Description

I recommend buying the Calpine Corp. Second Lien Notes at prices between 70%-80%. Depending on the maturity, these prices result in YTW of between 15%-27%.

CPN 2nd Lien Notes offer an attractive contractual yield in the event the company remains a performing credit at the 2nd lien level or a super cheap (relative to book or replacement cost) entry price to a reorganized equity.


Business
Calpine is a U.S. merchant generator of electricity operating 27,000 megawatts (“MW”) of electric generating capacity primarily located in three markets. 20% of the Company’s assets are in SERC (Southeast), 28% of assets are in ERCOT (Texas) and 28% of its assets are in WECC (California). 25,750 MW are gas fired cogeneration facilities build over the past ten years at a cost of $500-$600 per kilowatt. 750 MW are geothermal plants. 22,000MW of the Company’s capacity is base load; the remainder is peaking. The Company has an additional 3,700 MW of generating assets under construction. Calpine generates electricity by burning natural gas to run turbines. Calpine makes a profit when the spark spread, or the difference between the price the company can sell electricity and the company’s cost to generate electricity, is positive and sizable enough to cover fixed costs. In an effort to enhance profits on its power plants, Calpine, through subsidiary CES, engages in trading natural gas and electricity. Calpine operates in a commodity market with no ability to store output and long lead times associated with developing new capacity. Including zoning, it is difficult to build new capacity in less than three to five years.

In general, the non-utility electric generation industry works off of a dispatch curve, with the price of electricity set by the operator with the lowest variable cost generating asset necessary to produce the marginal electricity to meet demand. Over time, the marginal producer can change based on the level of demand (total MW needed to supply the amount of electricity being used) and each producer’s relative cost efficiency given its input costs. In the U.S., coal-based generating assets account for 50% of total electric capacity, nuclear 20%, gas 16%, renewable 10% and other 4%. Natural gas tends to be the most expensive of the big three sources of electricity generation. With gas prices currently over $10 per MMBtu, it is not even close. Natural gas is the most expensive). Within the natural gas based generating market, Calpine has some of the most efficient plants with an average heat rate of 7,000 (cost is determined by natural resource price multiplied by the heat rate; lower heat rate = lower cost for a given cost of natural resource). Natural gas fired plants tend to be the marginal producer in WECC and ERCOT. Gas plants tend only to fire during peak demand periods in SERC.

Electricity demand has grown between 2%-3% annually in the U.S. over the past fifty years. This trend is expected to continue. In the late 90’s, gas cogeneration was thought to be the best technology for new build electric generation due to low natural gas prices and the technology’s environmentally friendly profile. During the last five years, approximately 190,000MW of new capacity has come on line, up from 40,000 MW the preceding five years. Based on current estimates, new builds over the next five years will be similar or less than the 40,000MW of capacity built in the mid 90’s. The building boom coupled with economic slowdown, increase in commodity input price and the collapse of Enron and other trading platforms, has led to a glut in some markets and relatively depressed spark spreads across the industry. As a result of excess capacity, slowing rate of economic growth, and market manipulation (Enron and other traders), average spark spreads realized by Calpine have declined from $45 per MWh in 2000 to $20 in 2005. Capacity utilization has declined from 72% for the twelve months ended December 31, 2000 to 50% for the twelve months ended December 31, 2004. (For the three months ended June 30, 2005 capacity factor was down to 39.9%). Reduction in spark spread tends to be correlated with reduced capacity utilization, magnifying effects on the income statement.

Reduction in new capacity additions coupled with steadily increasing demand should eventually drive spark spreads higher. Calpine should ultimately be worth more than the cost to build its assets. As material costs continue to rise, demand growth leads to spark spreads increases, and the company enters into favorable contracts.

