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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2020 guidance uncertainty due to TX rate case, ENBL. CNP opted to not reaffirm its prior 2020 guidance of $1.75-1.90 due to some uncertainties as the company works to refine its expectations for next year. Our read was that the two key variables are timing / the outcome of the TX rate case and ENBL’s 2020 guidance. On the rate case, key issues are ROE and equity ratio. Possibility of a settlement sounded unlikely, though not off the table; a final order from the PUCT is expected in 4Q. ENBL will provide 2020 guidance on its Q3 call, the majority of which will depend on expectations for producer volumes next year in the Haynesville. That said, management reiterated that CNP’s 5-7% EPS CAGR through 2023 was still intact. CNP underperformed the UTY by 290bps following the report.
Quietly our Wolfe Yieldco Index has become the top income sector YTD and the only one beating the S&P 500 (see Ex 1). Yieldcos have overcome the huge uncertainty caused by PCG’s bankruptcy filing in January. Why have they done so well? 1) long-term contracts that are not subject to ROE resets like utilities so should benefit directly as interest rates fall; 2) the neighborhood improved meaningfully as parent companies changed from distressed owners to higher-quality parents (SunEdison to Brookfield, Abengoa to Algonquin, NRG to Global Infrastructure Partners); 3) Its Renewables stupid – the top growth space in energy with huge economic and tax subsidy momentum. While we are a bit wary of competition and financial discipline in renewables, we think the backdrop remains bullish. There is no better way to play all of this than NEP given their connection to industry leader NEE, huge growth backlog, cost-of-capital advantages and visibility on 15% dividend growth for at least the next 5 y
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.
CNP reported 1Q19 EPS of $0.46 which missed consensus/us ($0.52/0.55) by a wide margin. The miss was driven by a -$0.07/sh decline at Energy Services. The decrease was largely anticipated internally, but results ended even a bit weaker than CNP had projected. 1Q18 at Energy Services was abnormally strong due to very favorable weather; CNP was able to monetize most of its gas reserves in 1Q18 rather than ratably throughout the year. As such, subsequent quarters in ‘19 will see YoY growth given that CNP expects to end the year flat vs ‘18 at Energy Services. CNP underperformed the UTY by 380bps today as the quarterly miss highlighted the volatility of its non-reg businesses. Despite the weak start, CNP reaffirmed its ‘19 guidance of $1.60-1.70 as well ‘20 guidance of $1.75-1.90.
CNP gave initial 2019 guidance of $1.60-1.70, missing consensus and our previous estimate of $1.69 (now $1.66). More importantly, CNP lowered its 2020 guidance range at the top-end to $1.75-1.90 from $1.76-1.98, reducing the midpoint by $0.05. The company maintained its 5-7% EPS CAGR and extended the outlook through 2023. Assuming 6% growth off the new midpoint, this implied a lower 2021E by $0.07 as compared to expectations from the prior guidance. We have updated our estimates and our new 2021E of $1.94 assumes growth of 6.6% through the period. The update today was particularly disappointing given that some had anticipated that numbers could be raised post-merger. CNP underperformed the UTY by 362bps today following the update.
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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