Calpine Overpromises

Considering the sorry history of California energy regulation what would you think of a company that reports earnings from past sales in California for which they have not been paid?  What would you think of a company that reports positive earnings from sales under long-term contracts that may turn to losses in the future? 

The case for Calpine stock is that it sells at a low multiple of earnings and its earnings are growing rapidly.  In our opinion, current earnings are overstated because they may be dwarfed by future losses.  That in turn implies that rapid growth is an illusion.

The resemblance between Calpine today and Coastal States Gas in the early 1970s may help explain our view.  Coastal expanded aggressively by promising to deliver natural gas on long term contracts at prices below what competitors offered.  The problem was that after Coastal drove out its competitors, it did not have the gas to deliver.  When the price of gas went up surprisingly, Coastal was unable to obtain new supply at a price it could pay and Coastal stock lost most of its value.  (The company eventually recovered and today is part of El Paso Corporation (EPG)).

Calpine, too, has expanded aggressively by outbidding competitors and promising, in our opinion, natural gas that it will not be able to deliver.  The power plants Calpine would build need natural gas for fuel.  Calpine is expanding so aggressively that it expects to be buying 10% of U.S. natural gas supply in just a few years. The gas will be there, but electricity generators will have to outbid other users for the supply.  The profits Calpine projects are more likely to accrue to natural gas producers.

Now coming back to California, what do you think the state will do?  If the price of electricity stays low as it is now, the state will attempt to renege as it is doing now.  If the price of natural gas is high, the state will hold Calpine responsible.

Calpine is also overleveraged, we think.  Management targets a 65/35 debt/equity structure apparently on the basis that utilities have succeeded with that much leverage in the past.  The difference is that Calpine is building plants primarily for an unregulated market.  One of the premises of the regulated market was that ratepayers shared risks with utilities.  Since that is not the case in an unregulated market, a lower debt structure would be more appropriate. 

We also note that Calpine reports only nominal net interest expense even though it has some $7 billion of debt on its balance sheet.  That is another factor that might lead one to conclude that earnings are overstated.

In the end we come down to Ebitda.  Projecting next twelve months results near the current rate, we estimate present value at the same 9.0 times that we use for Mega Cap Energy companies.  When subtracting debt and dividing by shares we get about $11 compared to the current stock price near $27.