Knowing from the beginning of a year almost exactly what your revenue is going to be: sweet. Outperforming your peer group on share price: awesome. Being in the right place at the right time: priceless.
As things have turned out, the right time to take over the CFO seat at public power utility PPL was probably in June of 2014. That’s when then-controller Vincent Sorgi was elevated to the top finance role, a move prompted by PPL’s impending spinoff of its competitive power-generation business. Paul Farr, who had been the utility’s CFO since 2007, cleared the way for Sorgi’s promotion by taking over as president of PPL’s power-generation unit in preparation for later leaving with the spun-off entity as its CEO.
The spinoff was completed a year later, on June 1 of this year, forming Talen Energy by combining PPL’s generation business with others owned by Riverstone Holdings, an energy investment firm.
PPL was left with an entirely regulated power transmission and distribution company, with holdings in Pennsylvania, Kentucky, and the United Kingdom. Since then, its financial results have generally outperformed those of other players in the regulated utility industry. Meanwhile, Talen and its competitors in the unregulated power-generation industry have been battered, with the continuing glut of natural gas reserves and heightened volatility exerting a depressive influence on the pricing of energy and of company stock.
Sorgi recently spoke with CFO about the causes and effects of the spinoff. An edited transcript of the discussion follows.
What was the strategy behind the spinoff?
The purpose was to unlock what we thought was shareholder value that we were not seeing in our stock price.
The spinoff [had its roots in] 2008 and 2009. At that time 80% of the company was in competitive power generation, and our stock price was very highly correlated to the price of natural gas. We started looking at what would happen if natural gas fell all the way to $3, or $2 [per MMBtu]. Our stock price [which was in the $40s and $50s for most of 2008 and the $30s for most of 2009] would have gone down to something like $9. So we started looking at the strategic makeup of the company.
We decided to reweight the portfolio to add more regulated utility businesses in the mix, in order to create a much larger foundation of regulated cash flows and earnings. In November 2010 we purchased two Kentucky utilities from E.ON, the large German power company. And then in 2011, E.ON was selling two distribution networks in the [United Kingdom], which happened to be located right next to two that we had. We won that bid, and so by April of that year we had put the company on its head. We went from an 80-20 mix in favor of competitive generation to an 80-20 mix of regulated vs. unregulated.
The really precipitous decline in the prices of power and natural gas started in 2012. What had been 20% of the business [in revenue] became less than 5% by the time we put together our 2014 business plan. It was still generating positive cash flow, but it was creating enough volatility for the overall corporation that our stock was trading at a discount to our new peer group, the all-regulated peers.
At the same time, we found ourselves selling some of our generating units to raise cash to finance the capital needs for growth in the regulated businesses. Looking at this portfolio, we felt that our shareholders would be better off if we spun off the generation company and combined it with [the Riverstone] entities. The generation business could focus on growing without us cannibalizing it, and we could focus on the pure-play regulated business going forward. Our discounted [price-to-earnings ratio] would go away over time and we’d get valued more on a cash-flow basis.
The deal was structured so that shareholders automatically got Talen stock too?
Yes. Current PPL shareholders basically got a share of Talen for every share of PPL. Coming out of the spin our shareholders owned both companies and could either sell Talen or continue to hold it, depending on their investment risk profile.
But it seems as if you spun off a company that looked even before the spinoff like it was going to have rough times. What was the thinking about that?
We set up the balance-sheet structure for Talen to be very strong coming out of the spin. That’s something you look at with any kind of spinoff, because obviously you want to make sure both entities are financially viable. I would say Talen came out under-levered and in fact was the least-levered among all of its new peers. We did that to give the new company the opportunity to grow. If they wanted to grow via acquisition they had plenty of dry powder on their balance sheet to be able to do that.
So I wouldn’t say we set it up for failure. I think what’s happened subsequent to June 1 is that the market in general is not very favorable for the independent power-generation space.
Actually, the profitability of the companies in that space in all likelihood has gone up over time, because capacity pricing has gotten stronger and other conditions have improved as well. But the volatility and the risk of the business profile are perhaps more than investors are currently willing to take. Even when independent power producers have come out with good news, their stock prices have continued to drop.
Is there any remaining relationship between the companies other than as customer and supplier?
There’s that, and it’s totally independent now, just like our relationship with any other supplier. The only other thing is transition services agreements. Talen is in the process of implementing its own IT infrastructure, and in the interim they’re still using all of the IT systems and processes we had as a single company. We are providing transition services for a period of up to two years.
Is the deal working out according to plan in terms of the financial impact on PPL?
Things are progressing better than plan, in terms of both financial results and stock performance. When we announced the deal in June 2014, we said our earnings growth target would be 4-6% annually going forward, and our [total shareholder return] target would be 8-10%. In our last earnings call we guided to 6% earnings growth through 2017 — the high end of the original range — and we’ve increased our annual TSR target to 10-12% through 2017.
When we look at our stock performance vs. our new peer group of regulated utilities, if we’re not the top performer in 2015, [we’re among the top ones]. The other thing we look at is how we’re faring since the spinoff date compared with our former peers, hybrid generation-and-transmission/distribution businesses. We’re [about flat], and [Public Service Enterprise Group], First Energy, Exelon, and Entergy are all down, anywhere from 5% to 15%.
Clearly the spinoff was the right thing for us to do for PPL shareholders. Talen and the other independent power producers are down around 50%.
Now, some of our [improved] stock performance is because, as I said, we were trading at a one-and-a-half-turn discount coming out of the spin. Meaning, let’s say the average price-earnings multiple for a regulated utility was 15; we’d have been at 13.5. We’ve now gotten that discount down from 1.5 to 0.6. We’ve been out aggressively talking to investors, making sure people understand the strengths of the new PPL and our regulated assets.