Capuski
It would seem that the Street is far from convinced about the ongoing restructuring and business transformation efforts at NRG Energy, Inc. (NYSE:NRG), and the latest move – the $2.8B deal for Vivint Smart Home, Inc. (NYSE:VVNT) – is doing nothing to ease that anxiety. The shares fell about 15% on the deal announcement, continuing a trend of sharp moves between the mid-$20s and mid-$40s over the last five years as the Street tries to dial in the long-term cash flow consequences of management’s ongoing business transformation efforts.
I can understand why at least some investors would prefer the certain accretion of buybacks over another M&A transaction that brings integration and execution risk. I believe further transformation is necessary, though, and I favor using cash flow to build up (or perhaps shore up) the company’s future prospects and cash flow generation capabilities, so I see this as a short-term versus long-term debate. I do think the selloff makes the shares more interesting, but I do also see ongoing execution risk here.
Another Step In The Transformation
Over the last three years or so, NRG has undergone significant and arguably aggressive changes in the makeup and strategy of the business. The company sold most of its Northeast power generation assets, closed several Midwest plans, and refocused around its retail business. The company has been diversifying away from its legacy operations in unregulated power (including disposing of over half of its generation fleet) and transitioning toward an asset-light strategy focused on consumer services.
To that end, the Vivint deal makes sense.
On December 6, NRG Energy announced that it would acquire Vivint Smart Home (“Vivint”) in an all-cash deal worth $2.8B ($12 per Vivint share), with a total deal enterprise value of $5.2B. NRG Energy is paying around 7.1x EBITDA before synergies, or 6.3x after including the synergies NRG Energy management claims they can reap from the deal.
Vivint is a smart home/connected devices company. While there is no shortage of competition in the emerging smart home market (including Amazon (AMZN), Apple (AAPL), and Alphabet (GOOG, GOOGL), Vivint has taken a different strategic approach with its vertically-integrated “Smart Home as-a-service” stack of hardware, software, and services – a stack that should be leverageable as the company adds more services over time. The core of Vivint’s current offering is in the home security space, but the company has added residential solar capabilities. This business has been growing well in recent quarters.
How Vivint Could Help NRG Energy
As mentioned above, NRG Energy has been pivoting towards becoming more and more of a consumer services company, and the addition of smart home services strikes me as a logical extension of that transformation. Penetration rates in smart/connected home technologies are still low, and while there are many homes with some sort of connected device (whether a Nest thermostat, an Alexa system, Sonos, Inc. (SONO) speakers, or what have you), the overall concept is still in its infancy, and few homes have comprehensive integrated systems.
Over time, I would expect to see more and more household functions (security, power consumption, lighting, HVAC, appliances, etc.) integrated and connected – effectively allowing consumers to run their houses “by remote control” while optimizing power consumption and safety. That, in turn, should drive cost incentives like lower home insurance and utility costs to augment more subjective benefits like convenience.
With NRG Energy wanting more retail exposure beyond the provision of electricity and gas, this deal seems like a logical extension and a platform upon which NRG can build/acquire more value-added services over time. There should also be some cross-selling opportunities in the retail power business (selling electricity to Vivint customers), including NRG’s large Texas retail operation.
At this point, NRG is still heavily leveraged to its Texas retail power business. While Texas is one of the relatively few markets where I’d expect to see meaningful power consumption growth (with more people and business relocating to Texas), the reality is it’s a challenging business and the benefits of leveraging its captive generation capacity is offset by risks like power reliability (storms and or mechanical/operational issues) that can force the company to turn to higher-cost sources of power to meet its supply obligations.
NRG’s generation and retail power businesses can generate good cash flows (the company has a strong track record of converting around 60% to 70% of adjusted EBITDA into FCF), but the smart/connected home market is likely to grow far faster over the coming years. I believe risks are more skewed towards execution and competition than uncontrollable force majeure events like weather or political/regulatory changes. Given that, I think NRG’s decision to harvest cash flow from the power business and reallocate it to building/buying new FCF-generating assets with better long-term prospects is reasonable.
The Bottom Line
I can understand investor disappointment in seeing substantial sums of capital go toward M&A that could have been allocated to buybacks. I likewise understand concerns about taking on more debt and taking on the execution and competitive risks that come with a big move into markets that are new to NRG Energy management and investors. I believe the alternative of standing pat and continuing to return capital to shareholders wouldn’t offer much long-term upside, though, and would leave the company with ongoing risk from operational performance and weather issues, as well as low long-term potential growth.
I believe 7x is a reasonable forward EBITDA multiple for NRG Energy now considering long-term growth potential and risks, as Vivint adds meaningful growth long-term opportunities at the cost of elevated near-term debt, execution risk, and greater near-term macro risk (consumer discretionary exposure going into a likely recession). At 7x my pro-forma ’23 EBTIDA estimate, NRG Energy, Inc. shares should trade around $38.50. I believe this NRG Energy selloff on the Vivint deal announcement is an opportunity for readers to do their own due diligence and consider whether this is an opportunistic overreaction.
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