Vistra Corp: Full Stack Energy Provider - [Business Breakdowns, EP.138]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from, and we are here to bring them to you. To find more episodes of Breakdowns, check out joincollossus .com. All opinions expressed by hosts and podcast guests are soleater -owned opinions. Hosts, podcast guests, their employers, or affiliates, may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. I am Zach Bus and investor at Arrini Capital, and today we are breaking down Vistra Corp. Vistra is an integrated retail electricity and power generation company. It was spun out of energy future holdings and its emergence from bankruptcy and subsequently combined with Dynagy in 2018. The company through its subsidiaries is involved in electricity, generation and wholesale and retail energy sales to commercial municipal and residential customers across the US. The company serves four million Americans across 20 states producing 37 ,000 megawatts of capacity, enough to power 20 million hopes.

1:31To break down this, I'm joined by John DeGolis, partner and portfolio manager at Sound Shore Management. We go through the dramatic evolution of the industry, including John's history with Enron and TXU energy, the acquisition track record of Vistra, including its recent acquisitions and merchant nuclear power provider, Energy Harbor, and zoom out on the broader electricity production and distribution business and history in the United States. We hope you enjoy this conversation on Vistra Corp. All right, John. Thanks for joining us to break down Vistra. I thought an interesting place to start would just be with your history with this industry Obviously, it's been punctuated by the likes of Enron and TXU or energy future holdings And so why don't you got to take us through the last 25 years of how we got to where we are today.

2:22We've gone through a long period of time here since the early 90s deregulating not all of but parts of the electricity markets in the US They had this very long transition from a fully regulated electricity business or markets, if you will, with the traditional regulated utilities that everybody knows of the Duke energies and soathers of the world to breaking up the market a little bit between the generation side, so the actual making of the electricity, the transmission and distribution side of it and then the retail side of it, which is actually procuring the customers and delivering the power.

3:05And some markets remain completely for the most part still regulated all the way through. And the local utility has all three of those services. And then you have markets like Texas, which the acronym for it is ERCOT, where those three functions are actually split up. What you've seen is a series of business models trying to take advantage of the opportunity to be either a marketer or a retail provider, just a T &D or wires, and then just a merchant energy provider, which is the term people use for the generators. All the while competing with the fully regulated utilities, you have a series of regulators that are involved for obvious reasons, electricity and the sustainability or reliability of electricity is so critically important to our society that there's a pretty heavy regulatory overhang.

3:58So you take a step back and look at what happened in the late 90s and the most famous episode, of course, had to do with Enron, which originally was a natural gas pipeline company. They then forward integrated into the electricity markets, natural gas, of course, being a very important and fuel source to generate electricity. And at the time, some of these markets were opening up, and then Ron got into the electricity business and so did El Paso when there were a whole host of names back then. And they got themselves into trouble in a lot of different ways, but mostly by taking advantage of the accounting rules at the time, where if you booked a, let's say you booked a 10 -year commitment to deliver electricity to a commercial provider somewhere, and it It was 10 million bucks a year, so it had a nominal value of $100 million.

4:54You could then discount it back and at the time you could assume a margin and book all that as profit in the year that you actually contracted for it. And of course the cash flows would follow along on a 10 -year basis. And so that and a nut shell is what Enron was doing, not only in the electricity markets, they started doing and broadband and other places. And so the reported earnings were nowhere near what the real cash flow was at the time. And of course there were some debt involved. And so this all came crashing down, which was the first wave of restructurings that happened in the energy merchant power markets.

5:31And then in the 2000s, and this is where I'll get into the beginning of what is now Vistra, TXU, which was the utility in the northern part of Texas, basically Dallas and the surrounding areas. also had some exposure to these power markets and the stock was whipped around and they had some wholesale power businesses that they ran that got themselves into trouble. They brought in a turnaround executive to cut costs and rationalize the business which he did and stabilized it. Good cash flow generator and famously as well was at the time the largest LBO in history and that was at the time in 2007 when TXU when private led by KKR.

