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The following segment was excerpted from this fund letter.
Vistra Corp (NYSE:VST)
We had a hard time deciding which company we should discuss in this letter. By just about every metric, all our holdings are cheap from both a relative and absolute perspective – especially compared to the performance of commodity prices and the recent pullback in the overall complex of energy stocks. For the first six months of 2022, oil was up 41%, natural gas up 45%, natural gas liquids up 34%, and the futures curve for electricity (in the two biggest deregulated power markets) is up ~30%, but our holdings were only up a measly ~1% by mid-year! The point is all our positions are investment stories worth telling.
However, Vistra Corp stands out among the names we own. First, the market environment has improved materially over a multi-year basis, which will enhance VST’s ability to mint cash and at the same time underscores the longevity of VST’s asset base. Second, VST’s market value has remained flat, despite shrinking the share count by nearly 15% since adopting a transformational capital allocation strategy. The combination of those two factors results in ~50% more value in a VST share today than just six months ago.
The bottom line is that the discount to intrinsic value of VST’s equity has become more attractive than ever. To better understand the two broader points, as well as our heightened conviction, it’s worth providing a brief history of the IPPs and summarizing the original VST investment thesis.
History has a way of tainting sentiment
VST is one of three publicly traded electricity companies known as integrated power providers (IPPs), a not so helpful name for an extremely small subgroup of utilities. The IPPs primarily operate two symbiotic business segments: producing wholesale electricity (Generation) and selling that electricity to retail customers (Retail). The IPPs do not own transmission and distribution lines like the larger universe of regulated, investor-owned power companies (Utilities) do. And as such, the IPPs do not earn a regulated rate of return.
It’s a gross oversimplification, but investment returns for IPPs were historically almost wholly driven by commodity prices. That’s because IPPs were almost exclusively generation companies without significant retail operations.
At the time, investing in an IPP was considered a relatively safe bet – akin to owning a regulated utility with a lot more commodity upside. You would have been hard pressed to find anyone who thought natural gas prices (the marginal fuel source for power) would go down. Simultaneously, there was a significant buildout of natural gas-fired generation capacity.
Ultimately, however, the IPPs were not a safe bet and investors got burned – management teams were directionally incorrect on the price of natural gas (due to the fracking revolution) and leverage used to build new generation became untenable. The result was a slew of IPP bankruptcies during the 2000s.
The period between 2010-2020 was monumental for the US electricity market. Natural gas prices averaged $3.30/mcf compared to $5.80/mcf in the prior decade. Equally important, the US experienced massive growth in zero marginal cost renewables. Those two factors put enormous pressure on profit margins for conventional, dispatchable power plants.
More often than not, coal and nuclear plants were cash flow negative. As a result, the deregulated market participants rationalized operations and assets through consolidation and plant closures. For the IPPs that have since survived, focus increasingly shifted from wholesale power to retail sales (cash flow stability), reducing leverage, and, to a lesser extent, growing their own renewable energy portfolios.
Why sentiment remains stubbornly low
Despite all the progress the IPPs have made over the past decade, investor sentiment for the space never recovered. To attract investor dollars, IPP management teams have pursued various capital allocation strategies, highlighted ESG efforts, committed to carbon free capacity growth, and pledged to achieve investment grade debt ratings.
All the while, investors and regulators have become increasingly hostile to any business activity directly responsible for carbon emissions. The market has adopted the view that fossil fueled power generation is obsolete, and that green energy is the only ‘investable’ form of energy.
As a long-time observer of deregulated power markets, the aversion to invest in this sector is understandable. Not only is it difficult to gauge the direction of commodity prices, but it’s absolutely impossible to forecast the constantly changing regulatory environment and market rules that determine the profitability and ultimately the useful lives of power plants. Investor concerns surrounding asset duration are seemingly paramount – why else would the market allow a company like VST to trade at an enterprise value ~5x next year’s EBITDA and a roughly 25% free cash flow yield?
We think we’re being pragmatic in our view that VST’s portfolio of assets have a terminal value far more than what the market thinks is justified, and the electricity crises in Europe, California, and Texas are proving us right. That gets us to the original investment thesis.
The argument for owning VST shares
The basis for our interest in VST is the company’s ability to generate significant free cash flow, repurchase shares, thereby compounding free cash flow per share over time. With a free cash flow yield of close to 25%, VST could theoretically buy back every outstanding share in four years! But management has been postponing a massive buyback program for years. That changed in late-2020 when the board approved a new capital allocation framework whereby VST intends to repurchase $2B of equity through 2022 and $1B each year from 2023-2025, all while paying $315M in annual dividends.
