Shares of utility companies have been hit hard this year thanks to worries of an interest rate hike and the drop in energy prices, a key component in what utilities can charge.
Companies in the formerly hot renewable energy space have been hit even harder in recent months. There is fear that cheap fossil fuels will hurt sales of alternative fuels while the high cost of developing these assets will eat into cash flows.
One of the leading utility and renewable energy companies recently announced a plan to return a massive amount of cash to shareholders and dramatically reshape the company. Investors got spooked and dumped shares, but I’m buying in with a strategy to put even more cash in my pocket.
A Cash Machine in a Protected Market
NRG Energy (NYSE: NRG) is the largest independent power producer in the United States. It generates over 50 gigawatts of power primarily through oil, coal, gas and nuclear power, which it sells wholesale and to about 3 million residential customers across the country. The company also owns considerable capacity in renewable energy including solar, wind and thermal.
Before I tell you more, I want to give you a little background on the utility market in the United States. It is heavily regulated with most markets fixing allowable electricity prices to energy prices.
The upside of regulation for utility operators is that it keeps competition relatively fixed and cash flow stable. The downside is that lower energy prices weigh on electricity prices.
As analysts at Morningstar note, power prices in NRG’s primary regions tend to track natural gas prices, which are down roughly 80% since mid-2008. Additionally, the drop in fossil fuel prices has made renewable fuels even more expensive on a relative basis.
Shares of NRG Energy are down about 45% in the past 12 months, but the near-term issues do not detract from long-term demand. As long as people need electricity, they’ll need NRG.
And its diversification across multiple energy sources gives it staying power no matter where energy regulation and prices go. Cash flow from operations was $1.6 billion over the past four quarters, and the company generated more than $600 million in free cash flow.
The main thing I like about NRG Energy, though, is that last month management announced a corporate restructuring that should allow them to free up capital to return to shareholders in the form of share repurchases and dividends.
Specifically, the renewable fuels segment will be split off into a company called GreenCo, which may look to take on partners. This will reduce the amount of cash flow NRG will devote to the still-growing renewables segment. It’s committed a cap of $125 million starting Jan. 1.
NRG is targeting $150 million in 2016 cost reductions from the restructuring and planning to return a massive amount of cash to shareholders. Management said they will repurchase $251 million in shares by the end of 2015 and commit an additional $1.3 billion to share repurchases and debt reduction in 2016. Based on previous debt reduction programs, I see the potential for $500 million in share buybacks next year.
Combined with the more than $50 million the company has averaged on dividend payments in the past four quarters, we could be looking at more than $1 billion coming to shareholders through the end of 2016. That’s a fifth of the company’s current market cap.
Generate Even More Cash With This Income Strategy
I want to benefit from the company’s commitment to returning cash to shareholders while also seizing the opportunity to generate additional cash from what we at Profitable Trading like to call an “income loophole.”
The strategy is known as a covered call. If you’re not familiar with how it works or need a refresher, watch this short training video now.
With NRG trading at $15.20 per share at the time of this writing, we can buy 100 shares and simultaneously sell one NRG Jan 16 Call, which is trading around $0.95 ($95 per contract) for a net cost of $14.25 per share. This puts our cost just below the 52-week low, which is also the lowest the stock has been since late 2004.
If NRG closes above the $16 strike price at expiration on Jan. 15, our shares will be sold for that price. In this case, we will make $0.80 in capital gains and the November dividend payment of $0.145 per share. When you combine this with the option premium of $0.95 we received for selling the calls, we get a total return of $1.89 per share, a profit of 13.3% over our cost basis of $14.25. Since we’d earn that in 93 days, it works out to an annualized gain of 52%.
If NRG fails to rally above the $16 strike price, I will be happy to continue holding the stock and selling more calls against the position to collect additional option premiums. Continued weakness in energy prices may limit gains in the share price, but management’s commitment to returning cash to shareholders should drive investor sentiment and total returns much higher.
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