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  • Texas Energy Buyout

    Posted by Carl from Chicago on December 19th, 2009 (All posts by )

    One of the long-time major public utilities was known as TXU and was based out of Dallas, Texas. TXU was a large utility and expanded to include overseas assets; after the energy bust in the early 2000s TXU shed their overseas assets and participated in the deregulation schemes for the state of Texas.

    A bit of background is that utilities are pretty much regulated on a state-by-state basis. In addition, Texas (with the exception of El Paso, which is really almost more a part of New Mexico; I used to consult there) is on their own transmission grid known as ERCOT, that has its own voltage different from the rest of the country, meaning that power in Texas can’t generally cross state lines. This means that you can’t bring power into Texas that isn’t generated in Texas and you can’t sell Texas power outside of state lines. The subtle side effect is that, for power at least, Texas is like a “whole separate country” – if there is a surplus of generation in the state, rates stay low – but if they are short on generating capacity – prices will soar. Surplus or deficit power in neighboring states can’t help or harm Texas.

    Here is an instant tip for you – any deal done in 2007, at the height of the bubble, is generally in trouble. The 2007 mortgage “vintage” is the stinkiest year, and the same type of damage spilled over to the deal arena. Generally if you are looking at a 2007 deal, when equity values were at their highest and “easy money” for debt was readily available (meaning that you could “leverage up” higher), those are the deals with the characteristics likeliest to make them go South.

    So now that we have gone through a bit of background on the unique nature of the Texas electricity market, and gone through the general background of deals that were executed in 2007, now we move on to the current status of TXU, which became “Energy Futures Holdings” when a leveraged buy out of equity owners occurred during that year for $45 billion, led by KKR, Texas Pacific Group, and Goldman Sachs (see brief wikipedia article).

    Energy Futures Holdings incurred a large debt taking a utility public. Historically utilities have had substantial and steady free cash flow. Thus the plan typically is to leverage up with debt (which is cheaper than equity, because you can deduct interest on debt), cut expenses, and keep the cash flow. For a utility with large capital expenditures (investments), another obvious way to increase your cash flows is to pare back on new investments of items like power plants, transmission lines, and distribution networks.

    The debt of Energy Future Holdings is trading at a substantial discount to “face” value, which is 100 cents on the dollar. For this bond issue (each one is valued differently, because they have different terms, maturities and rights, although they generally move in sync along with the overall enterprise’s health) the bonds were trading at 70 cents on the dollar for the 2017 maturity.

    One item that is eye-popping is that this bond returns a coupon of 10.875%, almost 11% a year! The current treasury (risk free) rate today for bonds with a 7 year maturity (to be in synh with the 2017 bonds) is 2.74%, per this government bond yield table. Thus these bonds pay (10.875 – 2.74) = 8.131% HIGHER than the “risk free” rate, for a period of 7 years. Thus if risk was equivalent (which it clearly is NOT), then this bond would be trading for far above 100 cents on the dollar, maybe something like 150 (I will leave it up to Andrew from Aurora, the new guy on the blog, to figure it out if he feels like it).

    So for a bond to be trading at 70 cents on the dollar with a high coupon rate basically means that investors are bracing for a serious fall. A quick look at their financials shows why (even though they are private and have no equity investors, they have debt investors with publicly traded debt so they still file SEC filings and have quarterly conference calls). EFH has huge amounts of debt coming due in 2014, and it currently doesn’t appear that they are generating enough cash to pay down this debt. To be fair, when deals like this were done at the height of the “easy money” boom, you not only had models showing growing cash flows, but you also figured that you could easily re-finance and push out the maturity of debt as it comes due. In general, those days are mostly over unless you have a heavy equity component (a lot of your own money at stake) or a sterling balance sheet.

    Recently EFH had a bunch of complex stuff happen with its debt that frankly I don’t have time to go through in detail, but basically they are trying to push out maturities by swapping debt coming due in the near term for new debt issues coming due in the future.

    The logical question is – how does this impact the Texas electricity market? The answer – I don’t know. We kind of are moving into uncharted territory for the US energy market. Way back in the day an energy company going bankrupt or having very significant financial troubles was very rare – a utility in Tucson, one in El Paso Texas, and then the whole California markets had big problems. However, those utilities were at least “public” utilities, meaning that the shareholders were “mom and pop” people who were reliant on dividends and got some sympathy with the regulators. It will be very difficult for these private equity guys to get much sympathy from Texas regulators, by contrast.