As part of the Company’s effort to “maximize” results, Calpine operates CES, an energy trading business whose purpose is to optimize the Company’s generating assets’ cash flow by entering into forward sale and purchase of natural gas and electricity. Based on spark spreads and the Company’s view, each year Calpine enters into various fixed price electricity supply contracts. One hopes that they also enter into a corresponding fixed price gas contract, but it is impossible to be sure. If the Company were to enter into a series of poor contracts, such “maximization” could produce significant future liabilities. [Such liabilities should be obligations of a subsidiary of CPN and or general unsecured claims of the holding company and should not rank ahead of the 2nd lien obligations in the event of a bankruptcy.]

Capital Structure
Calpine in structured as a holding company. The 2nd lien notes are obligations of the holding company enhanced by a 2nd lien position with regard to various holding company assets. At 6/30/05 the company’s capital structure consisted of – financial liabilities structurally senior to any holding company claims with regard to the operating subsidiaries and projects of slightly less than $7.9bn. At the holding company, Calpine had $785mm of 1st lien obligations, $3.7bn of 2nd lien obligations and $6bn of unsecured obligations. On a consolidated basis, the Company had roughly $18.5bn of debt and total assets of $27bn. The Company also has $1.5bn of derivative liabilities related to trading/managing its asset/input positions.

The holding company owns 750 MW of geothermal generating capacity (net of approximately $200 million of liabilities at the Geothermal assets), cash, equipment (turbines) and the equity interest in various leveraged subsidiaries (which support the $7.9bn of structurally senior debt), trading books and projects.

Holding company assets, on which the company has granted a 2nd lien: 750MW Geothermal, Cash, 14 Turbines, Equity in 25,750MW of gas generating capacity, and equity of CES.

Value of HoldCO Assets

Geothermal $1.5 to 2.5bn

Cash $0.4 to 1.6bn

14 Turbines $0.15 to 0.4bn

Equity in 25,750MW $0.0 to 7.0bn

CES

1st lien HoldCo Debt $.785bn

Recovery to 2nd lien holders $1.25bn to $10.7bn

Cost of 2nd lien at 75% $2.8bn

Given the Company’s structure and discrete assets listed above, it is important to realize that in a reasonable worst case scenario, the 2nd lien will not be wiped out. In a worst case scenario the 2nd lien will recover the value of the geothermal assets and turbine, and have a call option on the value of the equity in the Company’s power plant subsidiaries and projects. Such an option could be considered worthless on a point in time/mark to market basis, but the option would be perpetual and, in my opinion, have tremendous value. Thought of another way, the reorganized company would have debt to assets of roughly 30% and $250-$500mm of FCF (the approximate profitability of the geothermal assets) to the reorganized holding company. At a price of 75%, a buyer of the current 2nd lien notes will have created the NewCo equity at 15%-20% of tangible book value.


Operating Results
Calpine generated EBITDA (defined as Cash flow from ongoing operation available to service debt and pay capital expenses) of $1.1bn & $900mm over the past 2 years. The Company has interest expense of $1,500mm ($640mm at structurally senior operating entities, $75mm of 1st lien holding company, $330mm 2nd lien holding company and $460mm unsecured holding company) and should operate with between $250 and $350mm of annual maintenance Capex on the Company’s fully constructed generating portfolio. Calpine had approx $1.6bn of cash at 6/30/05. Absent a material, unexpected near term improvement in the Company’s results, CPN is not capable of paying interest or debt maturities from operating results. The lack of profitability has forced the Company into a number of “creative” financing solutions, including gas prepays, partial sale of trading division, operating company preferreds, and the sale of certain non-core assets. Unfortunately for the Company, but fortunate for 2nd lien holders, there appears to be fewer and fewer solutions outside of bankruptcy. Barring a miraculous upturn in results, I would expect the company to need to seek ch. 11 relief in mid 2007. A 2nd lien holder will make an attractive yield if the Company honors its 2nd lien obligations or if the company converts the 2nd lien bonds into new, well-financed equity. A buyer at 75% will have the potential to triple his/her investment assuming the business is worth replacement cost.


Catalyst – Current interest and eventual ch. 11 process

Catalyst