NRG Power Play Would Inhale SolarCity

 | May 09, 2014 | 5:00 PM EDT
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When it comes to NRG Energy (NRG), investors listening to the first quarter's conference call could be confused. No, it is not about their earnings, they seem fine for now. It is about the company's strategy and vision.

Like all other utilities benefitting from the Arctic vortex, NRG posted a fine quarter. While they have an agile management team, last quarter was not about brilliance. It was about an unusual weather event. And as they say in sailing, a rising tide lifts all boats. In this case, a polar vortex lifts all revenues.

While NRG's management team executed well, their message about their "clean energy future" is confusing. It is confusing because NRG is currently one of the nation's most polluting utilities. Let me explain.

NRG is the largest competitive energy provider in the nation. It has a fleet of approximately 100 generators with a total capacity of approximately 55,000 megawatts. As of December, 54% of its generating fleet was natural gas-burning generators; approximately 27% was coal-burning assets; and  approximately 12% was oil-burning assets. Less than 10% of its generating fleet produced clean energy.

Currently, NRG makes money by selling coal at natural gas prices. To be clear, investing in NRG today is investing in a company that profits from air pollution.

This situation may not last. The NRG of tomorrow may be an entirely different company. Speeding it along is a decision recently handed down by the Supreme Court. Last week, the court upheld the Environmental Protection Agency's (EPA) Cross-State Air Pollution Rule (CSAPR). The decision is understood to be a challenge for coal-burning companies like NRG, Southern (SO), Duke Energy (DUK) and PPL (PPL).

NRG believes it will take a long time before the court's decision is sorted out. The company argues that it bought its old generating assets for pennies on the dollar. As such, if NRG only operates its coal units for a few more years, the company should earn a respectable return for shareholders.

For NRG, it is more interesting than retiring old coal plants. In a utility's value chain, NRG currently occupies two separate positions. On the front end, NRG is the nation's largest generating company. On the back end, NRG is one the nation's largest energy service companies. The wires that connect the two are owned by others.

NRG's call suggests it expect to lighten up on its front-end position. They may keep utility-grade solar farms, wind farms and standby capacity. However looking forward, it appears they expect difficulty arbitraging coal against natural gas in the future.

Consequently, NRG wants to jump in with SolarCity (SCTY). NRG want to install solar panels on the customer side of utilities' meters. In fact, NRG CEO David Crane thinks NRG is in a better position to take on this business than is SolarCity.

Crane may be right. Not only does NRG have a stronger balance sheet, it has several huge competitive advantages. First, NRG already has retail customer base of 3 million. Second, NRG is already delivering deregulated power over third-party wires, reading third-party meters and regularly billing retail customers. Third, they own and operate time-tested software to manage the customer interface. Last, NRG's marginal cost of operations for rooftop solar is small compared to SolarCity because its costs are incremental. In short, NRG is in position to become the nation's cost leader.

It could get better for NRG. By combining its utility-scale power plants, energy services and rooftop solar, NRG could hedge its retail energy positions against their power plants. In the process, they may earn higher capacity payments from their deregulated retail consumers than is typically available from the nation's grids.

For NRG's shareholders, a critical success factor will be how and when NRG retreats from its front-end position and migrates to the back end. In all likelihood, NRG will retire or convert its old coal boilers. They will retain some natural gas and oil-fired plants. If market prices for energy are high enough, they will run their plants for a nice profit. If not, they will collect capacity payments from retail customers or grids.

Because they are not a typical utility, NRG Energy is a speculative investment. They own no wires. Very few of their assets are regulated. However, in a face-to-face competition with SolarCity, I would pick NRG. They are the cost leaders in the distributed generation business and cost leaders usually win. 

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