We’re remaining bullish on the IPPs into 2019, particularly VST as our best idea for the year (note). We believe both companies are robust generators of free cash that provide attractive opportunities for shareholder-friendly capital allocation. VST is set to generate $4.4B in free cash over the next two years – allocated towards share repurchases (10% of market cap), a growing dividend, and debt paydown towards 2.5x Net Debt / EBITDA. NRG has over $2.5B of capital available to allocate in 2019, with the majority likely going towards buybacks, as the company has already hit its 3x Net Debt / EBITDA target. NRG’s free cash generation through 2020 would account for roughly 50% of its market cap. We believe the two companies can keep the two-year bull-run going in 2019 – share repurchases provide technical support and financial results should prove out the stability of the new IPP model.
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We view VST as our most compelling Outperform-rated stock in 2019. The company is attractively valued at only ~6x EV/EBITDA, mid-teens Free Cash Flow Yield, and sub-three Net Debt / EBITDA. Following the DYN merger the company is diversified across competitive markets and has a premier retail business that acts as a balance to wholesale power. We see strong EBITDA generation ($3B+/year) and conversion to Free Cash Flow (60%+) that drives capital allocation opportunities. In total, VST is projected to generate $4.4B of Free Cash Flow in 2019/2020 – allocated towards a mix of share repurchases, dividends, and debt paydown – see Exhibit 5. The share repurchases account for 10% of VST’s market cap and help support the stock. Our $31 Price Target is based on a mix of EBITDA and FCF, implying over 30% upside. Outperform.
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.
Utilities eked out a small 0.5% gain for 2018 on the heels of a massive Q4 rally as the market turned decidedly defensive ending the year down 6.2%. Utilities 670bps outperformance came despite a lot of headwinds on the group including higher interest rates (10-yr up 23bps), lack of tax reform benefits, over $15B of equity issuance, and the CA fires impact. Investors were looking for any place to hide and utilities fit the bill especially given their lack of exposure to tariffs and recession fears. Utilities came in second among income sectors for the year trailing only Pharma which was up 5.2%. Interestingly, all other income sectors underperformed the market in 2018 (see Exhibit 1). We remain cautious on utilities going into 2019 given their heavy dependence on a negative macro call and very high relative valuations (20% adjusted P/E premium vs the historic avg of 3%). In our view, buying defensive sectors at historically large premiums is not defensive.
Two years ago this may have seemed unimaginable, but as 2018 comes to a close, the power sector has had a great run. Since the end of 2016, NRG and VST are up 215% and 44% respectively, well ahead of the S&P 500’s 11% gain, as the new IPP model has worked – 1) better balance sheets; 2) more balanced business mix; and 3) disciplined capital allocation. In 2018 we saw the Calpine go-private and VST/DYN merger close, reducing the sector to two stocks. Amongst Integrateds, FE exited a bad generation business and saw its stock soar. EXC continued to benefit from the nuclear thematic as subsidies spread to CT and NJ. Meanwhile, PEG’s performance was more middling. As we look to 2019, these stocks have transitioned from self-help / fixer-uppers to execution stories. That said, market reforms will likely play an increasing role.
On Friday (12/14/2018), PJM held a meeting to discuss the latest on potential energy market reforms – publishing an updated white paper (link). Similarly, PUCT will host a meeting to discuss ERCOT energy market reforms on Thursday (see below). In PJM, the focus has been on reserve market procurement and shortage pricing, which if implemented is estimated to add $2.27/MWh to curves (offset by an estimated $5-30/MW-day decline in capacity prices). PJM is targeting a decision by the end of January, as its board had requested it. In both markets, these price reform proposals seem to be coming to a head. All else equal, both should improve pricing. That said, PJM and ERCOT forwards have seemingly continued to climb all year and anticipation of these reforms may be somewhat already embedded at this point.
Two weeks ago the IRS submitted a notice of proposed rulemaking to the Office of Federal Register – primarily providing greater clarity on the rules regarding interest deductibility limitations, particularly with regards to the utilities industry. The guidelines included language that interest deduction limitations would apply to the consolidated entity and that there would be a 90% de minimus threshold. For the mostly regulated utilities, this appeared satisfactory to avoid any potential issue, as they would be free of any cap on interest deductibility. For the utilities with under 90% regulated operations, there was to be a cap on interest deductibility set at interest costs up to 30% of EBITDA through 2022. Thereafter, the cap would be set at 30% of EBIT. This all appeared to be in-line with expectations across our coverage.
Last week, the PA Nuclear Energy Caucus released a report (link), detailing the impact of losing in-state nuclear plants and providing options to save them. Ultimately, the report favors modifying the state Alternative Energy Portfolio Standards (or implementing ZECs) with a “safety valve” that (depending on FERC’s PJM capacity outcome) would allow PA to adopt FERC’s proposed capacity construct designed to accommodate state’s preferred generation programs (Fixed Resource Requirement). The report strongly made the case against “doing nothing” and suggested moving to a carbon pricing program longer-term. The caucus has bipartisan backing heading into the 2019 legislative session. However, opposition is expected to come from the utilities, consumer groups, and strong oil & gas lobby. The IPPs are likely split, as FES and TLN could benefit given nuclear ownership.
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.
We saw two new power plant sales announced in the last week – first FES’ West Lorain peaker to Starwood Energy and then a trio of Emera plants in ISO-NE to Carlyle Power. West Lorain went for $264/kW, which seems consistent with recent history in PJM for peaking assets. The Emera plants, three CCGTs totaling 1,123 MWs, went for $525/kW. Notably, Emera acquired these same plants back in 2013 for $482/kW. Ironically, NEPOOL forward pricing was hovering around $50/MWh back then – similarly to where it currently sits. So this price point seems relatively fair.
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