6:14Because of the nature of the electricity business, historically, particularly on the regulated side, capital intensive business, very low growth, mostly regulated for the history of it. Dad is always involved. These are levered balance sheets because the cash on cash returns for the business over time are usually in the mid -single digits. And so to get yourself into the low -double digits, It's, or even around a 10 % ROE, you needed leverage. So often there is debt and levered capital structures have also been a big part of the history of this business. I'm bringing that up for a reason. You know, you're then famously an LBO, of course, is by definition using leverage.

6:57And so TXU levered themselves up just at a time when we were about to have a natural gas glut and for reasons that I could certainly spend a lot of time on it. But on the margin, when you look at the sources for electricity, natural gas, which is now about 40%, just under 40 % of the fuel source for the electricity in the United States today. In many markets, the price of natural gas is the key fuel source in driving the changes in electricity prices. The bad luck, I guess, on the part of a KKR and the management team, but in early 2000s, the Shale Revolution hit. We found a lot more very low -cost gas in the United States.

7:42Gas prices went from eight bucks down to two, or even less. In a many markets, electricity prices followed. And so those generating assets were making far less money than they had predicted. and ultimately was one of the largest bankruptcies ever in 2014. So now you have a second set of restructuring in bankruptcies in this. At the time was really the beginnings of the merchant energy and deregulated electricity markets. Vistra, at least the major part of it, is actually the generating assets. plants. So the power plants, if you will, from TXU, they called it luminant at the time. These consultants come up with these names.

8:30I have no idea where they come up with them, but it was called luminant, which was the power plants. They've got a nuclear facility. They've got gas plants, coal plants at the time, a little bit of wind, but traditional fuel source plants. They then also began to do some acquisitions on the retail side. And so that's when you're a provider of the electricity. You actually don't own any physical assets. And so that's today's Vistra. So I think we've done a good job setting the stage for how this business came to be in its current form. I want to spend a couple of minutes here going deeper on the specifics of their business model.

9:12So maybe just start with a brief overview of how you'd explain this business to somebody that was completely unfamiliar with Vistra specifically in the markets they operate in and what their revenue model is. So the Vistra of today is a generator and marketer of electricity. And it's about three quarters of what they'd call a merchant generator. So these are power plants that generate electricity. And then about quarter of the businesses, what's referred to as their retail business where they are the actual client facing contact for both retail and commercial customers to source their electricity.

9:54And that business is around a billion in EBITDA, so it's about a quarter of the size of the profitability. That business, the retail business is principally in Texas. They do have some smaller exposures in other parts of the country, but that business is for the most part in Texas, what's known as the ERCOT region, you know, electricity region. And on the generating side, Texas is also their biggest region, but they also have exposure in the mid -Atlantic and Midwest, which in terms of the electricity or regional transmission organizations is called PGM. And that stretches from all the way across the United States, It's starting in Illinois and moving all the way across and through Ohio and some in Pennsylvania and so forth.

10:43So those are the two principal regions. They also do have some exposure out in California. That's in the form of a couple of gas plants and then also two big storage facilities as well called Moss Landing out in California. So that's their business. And they make money by selling electricity. So they're either selling electricity through the wires in all those different areas. So whoever owns the transmission and distribution and they do it by nuclear facilities, natural gas powered coal, wind, solar, and even battery as I mentioned. So it's all of the above, if you will, in terms of the way they generate the electricity, but nevertheless they're selling into those markets.

11:23And then the retail business makes money as a spread, as a retail customer. You could sign them up called TXU Energy in Dallas or Houston. And they'll be your electricity provider. And then they go and source the electricity sometimes because they've got their own generating facilities in Texas. Those electrons could be coming from their own generating facilities or they've got a wholesale and trading operation that sits in between these two businesses and if it's more economical for them to go out and buy the power from another source, they'll do that. There's a natural hedge there as well as you might imagine.

12:02The retail business is inherently short power. They're sourcing it from different places. They don't have their own generating facilities and then the rest of their business is inherently long power. Ultimately and principally in the Texas market, they're still net long power for the whole company together, but that's how they make money. Maybe now, I think the best way to do it is just to talk us through the value chain of merchant power from generation to retail, and then you alluded to where Vista sits in that ecosystem, but now we have all types of pressures around renewables, the inflation reduction acts, how do you think about where they sit within this industry and what's important?

