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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Quietly our Wolfe Yieldco Index has become the top income sector YTD and the only one beating the S&P 500 (see Ex 1). Yieldcos have overcome the huge uncertainty caused by PCG’s bankruptcy filing in January. Why have they done so well? 1) long-term contracts that are not subject to ROE resets like utilities so should benefit directly as interest rates fall; 2) the neighborhood improved meaningfully as parent companies changed from distressed owners to higher-quality parents (SunEdison to Brookfield, Abengoa to Algonquin, NRG to Global Infrastructure Partners); 3) Its Renewables stupid – the top growth space in energy with huge economic and tax subsidy momentum. While we are a bit wary of competition and financial discipline in renewables, we think the backdrop remains bullish. There is no better way to play all of this than NEP given their connection to industry leader NEE, huge growth backlog, cost-of-capital advantages and visibility on 15% dividend growth for at least the next 5 y
AGR missed expectations badly for the second consecutive quarter to start 2019 – posting Q2 EPS of $0.33 versus consensus/us at $0.40/$0.39. Primary pressures were non-deferrable storm costs and weak wind conditions, which also caused the company to cut 2019 guidance. That said, trimming the top-half of the range to $2.25-2.35 was perhaps better than feared, considering consensus ($2.23) was already below the range. The primary offset is an aggressive cost cutting initiative targeting $70-85M in savings this year and renewables asset sales ($0.05-0.10 in guidance). The stock traded in-line with peers on the day, even after recent underperformance. Questions remain on financial credibility – namely assumed wind conditions and operational issues.
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.
Utilities have rallied on the large drop in interest rates in recent weeks. For the year, 10-year Treasury yields have dropped to 2.01% from 2.69%. While underperforming the market, utility stocks are up 12% YTD and valuations are at or near all-time highs. This has been great news for investors, but lower interest rates are a double-edged sword for utilities. They increase the risk of lower allowed ROEs in rate cases which have otherwise held pretty stable over the past year. In this report, we identify those most and least at risk to ROE cuts and highlight pending cases with ROE sensitivity.
Our annual utilities pension review – still underfunded, not much progress
Our utilities pension review, with help from Wolfe’s Accounting/Tax team and their comprehensive report, takes a look at the state of pensions in the sector using year-end 2018 data. Utilities remain underfunded for their pensions/OPEB – with most companies in the same place amid weak equity markets and higher rates. This dynamic has reversed in 2019, with yields sharply falling. There remains wide disparity in funding levels and accounting assumptions within our coverage.
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.
Utilities rose only 0.9% in April, while the market rallied another 3.9%. Utilities are now underperforming the market by roughly 670bps YTD; they have given back their entire 2018 outperformance. So, what should investors do now? The stock market rally in 2019 is becoming historic - this is only the 3rd time in the last 40 years the S&P 500 rose more than 15% in the first 4 months. One of them ended badly - the 1987 crash during which utilities outperformed. The other year was 1983 - the market flattened out the rest of the year while utilities continued to underperform. We also looked at years where utilities underperformed 650bps or more in the first 4 months as well. This has happened 16 times in the last 40 years. Interestingly, 10 of those 16 years utilities continued to underperform into year-end by an overall average of 200bps.
AGR continues to struggle with inspiring investor credibility and Q1 results did little to change that narrative. The company reported EPS of $0.71 that missed consensus/us at $0.80/0.79. The disappointment was primarily driven by far weaker than expected wind conditions (-17% vs. normal) and winter weather that caused ice on turbines forcing shutdowns. While AGR was able to reaffirm guidance at $2.25-2.40, the Renewables segment was revised lower; offset by a one-time tax benefit at the Corporate segment.
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