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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CMS reported 2018 adjusted EPS of $2.33 – in-line with consensus/us and at the high-end of guidance. Accordingly, CMS re-based off this number and boosted 2019 guidance a penny to $2.47-2.51 and reiterated 6-8% EPS growth long-term with conviction around the midpoint.
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.
Our utility financial “checkup” examines projections for utility balance sheets and credit metrics. Tax reform was the overarching theme in 2018 for utility balance sheets and precipitated a large portion of the equity deals completed this year; in total, we saw +$19B completed across our coverage via blocks, forwards, or internally. Since our mid-year review, we now project slightly better FFO/debt in 2020 (+0.5%) due to equity issuances and asset sales. EV/EBITDA is now a half-turn higher given the run-up in equity valuations. Overall, we continue to see utility financial metrics stagnating with higher leverage at certain companies leading to wide P/E dispersion.
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:
This note feels like breaking up with our best friends. AEE, CMS, DTE and WEC are high quality utilities that we have liked for a very long time. At some point, there is a price for everything though and with the stocks at 18-19x P/Es on 2-year forward earnings and 10%+ premiums to the sector average, we struggle to see upside from here. In past utility rallies, we have been more flexible on valuation since bond yields were historically low. But bond yields are now at 7-year highs and at the same time these stocks are hitting new all-time highs. These companies will consistently grow 5-8% and we have high confidence they will execute, but we are not willing to pay as much for that in a higher rate environment. We think it’s prudent to move to the sidelines and look for a better price to jump back in.
We are downgrading CMS to Peer Perform from Outperform, as we find it prudent to move to the sidelines on several high quality names trading at record premiums in a higher interest rate environment. We’ve favorably viewed CMS and its high-growth, well-run story for some time. However, we struggle to stretch our target valuation further. See more in our sector note.
Utilities are on a hot streak this month recapturing all of their underperformance for the year in just 2 weeks. While we expect neutral to positive Q3 and Edison Electric Conference (EEI) updates, we remain skeptical that the recent rally can be sustained. We project Q3 up 6.4% driven by favorable summer weather, rate relief and better core sales growth. Our bottom-up 2018/2019 EPS forecasts are 5.7%/6.1% respectively. Several companies will be updating their capital plans – AEP, FE, LNT, WEC, XEL, POR, DTE – with a further upward bias to capex but not much change to EPS growth rates (except XEL). Midterm elections will also be a key topic given importance of state politics for utilities; AZ (PNW) and GA (SO) will be in focus with both having tight commissioner elections and the renewables ballot initiative in AZ.
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