12:42On the last 10 years, the big change in the electricity markets has been the rise of alternative renewables, if you will, so wind, solar for the most part. The political and regulatory push to develop those as fast as we can, given the overall needs to get our carbon footprint down. This has been going on actually for years and there's a lot to still go but it's a combination of closing for the most part the coal plants which you go back to the year 2000 or even 2010 and coal would have been 40 % of the US's fuel source today. It's a 23 and it's projected to be less than 10 % 20 years from now.

13:34natural gas has grown because of the shale boom and the low cost of natural gas. And it's also in spite of it being carbon much cleaner than coal plants. And then the alternative is grown. And so depending on the region, you've seen it. First, it was mostly wind and now solar is coming quickly behind it. And so renewables today are around 20 % of the generating capacity. and that's supposed to more than double over the last 20 years to something in the 40 to 50 percent range. The other thing that happened was the Fukushima accident in Japan highlighted the safety risk of nuclear plants. Still have nuclear, which is around 19 percent of the stack today.

14:24It's been pretty steady over time. It's still supposed to decrease slowly over time, but we now have incentive to keep the plants that are still open open and I'll get into that. So in Fukushima there was a concern that these old plants because most of the nuclear power plants are 40 years old or more and there's a bunch of different technologies to talk about. But that was a pretty unique problem being on the coast in Japan and the way the heating and cooling system worked. It was susceptible to that meltdown. Ultimately the health risk was There's the first, de minimis in spite of the scare.

14:59And you had different reactions around the world. And you asked, thankfully, they very quickly took a look at our nuclear fuel plants, reinforced the safety systems and cooling systems where they needed to be closed. A couple of plants that they thought this highlighted were an elevated safety risk. But otherwise just reinforced them and kept them open. What impact have those changes in this transition to cleaner fuel sources had to the supply demand dynamics in the energy market? And then can we talk about specifically how Bistro fits in? So you fast forward to today and you've had this transition that has been at different paces and different places, but it has led to a market now where we have closed a lot of the old or carbon -based fuel source plants, replaced them with renewables, which has brought our carbon footprint down.

15:50And so when you look at energy -related carbon dioxide emissions, So this isn't all of the United States, but just the energy related. They have dropped from 6 ,000 million metric tons of CO2 emissions in 2000 to around 5 ,000. So most people don't know that. I mean, we've actually been reducing our carbon footprint from an energy. Now the pace needs to be faster, and obviously we need to get an absolute basis, get it down a lot more, but we've actually been reducing it now for the last 20 years, given what I just said that's the good news. The bad news is and we're finding this out now because of the brownouts that are happening and the weather -related risks that we're seeing in places like Northern California and some of the coastal areas as well with the storms.

16:42The system's a lot tighter and the reason is in spite of an overall nominal capacity that appears to be add or above what we had before, the reliability of the wind and solar is not there for obvious reasons. You need the wind to blow, you need the sun to shine. Those that are intermittent, if you will, they peak at certain times during the day where their patterns can change it. And the ability to store electricity is actually really difficult. At the moment, the battery technology that we use is the same chemistry that was developed 50 years ago. It has its limitations. We're getting better at using them and we do have some utility scale batteries.

17:25And in fact, Vistra has the largest utility scale storage facilities in the world in California in Moss Landing. And they're very expensive and they only give you about four to six hours. which is amazing actually when you think about the amount of time and money that gets spent on these things. But that's helpful, particularly if you're in California and you renewables are a third of your stack and you're having liability problems, these batteries are important. But it's not just the overall demand that's changed and the fuel source. It's also the load is changing. So when you're having your peak periods of electricity is also changing, which is making the demand supply problem even worse.

