This Irrational Move In The Market Could Be A Great Trade

Overnight here in the U.S., when the British energy company Centrica announce the sale of their U.S. business to NRG Energy (NRG), the shares in the two companies moved in opposite directions. On the London Stock Exchange, Centrica posted record gains of nearly forty percent as traders cheered the company’s exit from the depressed American energy market, while in the pre-market in the U.S., NRG dropped around six percent. That stock has since recovered, however, and looks set to open roughly unchanged from yesterday’s close.

So, which move should energy investors be paying attention to in NRG, the drop or the bounce?

The drop was understandable in some ways. Any talk of expanding in the U.S. energy markets will be met with pessimism right now, and not just because of the presumably temporary blow from the pandemic either. Energy has been underperforming the rest of the American market for around a decade, through several boom and bust cycles. In that context, it is no surprise that shelling out $3.6 billion to expand in that market prompted a negative initial response from traders.

NRG’s purchase, though, has little to nothing to do with those booms and busts. They were about the rise and fall of shale oil, upstream and midstream operations, while this is about expanding NRG’s retail footprint. That may not prove to be a bad idea over time.

Expanding into a depressed market is what energy companies of all stripes do all the time. The giant multinational energy companies of today were built on that very strategy, and, more relevantly, several of the larger U.S. utilities and electricity generators and suppliers have done the same thing. The obvious advantage of the strategy is that you can pick up assets with long-term potential on the cheap, and that is what seems to have happened here.

Initial estimates suggest that the purchase will be immediately accretive for NRG, adding around $740 million in adjusted EBITDA. Simple math means that even absent any growth, the deal will pay for itself in around five years. Presumably, the bounce is in response to that.

If NRG had gone into this deal with a dodgy balance sheet and looked to be really stretching themselves to make the purchase, I would definitely say that the drop was the move that would extend over time. That, however, isn’t the case.

As energy collapsed and America shut down, NRG, like every company in any way connected to energy, took a hit. Q2 earnings won’t be out for a couple of weeks, but in Q1, earnings fell early 75% from the same quarter the previous year. Q2 undoubtedly won’t be pretty either, but crucially, and especially in the context of this deal, NRG has maintained free cash flow of over $1 billion and have $759 million cash in hand. That is crucial because it increases the chances of NRG maintaining their dividend, even after splashing some cash around.

What we are left with then is a power generation and distribution business that offers something quite rare in that field…growth. Add in the inherent appeal of a forward dividend yield of over 3.5% in a world where the 10-Year yields around 0.6%, and it quickly becomes clear that it is the bounce, not the drop earlier this morning, that makes sense and will likely be indicative of the future for NRG.