Thursday, March 24, 2011

So why NRG?

Well I'm finally getting around to my NRG write-up, sorry for the delay!  Anyway, here's why I like NRG:
  • I think the stock is cheap at $20 a share: EV/EBITDA and FCF yield are quite attractive plus the value of NRG's assets (i.e. power plants) alone could support a stock price in the high $30's.
  • NRG's CEO, David Crane, is considered one of the best in the business.  Additionally, he is aligned with shareholders as he owns a significant amount of stock/options (many of which are out of the money).  
And here's why I purchased LEAPS instead of common stock:
  • NRG has significant balance sheet leverage (i.e. debt): the more leverage a company has the harder it is to determine its fair value.  However, a high degree of leverage can really boost returns when things work out well.
  • NRG has significant operating leverage: profitability for IPP's are highly dependant on commodity markets.  If the price of natural gas goes up (which is by no means guaranteed), NRG's revenue and profitability will go right up with it. 
  • At $0.60, the LEAPS were cheap.  When buying out-of-the-money options I look for asymmetrical risk/reward situations.  In the case of NRG, if the stock goes to the mid to upper 30's I'll make a 10x return, if the stock goes to the low 40's I could make a 20x return, which IMO is well worth the risk.
So where does this leave us?  In short, NRG is a potentially cheap stock with quality management.  However, its high level of financial and operating leverage make its future very uncertain - the upside potential is significant but the downside risk is still very real.  Luckily for us the LEAPS were cheap, thereby creating an opportunity with decent odds and a very asymmetrical risk/reward if things go our way.

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