18:11And so my point being it used to be in most of these markets, the peak peak day would be four o 'clock on an August afternoon, a hot, hot day late in the afternoon in California, but even in other parts of the market. And now, because we're using electric heat pumps in more than a third of homes, and that's increasing, you're now having loads that are peaking sometimes on winter mornings or when you have storms and you knock out all of the alternatives wind and solar and you're dependent upon only more traditional fuel stack of coal, nuclear, and gas and so now your capacity is down and your demand draw is up and you've got a problem and so we've seen that in a lot of places I met with a senior executive of a regulated utility that has business in the Northeast a couple weeks ago and I was talking to him about New England and he said I'll put it to you this way.

19:16New England, which is avoided most of these problems so far. At this point in his words has one foot on a banana peel and another on a bar of soap. And so these markets are tight and what we need is reliable, base load power and that comes from nuclear power plants, gas plants and the few coal plants that we still have open. Okay so John you've set up the groundwork very well. I love you to explain now how Bistra is positioned in light of these tight markets and then the secular shift to renewable energy. They are a set of assets run by a management team that are built for this time. They have all the fuel sources.

20:04They have a wholesale power team that can manage and see what's happening in the markets and take advantage of the volatility. They have a retail business which is a natural hedge as well but they still are net long power. And if you manage it appropriately in the market that is now basically short power and will be for years because this takes a long time to fix. They are making more money than even they had expected and I think probably will for the foreseeable future. And so this is a business that you go back to a couple years ago, they were hoping to make three billion of EBITDA and maybe a billion dollars of free cash flow.

20:52They're now making $4 billion of EBITDA and a billion and a half of free cash flow. And I'll get into my definition of free cash flow, which is different than you see on their reports because they give it to you before growth. I'm a little more conservative. I'm using free cash flows, I call them cigar box. So after everything, all in, after working capital and growth capital, what is actually left over? It's around a billion and a half dollars today. The market has come their way. And then the last piece is the nuclear side of it. So we've gone from nuclear power plants that are all going to be closed because they were old and they're expensive and there's the black swan safety risk and Fukushima concerns.

21:33To now, oh my god, we're short power. These are no carbon. They're already here. We've reinforced their safety and cooling mechanisms. We need to actually keep them all open for as long as we can while we continue to build out and reinforce our wind and solar and decarbonize over the next 25 years. And so there's been this complete flip and it's not only from industry and regulators, but even environmentalists, which wholly, mostly against nuclear 10 years ago, I'd say this split now is probably 50 -50. The regulators have completely flipped so much so that in the IRA, so the Biden administration's legislation they put in there a production tax credit as a price support for nuclear facilities to incent them to stay open and It's remarkable most people still don't know about this It starts next year It pays a minimum and there's some other nuances, but just simplistically price of $43 .75 a megawatt to a nuclear power plant that qualifies and I can get to that, but it's a price floor.

22:51Now you have the nuclear stack which constellation energy is almost all nuclear and you have at Vistra one nuclear power plant and they are buying energy harbor which is three more plants that are nuclear and that is going to close this quarter so they're taking their mix to increase the nuclear side of it. So you now have that value that's accruing to these nuclear plants and it's not just baseload, cheap power in a market that is inherently short in certain times. But it's also green. You're selling into a market that's tighter in the traditional sense and then going forward they're going to be getting premiums and they're starting to get premiums because it's no carbon power and so for green hydrogen, which we can get into, for data centers, the constellation just signed an agreement with Microsoft for their new data center in Virginia to provide 24 hour green power to them and it's at a premium.

24:00So you got a market where prices are up and then the nuclear side of it is now getting premium. So the value of those nuclear plants has gone up quite a bit. And so when you used to traditionally try to think about how you would value a business like this high -fix costs highly volatile commodity -oriented end markets that would whip all over the place just enormous volatility in the end market pricing Usually levered these would trade for very low multiples now for a nuclear power plant and In particular both Vistra and constellation have good balance sheets You have a power market that's inherently tight and will be for years.

24:41You're getting a premium for your green power and you have a price floor. So put that into your DCF. It's worth a lot more. Vistra, particularly after they buy the energy, Harbor will continue to be a very well -positioned set of assets with a management team that is extremely focused in on maximizing the value of these businesses. They're basically slowly going private by buying in the stock and returning capital in form of dividends as well. Just in the last four years, they reduced the share count by a third and they're continuing to do that in a marketplace that now has come their way. Obviously, when you're dealing with industrial utility, associate industries, from a financial on the analyst perspective, we look at it one way, but then what people see when they pay for their energy bills at the end of the month is different.

