For the second straight year, FERC tried to steal the spotlight from the NCAA on the first day of March Madness, but this year the consequences were not nearly as drastic for midstream companies. FERC opened an NOI for the ROE rate setting process for oil and gas pipeline companies. Among other questions, FERC has asked for stakeholders’ opinions on the validity of the current two-stage DCF methodology and whether or not to incorporate CAPM, risk premium, and expected earnings models. As FERC awaits feedback, investors are contemplating the possible outcomes. Could the expanded approach impact ROEs significantly? When would the proposed changes come into effect?
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We thought results in Q4 were solid with an average EBITDA beat of 3%. DCF/share growth of 8% YoY in Q4 was down from the breakneck double digit growth seen in Q2 (13%) and Q3 (18%), but is clearly still attractive total return when combined with safe 7% yields. Our updated forecasts still call for 5% DCF/share growth in 2019, preserving a low double digit total return investment proposition. That said, the group now seems more dependent on a valuation call near-term given more uncertainty over the pace of production growth and concerns over high levels of competition and a cyclical shift toward potential overbuild.
Can utilities keep the defensive rally going? We’re skeptical. Utilities beat the market by 1500bps in Q4 2018 and outperformed 670bps for the year. This may continue near term given a host of negative macro signals, but these big defensive utility moves have historically been good times to take profits in the group.
Market volatility in October caught many off-guard and the hope was things would settle down post earnings. Well they got much worse spurred by the disruption of the CA fires. PCG and EIX ended November down 44% and 20%, respectively, on the heels of the destructive fires. These were popular value names in the utility space and their sharp stock collapses clearly caused investor pain. However, the second derivative impact was just as meaningful. The “Anything but California” trade took over amidst utilities, lifting already expensive low-risk utilities to higher levels. Many investors got just as hurt by being short or underweight these names as being long CA. With investors suffering and year end approaching, the last two weeks have showed signs of portfolios shrinking and extreme risk-aversion which has only exacerbated the problem. Everyone needs a holiday.
Last week, as the California utilities collapsed amidst the fire risks, we saw increasing investor focus on second derivative impacts. One of the obvious ones relates to renewables contracts with the CA utilities, especially PCG who drew down their bank lines last week. The primary concern is what will happen to these contracts in the event that PCG files for bankruptcy due to all the fire-related claims. This primarily impacted NEP and CWEN, given they have the most exposure, though there has been somewhat of a relief rally as investors realized the chance of a PCG bankruptcy in the near-term is low. Importantly, even if there was a surprise filing at some point, we believe these power contracts with the California utilities are likely to hold up. We are buyers on the recent weakness and view NEP as a top idea here.
The annual EEI conference will be held November 11-13. Management from most of our covered companies will be there. This report is a helpful guide for investors attending and includes questions to ask each company and summary model information. Some of the industry topics we will be focusing on include:
Utilities fell 0.9% last month underperforming the S&P 500 by 130bps and they now trail the market by 900bps YTD. This is actually better than feared given that bond yields jumped 20 bps last month and remain near multi-year highs; plus the sector saw more equity issuance with CNP’s $2.5B of equity/converts at the end of the month. Other income sectors performed worse led down by REITs (-3.0%) and MLPs (-1.6%). We remain cautious utilities right now mainly as we sit on the edge of bond yields potentially breaking out to 7-year highs. Short interest remains subdued at the moment and valuations are still just slightly below the market multiple. The one positive is that the large equity deals appear to be near the end with only ED left (estimated $1.2B). Q3 earnings season for the broader market and the midterm election reaction will likely be key events to see whether the bond market and utilities break down. We remain Underweight.
We look forward to seeing you at our Wolfe Utilities & Energy conference next week. Participating utilities/power companies are on the right and there is still time this week to register (here). The conference provides a unique mix of company presentations via panel discussions and guest speakers that provide industry insights. This report is focused on the utilities and power companies with a list of questions to ask companies, model summaries and industry themes below. See separate reports with questions for energy companies (here).
Last week we had the opportunity to meet with INGAA and the staff of FERC to review the latest on the changes on the pipeline regulatory policy front and the next steps to watch for. Overall we got a better understanding of the legal constraints FERC was under that led to the decision to change MLP tax policy to eliminate the tax allowance for cost based pipelines. We came away with the view that there is not much room to change the policy. In that context it is not a surprise that in front of the 501-G filings this fall that already many pipeline MLPs are moving toward corporate structures - SEP, EEP, WPZ, BWP, and TCP. Despite the MLP tax policy change being unwelcome, we still believe the acceleration of structural changes is a good thing for the sector.
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