    And how is this impacting capital programs? I don’t know. The company would probably say “not at all” and this makes some sense because right now Texas is awash in electricity due to falling demand and the fact that excess power can’t be “wheeled” out of state. There are a couple of coal plants in the queue that EFH continues to work on (lignite) but when this buyout was proposed originally the former TXU had grandiose plans to actually increase generating capacity significantly with new plants; now those plans are shelved.

    It will be interesting to watch what happens in Texas if current trends of low electricity usage continue, and how the company does with its high debt load (and distressed pricing), or if electricity demand surges, whether or not they begin a big capital program to add new capacity.

    Kind of uncharted ground for the energy industry, having a private buy out on this large a scale.

    Cross posted at LITGM

     

    5 Responses to “Texas Energy Buyout”

    1. Whitehall Says:

      When Texas Utilities (TXU) went private, some very fast, very easy money was made. I think it was a quick $6 billion profit for Texas Pacific, a hedge fund, that flipped TXU into EFH/Luminant.

      Note that TXU largely serves the Dallas/Ft. Worth market and has plans for a 2 unit Mitsubishi nuclear plant to join the existing two reactors at Comanche Peak through EFH’s Luminant subsidiary. However, I don’t see that project having a high burn rate yet.

      http://www.luminant.com/about/default.aspx

      Part of their problems lie in the must-take provisions for wind power. With a state’s renewables mandate of 20% of capacity (or production, I was never clear which), the expensive and unreliable wind farms push down capacity factors for the coal and gas plants that all utilities use for intermediate and peak loads. They claim to the largest purchaser of wind electricity in Texas.

      Looking at their last SEC filing (http://phx.corporate-ir.net/phoenix.zhtml?c=102498&p=irol-sec) it looks like they are taking hits on low commodity prices and reduced distribution demand.

      Plus they have a very large exposure for carbon dioxide restrictions since they burn so much lignite coal.

      In summary, EFH is highly levered for a utility, is exposed to Federal cap and trade legislation, and is suffering from a demand downturn.

      Their bonds look a bargain to me. Texas electric demand will pick up before most of the country and cap and trade is dead. With a steady hand at the wheel, I’d expect them to come through hard times without too much risk.

    2. Carl from Chicago Says:

      I think that the variable isn’t demand in Texas it is the overall credit market.

      If they can find a way to push off their debt coming due in the next few years because there is new financing available this will give them time to figure out how to make enough case to restructure their balance sheet.

      As far as their new nuclear plant, I wouldn’t count on it. I have a ton of posts (look under Energy or click on the post above) for my posts on the difficulties of getting anything done in that sector.

      But they certainly could come through and turn out to be a good investment, I don’t know. I do know that having a giant utility like this with such huge leverage and a private owner is new for the industry and may have unknown impacts if factors work against them.

    3. Whitehall Says:

      The key word here is leverage.

      TXU as a regulated public utility probably had the standard capital allocation of 50% equity and 50% debt. That was the compromise every state settled on following the electric holding company scandals of the late 1920s.

      Any idea what EFH’s capital split is? I bet its pushing 20/80.

      As to Comanche Peak 3 and 4, look to the Japanese vendor to take some sort of equity stake in them just like the other Japanese vendor did for STP 3 and 4. MITI is bankrolling market penetration strategies for their nuclear suppliers similar to their earlier efforts for electronics and automobiles.

    4. Carl from Chicago Says:

      I don’t know what the equity component started out to be but it must be very near zero today in current value if the bonds are this distressed. They turned a regulated utility into a totally leveraged company and that is what is so unprecedented.

      I had a different thread on STP 3 and 4 recently Whitehall and one of the main engineers commented on the thread and it was interesting. I am ALL FOR nuclear power, unfortunately, it just ain’t happening.

      https://chicagoboyz.net/archives/10601.html

      You should check out that thread.

    5. Whitehall Says:

      Wow o’ wow!

      That engineer guy you linked to is the wisest writer on the Internet today! ;)

      So if EFH goes belly up, the bankrutpcy court will let the current management run the operations while the bond holders get pennies on the dollar and the stockholders get zip.

      Texas Pacific and KKR will have stolen a lot of money from the suckers and the widows and orphans. The current construction projects will be abandoned or delayed. Wonder how much TARP funds get consumed by their bankers?

      Guess that was just another payday on Wall Street.

      Here’s a link to the “deal”

      http://www.tpg.com/news/080208_deal_txu.pdf

      Note the connection between environmentalists and Texas Pacific. Of course, the owners created their own bargaining chip by proposing a massive new fleet of dirt burners (lignite plants) that they could scrap as a trade-off.