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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We have seen big performance dispersion in the sector this year and widening valuation spreads. What value names can finally wake up? CA legislation should continue to benefit EIX/SRE and the associated Yieldco names NEP and CWEN (still on sidelines on PCG). We think FE can finally get past FES and NI can hopefully move past Columbia MA. SO will have a key update on the Vogtle plant from PSC staff (which tends to have a cautious bias); other project risk stocks DUK, D, AGR likely stay in limbo for now. CNP and EVRG will be focus names on whether they can rebuild credibility in hitting numbers. PNW and ED likely stay pressured by regulatory overhangs. And then there’s Power, which we think stays under N-T pressure into the August PJM auction even as we expect the companies to reaffirm 2019 outlooks.
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.
AEE 1Q19 EPS of $0.78 beat then-consensus by $0.10, but AEE affirmed its 2019 guidance of $3.15-3.35, as the quarter benefited from some weather and timing items. AEE continues to target 6-8% EPS growth through 2023 off 2018A of $3.05, largely driven by its $13B capital plan. Excluded from that plan is potentially another $200M of wind investment at least. AEE is in talks with developers and could soon announce new projects to meet its “at least 700 MW” target by YE20 (two projects totaling 557 MW already in plan). We estimate growth in the top half of AEE’s 6-8% through 2022; our estimate assumes $250M more wind capex than the $1B planned. AEE beat the UTY by 85bp and is ahead by 200bp YTD. AEE is a low-risk, high-quality name, but it trades at a 1x premium to peers; we await a more attractive point to reenter.
Our Q1 investor poll shows investors remain underweight utilities even after the sector has already underperformed by 700bps YTD. The poll has eerily similar results compared to our year ahead poll. Only 22% expect utilities to outperform for the rest of 2019 (down from 29%) and 54% expect them to underperform (up from 51%). There is roughly the same preference of midstream vs utilities (60%/40% vs 62%/38%). Power remains the preferred sector within the space (52% overweight vs 53% last poll) followed by Regulateds (43% overweight vs 52%) and then Yieldcos at the bottom (25% overweight vs 33%). Most investors (59%) expect interest rates to stay in the 2.5%-3.0% area though a lot less see rates rising back over 3% (only 5% vs 22% at last poll).
We recently hosted meetings with management in Australia. We came away with more confidence that AEE can execute on its 6-8% EPS growth target through 2023 off 2018A of $3.05, as cost reductions create headroom for $13B of investment, over half of which is slated for MO. And we believe there is potential to add another roughly $500M of renewables. We estimate growth in the top half of AEE’s 6-8% through 2022 – above that of its peers. And AEE is a low-risk, high-quality name, given its operations are in constructive jurisdictions with timely cost recovery. But AEE trades at a 1x premium to peers; we are looking for a more attractive point to reenter.
We hosted our annual investor meeting with the Moody’s team to get their latest credit views on the utilities, power and midstream sectors. For utilities, things have quieted down (ex California) as tax reform impacts have largely played out as expected. FFO/D metrics have dropped 150-200bps on average due to lost deferred tax cash flows and currently sit in the 15-16% area and likely stay there. Companies have taken actions to support their metrics (lot of equity) and have better visibility on regulatory treatment of tax reform. So 2019 is about executing on plans, hitting metrics and sticking to balanced funding plans (ie more equity). Moody’s still has a negative outlook on the sector but will likely go back to stable with good 2019 execution.
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