Assuming no growth in earnings (which is what consensus suggests) or any change to valuation, the cash returned to shareholders will average 20% per year through 2025. More importantly, free cash flow per share would compound at more than 16% per year resulting in nearly $8.00 per share by the end of 2025 (VST currently trades at only $22.80!). That’s a shareholder return story that we salivate over and reason enough to make it a large position within the fund.
Even so, a fairly long list of recent events (both market-based and geopolitical) has given us greater conviction in the market environment, profitability, and longevity of VST’s business. Those events include market reforms in Texas post Winter Storm Uri, the astonishing increase in commodity prices since the invasion of Ukraine, growing power demand, and scarcity of supply in key areas of VST’s operations. The resulting improvement in power market fundamentals has compelled us to make VST the top position in the fund.
The improvement in power market fundamentals was highlighted in the most recent VST earnings call by outgoing-CEO Curt Morgan: “Frankly, in my 40 years, I have not seen a confluence of events quite like this. Certainly, Vistra is in the right position to capitalize on the strong forward curves…It is a rare opportunity presented to us and it is our job to create the most value out of it while managing the risk”. And that improvement is reflected in recent multi-year guidance from VST – something the IPPs never provide due to the illiquid nature of the electric power price curve.
It’s worth expanding on this point. First, for more than a decade, the power price forward curve has almost always been in steep contango with a low starting price (power prices in outer years decline). Over the past six months, the entire curve has moved up substantially – for 2022 and 2023, ERCOT forwards are up 55% and up 58% in PJM, the two key markets for VST. Moreover, forward prices are up another 10% since VST provided their multi-year guidance.
For that reason, VST has increased its commodity-linked facility from $1B to $3B over the past several months to secure hedged positions that lock in future cash flows in the face of one the highest power price curves the company has ever witnessed and farther into the future than the company has ever hedged. To put things in perspective, VST is now ~50% hedged for the 2023-2025 period. This is notable because VST is typically only ~50% hedged over the ensuing 12-month period (compared to 36 months today).
Concurrently, VST’s retail electricity business has been performing well and appears better positioned to grow both the number of customers as well as volumes. Residential customer count grew organically in Q1 2022, something that hasn’t happened since 2008, as the retail business begins experiencing tailwinds from the fallout from winter storm Uri (i.e., customers fleeing financially distressed Texas retail providers who were caught massively short generation during the storm).
Retail volumes are also experiencing tailwinds from the influx of people, economic growth, and crypto miners moving to Texas (not to mention increased demand from extreme weather). Indeed, already this year, ERCOT has witnessed more than a handful of record-breaking demand days for June and July. During some of those record-breaking days wind energy, a significant portion of the state’s capacity, failed to deliver (only about 8% of peak capacity on 7/11 and 12% on 7/13).
The dearth of capacity has pushed prices into the thousands on several occasions and the state has already hit the scarcity price ceiling of $5,000/MWh for several hours in the second week of July (that’s more than 225x the average price of power in 2020!).
This gets us to the second reason why we have even more conviction in owning VST shares – despite all the positive trends and market improvements, VST’s equity value has gone nowhere. Not only has VST’s capital allocation framework already reduced outstanding shares by ~18% and provided investors with dividend growth of 18%, but it has set the foundation for even more capital allocation flexibility. In short, a cheap stock keeps getting cheaper, and over the next several years management will have even more dry powder to return cash to shareholders.
To highlight the potential value in a VST share and what we view as a compelling capital allocation strategy, as a mental exercise, just extend the buyback program through the end of the decade. Adopt the longstanding Wall Street assumption that VST is a no-growth business. And finally, assume the share price stays flat. From 2022-2030, VST should generate a total of $21B in free cash flow. By the end of 2030, shares outstanding would decline by 90%, giving VST a market capitalization of $0.9B, and net debt would decline from $9.6B to $1.3B.
This would result in an enterprise to EBITDA multiple of roughly 1.0x. Free cash flow per share would compound at 33%, growing to roughly ~$58 per share (a 250% free cash flow yield!). Even more important for a long-term shareholder, the equity interest in a single outstanding share held over that period would increase by over 900%!
What isn’t convincing about the above hypothetical is that share prices rarely remain constant, and we have no illusions about the volatility in VST’s share price. Kris wrote in his 2019 year-end letter that “we would actually prefer it if [VST’s share price] went nowhere for as long as possible… [and] management dramatically shrinks their share count, making eventual value realization that more meaningful to long-term investors like us.” At the time, the shares were priced at ~$17 and management were allocating all excess cash to debt reduction.
Now the priority is shrinking the share count. Whether the share price moves up meaningfully or the share count is reduced drastically, we think both scenarios work in our favor.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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