Surge ahead for International Power

Since September, fears about an impending refinancing deal and a weakening US power market have sent shares in International Power falling by around 40 per cent. That means they are now trading almost 70 per cent below the two most recently issued analyst target prices of 450p and 456p, compared to a much slimmer 16 per cent discount for other large utility stocks. So can investors expect its share price to power back up again?

International Power has interests in 45 separate power stations in 21 countries in Europe, the US, Middle East and Asia, with 33,000 MW of power generating capacity. Long-term contracts currently cover 34 per cent of its generational capacity, with short-term contracts accounting for 29 per cent. A further 24 per cent is uncontracted, giving greater potential for volatility due to fluctuating power prices, although this area has performed strongly in recent years.

Since 2004, IP has grown both its profits and its asset base by shrewd recourse to the debt markets, and analysts believe IP has used its money wisely, snapping up distressed generation assets at keen prices. But this expansion strategy now looks past its sell-by date. Not only is borrowing more difficult and expensive, but the power price rises that have driven up the value of its generating portfolio now appear to be in reverse. That means the company is more reliant on the merchant markets than ever before.

Nevertheless, the operational story is encouraging. At its, the European business reported a 12 per cent rise in operating profits, although this was eclipsed by news that unplanned outages in the UK and Australia would wipe around £60m from full-year operating profits. Broker Deutsche Bank has since upgraded its forecasts, however, noting that IP has made the most of a tight UK generation market (thanks to outages from rival generators), and commenting that Europe was performing more strongly than expected. This region accounts for more than half of the company's profits, with 50 per cent of these from the UK.

And analysts agree that what has caused shares to short-circuit are fears surrounding a £550m refinancing due in 2010. For a company of IP's size, these worries seem surprising, but the answer can be found within the group's structure.

While the parent company has debts of just £395m (12 per cent of assets), underneath this structure, every power generating asset sits within its own project company (there are 45 in total). Given the long-term contracted nature of these assets, most are geared at between 80 and 90 per cent. Importantly, these companies are financed on a non-recourse basis. So, in the event that one project encounters difficulties - which can never be ruled out in emerging markets like Pakistan and Indonesia - this would in theory be ringfenced from the rest of IP's operations.

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To date, the 'non-recourse' arrangement has not been tested. However, the credit rating agencies have expressed their concerns in the form of the group's 'BB' rating, and some brokers insist that the rather thinly capitalised holding company would have to inject more equity if a project went wrong. But analyst Angelos Anastasiou of Pali International argues that IP's strong track record of post-credit crunch refinancing stands it in good stead for future negotiations. The company successfully completed £100m of refinancing last year, not to mention securing new non-recourse finance on a €448m (£416m) project in Belgium. He also forecasts that IP's shares will be yielding 5.1 per cent in 2009, compared to 4.5 per cent for the sector.

Weaker power prices in America are worth keeping an eye on, though, as this market typically accounts for around a fifth of profits. By this time last year, IP had forward-sold nearly 70 per cent of its US generational capacity. This year, it has intentionally held back, believing that power prices will improve as the year progresses. If this is the case, and a hot summer causes Americans to switch up their air conditioning a few notches, IP will do better than current analysts' estimates. If prices remain flat and summer is a washout, they could be adjusted downwards.