We are reiterating our Overweight rating on the IPP sector, as we continue to see attractive value at both VST and NRG – relative to our sector coverage and the broader market. We’ve refreshed our screen in the table below – searching across the S&P 1500 for stocks that exhibit strong free cash flow generation supported by a solid balance sheet – setting parameters at Free Cash Flow yield > 15%, Net Debt / EBITDA < 3x, and EV/EBITDA under 8x. Only 15 companies (1%) in the S&P 1500 fit.
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We hosted a fireside chat with PSEG CEO Ralph Izzo last week, who came across as upbeat on the utility growth prospects, cautiously confident in ZECs approval, and generally satisfied with the company’s strategic fit. We continue to see long-term fundamental value in the stock, as utility earnings become a bigger overall percentage and power uncertainties resolve. The full replay can be listened to here. A summary of the most important talking points is below. While a more detailed review of the call is on page 4.
This week NEP put the question of California risk to the sidelines following the 600 MW asset drop and attractive portfolio financing announced on Monday (see details in note). The cash flow from these transactions will more than offset the ~$100M of CAFD at risk from PCG-exposed projects and drive the 15% distribution growth in 2019. We continue to see NEP as highly attractive, especially with the increased certainty from the asset dropdown. We are not aware of another income vehicle with the distribution growth potential and duration – 12-15% through at least 2023 – with such a strong parent. Outperform.
Wolfe Research's Senior Utilities analyst, Steve Fleishman, hosted a Fireside Chat with Fireside Chats with Ralph Izzo - Chairman of the Board, President & CEO of PSEG.
We came out of earnings season seeing little conviction, from both companies and investors alike, as to when and how FERC will ultimately rule on the PJM auction’s treatment of subsidized units. Prior communications had been that a decision was required by March-end in order to keep the August date for the auction as scheduled. March 17 is the first date a capacity resource intending to offer into the auction must certify whether it is subsidized – for now PJM is suggesting a parallel path – operating under the assumption that both the old auction format and PJM’s proposal are possible, particularly as it relates to a MOPR. Of course, FERC could ultimately decide on neither option. We continue to view PJM structural changes as important, but less of a gamechanger given the diversification of the power companies – Integrateds with growing utilities business and IPPs with significant ERCOT exposure.
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.
Several companies rebased their growth rates that effectively lowered long-term numbers - AGR, EVRG, CNP, DUK and NI. While these were all for different reasons, we see more strain in utilities to keep growing 5% or more. We also saw several companies talk to slower dividend growth for the first time in several years – DUK, PPL, EIX, NI, and D. Mega project risks and event risks seem to be spreading in the sector. Risk-averse investors tell us they are seeing their investable universe shrink as they try to avoid project risk, big equity needs, poor management, higher-risk businesses, and of course, CA. The problem is the “clean” companies keep trading at higher and higher multiples which in and of itself becomes a risk.
In the last earnings call of the YE18 utility reporting season, EIX disclosed a $2.5B ($1.8B after-tax) charge related to wildfire claims. The amount/timing are somewhat surprising, but EIX warned last fall about potential involvement of its equipment in the 2017 Thomas Fire, which caused over $2B of insured losses when including subsequent mudslides. Then, the Woolsey Fire caused damage in Nov 2018, with over $3B of insured losses. CAL Fire has yet to determine the cause of either fire. EIX has underperformed the UTY by around 300bp YTD. We believe any legislation that limits or eliminates wildfire liability risk to utilities would benefit EIX, but the upside to EIX stock is much less than that to PCG (see note).
PCG said it is probable that its equipment will be determined to be an ignition point of the 2018 Camp Fire; PCG took a $10.5B pre-tax charge in 4Q18. To date, PCG has charged $14B related to Camp and the 2017 North Bay Fires. PCG said fire liabilities could exceed $30B. We believe the stock reflects over $35B. PCG shares trailed the UTY by 470bp. But we believe the decline was tied more to a WSJ article implying PCG deferred maintenance on a suspected line in the Camp Fire and concern over potentially negative headlines related to pending CPUC investigations and critical rulings from Judge Alsup (federal judge overseeing PCG post San Bruno conviction). We remain optimistic a deal can be worked out with key stakeholders ahead of fire season this fall.