Momentum has no valuation ceiling while risks and uncertainties have no valuation floor. This is the story within utilities and among the market overall. A choppy Q2 due to unfavorable weather and weaker core sales growth seemed to only exacerbate this trend. A few companies appear to be re-rating on lower risk perceptions – ETR, FE, EVRG, SO, EIX, SRE – but otherwise we continue to see more divergence between the pure play safe regulateds vs those with diversified businesses or project/regulatory risk. Given our value focus, we are resigned to keep focusing on the messy ones.
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AES underperformed the UTY by 500bps today (08/06/19). This came despite no big surprises in 2Q results. AES reported 2Q EPS of $0.26, matching our estimate and a penny below consensus. FY19 guidance was narrowed to $1.30-1.38 and still targets the same $1.34 midpoint. There was a fair amount of questions on the call related to DPL’s DMR in light of the OH Supreme Court’s ruling which deemed FE’s illegal. But nothing we heard on the DMR was new. Perhaps some of the stock weakness was related to the DMR, but we think prevailing macro headwinds on trade issues is more to blame given AES’ emerging markets exposure.
Utilities rose 3% in June on the back of continued declines in L-T rates. But the market left utilities in the dust rising 7% for the month. The S&P 500 is now up 17.3% for the first half of 2019, the best performance since 1997. Utilities have held their own up 12.8%, but still trail by 450bps. At least so far, it appears that lower interest rates are helping the broader market more than utilities. Lower rates are a double-edged sword for utilities (see our recent report), as they can lead to lower allowed ROEs in rate cases. Several of the more near-term exposed companies – PNW, CNP, AGR, ED and AEE – were among the worst performers last month.
CA Utilities – Gov’s plan, Gov’s plan
CAL Watch – CA nonpartisan advisor issues report on allocating utility wildfire costs for lawmakers
PEG – Selling its stake in Keystone/Conemaugh coal plants
PEG – Ørsted’s Ocean Wind offshore project selected in New Jersey RFP; PEG has option to own
DTE – Elects Jerry Norcia to become CEO effective next month; Gerry Anderson to become executive chairman
Macro – The dividend investing playbook – near term tailwinds for yield-focused investors; AES, D, EVRG, OGE, PNW, and SRE screen attractively
SRE – Files to more than double size of Port Arthur LNG and proposes pipeline to serve it; long-dated options
Midstream of Consciousness – Oil market uncertainty rising – a look at stock correlations; Updates on MVP
This morning (6/19/2019), the OH Supreme Court issued a 4-3 ruling ordering the removal of FE’s distribution modernization rider (DMR) from customer rates. The majority found that in authorizing the DMR, the Public Utilities Commission of OH (PUCO) “failed to place any conditions on the additional funds that would allow the rider to act as an incentive”. Our understanding is that the order is effective immediately, with the DMR benefit ended only on a prospective basis. FE’s $132.5M/yr (post-tax) DMR was originally put into place to help keep its balance sheet healthy while enabling grid mod investment. AES $83M/yr (post-tax) DMR was specifically put in place to de-lever DPL in order to allow for a financially stable utility (prev junk rated). Both have extension requests pending, but only AES embeds approval within its forward guidance.
The revival of the US/China trade war stopped the 2019 bull market in its tracks with the S&P 500 falling 6.6% and bond yields declining 36bps in May. Utilities were a place to hide and only fell 1.3% beating the market by 530bps. For the year, utilities are still slightly trailing the S&P 500 (9.4% vs 9.8%) though it feels like they are way ahead. Utilities are back to a 21% P/E premium to the market vs a historic average of 3%. They have hit this level a few times before – including this past December – and its proven to be great selling opportunities since this premium never lasted. So while we worry about the economy and trade wars and bonds going toward zero yields, we still think buying utilities here is buying near a peak and stay Underweight. With rates this low, we are more wary of utility rate cases and ROEs – last month we saw NY PSC staff recommend an 8.3% ROE for ED.
We hosted investor meetings today (5/13/19) with CFO Gustavo Pimenta. Despite recent stock weakness, the tone of the meeting was constructive with Gustavo highlighting AES focus on de-risking the business and expanding renewable, storage and LNG platforms. Mgmt sees their stock as very cheap on straight P/E, pointing to European peers (eg Ibedrola) which trade near 15x on 2020E whereas AES trades just above 11x. We remain Peer Perform with a $17 PT which is derived using a weighted-average of our three valuation methodologies (SOTP, target FCF, discount utility P/E); see pg 5.
AES underperformed the UTY by 140bps today despite announcing an incremental $100M cost cutting initiative. The cost savings are expected to be realized at the SBUs by utilizing technology (robotics, drones, etc.) to lower maintenance expense and increase plant availability. AES expects to realize the full run-rate by 2022, with the bulk of the savings coming in 2021 and 2022. Our sense is that the incremental costs cuts will be a positive driver within AES’ current guidance or act as an offset to unforeseen issues if needed. Overshadowing AES’ Q1 update was renewed concerns for emerging markets (i.e., Trump trade war rhetoric with China). Recent news stories concerning Argentina’s economy / presidential election have also been unsettling as a Macri loss in October could change the pro-market narrative in the country.
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