25:37And you kind of take us through from a first principle basis how a business like this generates revenue and what the margin structures look like as a function of how it makes money. The deregulated construct is set it up where there's three main parts to the business of delivering electricity. One is the power plants that make it. the second are the transmission and distribution, so the wires that move it from the power plant to your home or your business. And then the third is the actual client relationship what's now referred to as retail. And Vistra makes money on the first one. Obviously they have the power plants and on the retail on the third one.

26:19They actually don't really have any of the T and D. And when you think about how much we all pay for electricity and US consumer pays is something like 18 cents or a kilowatt if you will and it's as low as 12 and as high as in California to my point before given their regulatory push for renewables the average consumer there's paying 28 cents so it's a lot and When you break down that say 18 cents it depends on the market it, but it's 20 % the retail side of it, another 20, 25 % the T &D, so the wires and then the rest about half of it is the actual generating. That's not the revenue breaks down.

27:06And then the returns, if you will, vary all over the place for the participants and all three of those, depending on their cost structure. The retail business, although it's quite good for Vistra, is very volatile. You're inherently short power. And again, their integrated model allows them to source the electrons both from their own stack or their marketing guys can go out and buy it in the open market. So they're able to manage that volatility. and for instance, in the case of Yuri, a lot of the smaller retail players in the Texas market went out of business. And so they stayed in business, given there it was absorbed the losses and they've grown quite a bit in that business.

27:53But that's a low return business. I'm going to say high single digit RLE. It's not capital intensive. So when you get it right, you can generate a lot of free cash flow, but it's not a high return business. And then the T &D business also is mostly regulated. The returns are in the 8 to 11 % ROE, and that's what's leveraged because it's just an infrastructure business that's mostly regulated in almost all the markets. And so that's a low -stable return low -growth business as well. And then the power plants is where most of the volatility really lies because of the volatility of electricity prices, which move all over the place.

28:37And again, it's a business that has booms and busts over the years has also been a very low return business. I mean, generally speaking, the electricity business is a bad business. You may find it funny to have me say that, but it is. It's very capital intensive. You've got commodity markets, you've got weather, you've got regulators. There are very well run utilities that have good regulators that have been pretty good businesses. But even those that are very well run are low growth, low return businesses that the market trades them like bonds for obvious reasons. What you really only get is the dividend yield and some very modest growth.

29:21and then every once in a while, in a flash, you go out of business, which doesn't happen very often. But you've seen it in Northern California and the wind and the fires and now Hawaii electric. There are instances when tailors are enormous. And so it's a tough business. The returns are inherently not very good. But as I said before, we are in a different place now than we have been for decades. And not all assets are positioned well for it. There's been a lot of money thrown at. The alternatives, you've seen it. And we can talk about some of these stock prices or companies that boomed when there was no interest rates and a lot of green money chasing the decarbonization theme, which is happening.

30:15It's not that it isn't happening, but as You got a lot of companies that their participation really doesn't end up being nearly as profitable as they thought it was going to be in their balance sheets Don't have the strength to absorb the volatility So that's where we are at the moment and a traditional player like Vistra that has all of the above on the fuel sources So everything from old coal to new wind and solar and the nuclear in the middle with a very good balance sheet and season and management team is particularly well -positioned. So a key question for utility investors and utility customers is typically the allowable level of return on equity.

30:52And so I'm just curious in the context of a business like this, are there any limitations on who they can charge what? I hate to say it depends, but it really depends on what region you're in for the fully integrated electric utilities, which is still a large portion of the United States. You've got a state electricity council that oversees the rates that are charged and also the returns of the low utility gets. So you have to set those up through the regulatory agencies, but they work hand in hand and understand it's a cost plus model in a sense. And as long as you can justify, these are my expenses, which of course get it audited and they discuss these things all the time.