From our investor meetings and surveys, most seem to agree with our underweight utilities view. Nonetheless, the sector is keeping pace with a strong bull market YTD and most investors are asking why? We think: 1) Rates are staying stubbornly low – 1.8% on the 10-yr; 2) Protection from risk of a market correction; 3) Protection from the risk that Trump has a setback and the Presidential race gets closer; and 4) Utilities are momentum stocks now. On the last point, utilities became the second highest weighting after Tech in the ishares MSCI Momentum ETF (MTUM) in December. We wonder if this means they won’t be that defensive if the market corrects.
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We thought NI could get past the 2018 Mass. gas explosion last year, but more operational concerns and lingering regulatory and B/S issues got in the way. We like the risk/reward here and see 2020 as a de-risking year for NI as it removes equity overhang and resolves lingering MA reviews. But it’s not just de-risking – we think NI has upward bias to its 5-7% EPS growth rate long-term, with visibility on renewables opportunities at NIPSCO coming into view later this year. NI currently trades at a full turn discount to the electric average; we see potential to re-rate closer to its historic 5-10% premium as these catalysts play out.
This morning, Brookfield Renewable Partners announced that it had submitted a proposal to acquire the remaining 38% of TerraForm Power (Brookfield already owns 62%) for $17.31/sh in a stock-for-stock transaction. This represents an 11% premium to TERP’s Friday close and continues the consolidation of Yieldco space. After several take-unders back in 2018 (NYLD/GIP and CAFD), the YieldCo space is now seeing modest takeout premiums even after strong stock performance. Infrastructure funds, led by the Canadians, have been the main buyers. That said, this now leaves an ever-smaller publicly-traded sector. Essentially, we are down to GIP-backed CWEN, NEE-backed NEP, and AQN-backed AY. There’s also Brookfield Renewables, which is a Canada-listed partnership – citing $50B in total power assets equating to ~18 GW, with a more global focus and predominantly hydro. Brookfield plans to structure shares so that investors can gain exposure through a corporation, if unwilling to own partnerships.
Following a tough 2019, history says utilities may do better in 2020…The sector trailed the 2019 bull market by 500bps and has ping-ponged between out- and under-performing 6 years in a row, suggesting a bounce may be due in 2020. In years after large market rallies, utilities tend to meet or beat the market the following year.
As we discussed last week, 2019 turned out to be a year of disappointment from a stock performance perspective for the IPPs. While we’ve often cited high-teens free cash flow yields (now 20%+ for VST) as a key part of the investment thesis, we’ve decided to analyze this in another way – how the stocks would look in a leveraged buyout scenario. This hypothetical got some play over the summer when the stocks languished before fading as they subsequently rallied. On our math, the data is compelling – both stocks could be bought out at 30% premiums and a private equity investor should be able to recoup its investment within 6 years or less. We believe this puts a floor value on the stocks and may ultimately drive firms to take action.
Utilities ended 2019 up 22.2%, a great year on an absolute basis but nothing special in 2019. The S&P 500 ended up 28.9% beating utilities by over 500bps, including dividends. Utilities now trail the market on a 1-yr, 3-yr, 5-yr and 10-yr basis which may be surprising to some. This is the 6th year in a row that utilities have ping-ponged between outperforming and underperforming the S&P 500, highlighting the shifting risk-on, risk-off trade amidst an underlying bull market. A unique aspect to 2019 was the breakdown between utilities relative performance and L-T interest rates. Utilities underperformed despite rates falling almost 100bps. In retrospect, utilities moved ahead of bonds with their strong move in late 2018 and thus had less room to run. While there is a lot to worry on in 2020, including the election, we remain underweight utilities and wait for the current 11% premium to get closer to its historic 4% average.
After big years in 2017 and 2018, the IPP rally hit a pause in 2019, as VST and NRG are set to end the year close to where they began. This is relative to the S&P 500 up close to 30%. Many investors are scratching their heads after what seemed like a generally positive year fundamentally. For VST, the selling shareholder issue ultimately proved to be too much of an overhang. Apollo sold throughout the year and then Brookfield unloaded a massive block in December. The good news is this should be mostly behind it. NRG’s issue may have simply been that after rising over 200% during 2017-2018, the stock was due for a breather. Finding the incremental buyer with fewer catalysts, has become more difficult, in what remains a sector of two publicly-traded stocks. The year started off strong – rallying with the risk-on market following a rough December. Then spring fear on ERCOT summer and the PJM auction drove underperformance, followed by a rally after ERCOT prices spiked in late-summer.
We recently met with SRE CEO Jeff Martin and team in NY and also hosted them for a virtual roadshow with Australian investors. Jeff’s main message is that growth visibility for the company is as good as he can recall led by the CA utilities, Oncor and LNG growth. We raise our estimates $0.30-$0.50/share in each year to better reflect the CA GRC order, asset sale proceeds and higher growth at Oncor. Our price target is now $164 up from $155 – see note for detailed S-O-P valuation. Even after strong 2019 stock performance, we reiterate Outperform and view SRE as a core growth holding among utilities.
FERC published its written order on the PJM capacity auction late Thursday night (12/19/19). We painstakingly read it and touched base with our covered companies. At a high-level, not much has changed from our initial take. The MOPR was expectedly strict and will likely push out many subsidized resources going forward, namely EXC’s nuclear units. There is the potential for unit-specific exemptions that PEG may pursue in New Jersey. For now the strict MOPR is a net positive to the residual capacity market, as all else equal prices should go up as lower bids are pushed out. That said, at least one state may try to exit the market (Illinois), which should play out over 2020. Longer-term, there could be more and the state of the capacity market seems to be at a crossroads. From an auction timing standpoint, it appears the 2022-2023 rendition will take place in late-2020 at the earliest, leaving uncertainty. As a reminder, we laid out company sensitivities last month.
FERC puts forth strict MOPR in new PJM capacity rules as expected
At today’s meeting, FERC discussed the long-standing proceeding related to subsidized generation within the PJM capacity auction. FERC ruled 2-1 along party lines with Commissioner Glick strongly dissenting. The primary takeaway is that the PJM capacity auction will employ a strict MOPR (minimum offer price rule) with limited exemptions (mainly existing renewables, self-supply, EE/DR), particularly for new generation. Resources that fail to qualify for an exemption will be able to apply for one on a unit-specific basis, though we need more clarity. This is what most had expected (companies and investors alike). FERC’s press release can be found here. A written order is expected to be published later today, after which we expect to follow-up with more thoughts. Details will matter here.
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