:           And I felt, like, my mouth getting dry and trying to get through that as quickly as I can. I made it through and with good humor and I’ve gotten a lot of jokes about that after but I think people realize that wasn’t by my choice. But I’m pleased not to have the experience to relive that again. I’m also happy to report I probably started a little early than scheduled on the last investor day and I think that’s as it should be. It’s a by-product and a benefit of the fact that our elevator speech was a whole lot easier to tell this go around.

Nate:         Yeah. That’s a good sign. No, I remember that analyst day. That was at the Zaza hotel, right?

Kirk:           Yeah. Down in Houston, exactly.

Nate:         Yeah. I just remember seeing a lot of folks having their suitcases and everything ready and packing up and walking out while you were talking. And I was like, “What! This is one of the most important parts. Why in the hell are people leaving?”

Kirk:           Yeah.

Nate:         I didn’t realize, yeah, the dynamic about flights, and having to get out.

Kirk:           Well, fortunate enough, I had the luxury of not taking it personally. One, because I wouldn’t anyway. But our share boulevard investors, maybe you knew, probably know now, knew at the time, came up to me at one of the breaks and said to me, “Hey man, this thing looks like it’s running over schedule. I’ve got a hard stop, I’ve gotta leave this and so I hope I get to see your presentation.” So, that was the other reason why I scrambled to try to get all my words in, but I realized that as people started to walk out as we were getting towards the end. That’s just a consequence. I get it, you gotta make that flight.

Nate:         Yeah. Yeah, definitely. Well, hey Kirk, I know I’ve taken more time than you probably wanted to give, but sincerest thanks from me personally and IWTB. It’s been a pleasure talking to you.

Kirk:           Thank you, Dave, happy to do it.

Nate:         Sincere thanks and good luck out there.

Kirk:           No problem. Well, good luck with it.

PART 3 OF 3 ENDS [01:06:22]

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