GenOn Energy (NYSE:GEN), a $1.7 billion market cap electric utility which operates in many different states across the U.S., is on target for a merger with the larger NRG Energy (NYSE:NRG) (NRG has a market capitalization of $4.3 billion). Shareholders of GEN will receive one share of NRG for roughly every eight shares that they own- the precise ratio is 0.1216 NRG shares per GenOn Energy share. This represents roughly a 20% premium over GenOn’s stock price prior to the announcement.
Steven Cohen’s SAC Capital Advisors (see Steven Cohen’s top stock picks) recently filed a 13D with the SEC to announce that he had acquired 36.7 million shares as of July 20th, which represents 4.7% of the company’s shares outstanding. SAC has not made public why it made this move, but merger arbitrage is a common hedge fund strategy (learn more about merger arbitrage strategies) and the fund may be trying to exploit differences between the stock price at the time it made its purchases and the amount it expects to receive from selling NRG Energy shares after the merger is completed. Alternatively, SAC may plan to urge other shareholders to hold out for a better deal from NRG because it believes that GenOn represents a still higher value to the larger company.
Utility stocks are not particularly attractive to hedge funds because their business opportunities and cash flows are fairly predictable and the share prices tend to not change very much. GenOn Energy was not owned by any hedge funds in the most recent quarter, according to 13F filings. NRG Energy, as a larger company, had some interest: Solus Alternative Asset Management owned 2.9 million shares (find out more about this fund’s portfolio) after increasing its stake for about a year, and Ron Gutfleish’s Elm Ridge Capital more than doubled its position in the company to 2.4 million shares (see more stock picks from Elm Ridge). Still, neither of these funds- nor any other- reported a position of at least $50 million in the stock.
The 10-Q for the company’s first quarter revealed that it took a net loss, though this net loss was smaller than what GenOn had experienced in the first quarter of 2011. The lower net loss was driven by cost cutting, as revenue was down from the previous year. Between the utility’s two major segments, the Eastern market had a gain in revenue and the Western market had lower revenue (GenOn separates its California operations into a smaller segment). Because of milder weather, power generation was down.
GenOn has negative earnings on a trailing basis, and Wall Street analysts expect it to take another loss in its next fiscal year. The company does trade at about a third of its book value, below NRG’s market-book ratio. Alternatively, the merger seems to provide a way for NRG to add EBITDA cheaply: NRG Energy’s enterprise value as a multiple on trailing EBITDA is 10, while the multiple for GenOn is half that. This may be because GenOn Energy, as a smaller company, does not attract as much investor interest; it may be because NRG has better management and utilizes its assets better; or there may be a number of other factors driving the difference in value. In theory, NRG Energy also hopes to benefit from lower fixed costs as a result of the merger, creating shareholder value out of thin air. A public peer of the two companies is Calpine (NYSE:CPN). Calpine trades at higher values of twice its book and 11 times its trailing EBITDA; though it is a larger company than the would-be mergers by market cap, a successful merger would actually result in a combined company with higher electricity production than Calpine. The transaction, which requires a number of approvals from regulators as well as shareholders of both companies, is scheduled to close in early 2013. We will have to see what Cohen and SAC’s plans are for this trade.