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.
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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:
Shares of CNP traded down 1% on the day, underperforming the UTY by 60bps. We believe that the underperformance was partially a weak quarter due to O&M timing and that CNP did not update the details supporting its 2020 pro forma EPS outlook for the VVC merger. However, they did strongly confirm that guidance. The stock trades at a discount to the rest of the regulated group despite decent growth prospects. We willl be looking for a more detailed picture of CNP post merger on the Q4 call. Peer Perform.
Utilities rose 1.9% in October beating the market by 880bps. This was the 9th best relative month for the sector since the S&P GICS were formed in 1995. It was the second best in the last 17 years. The month started with bond yields breaking out to a new 7-year high and we thought it would put the nail in the coffin for utilities. But rising bond yields ended up killing the market instead while utilities actually rallied hard. This defensive trade was evident in other sectors as well with Staples rising 2.1% for the month, slightly ahead of utilities. We view this utility rally as a trick, not a treat. Bond yields are still near 7-yr highs and would not be here if a recession was coming. The relative valuation of the sector is well above average on both a P/E and yield basis. We continue to recommend fading this rally.
This week we take a look at power prices ahead of Q3 reports, as generators often mark their guidance to forward curves around the end of each quarter. This is particularly meaningful for both NRG and VST, who are expected to issue / refresh 2019 guidance. Aside from ERCOT 2018, the forward pricing story in Q3 was largely positive when compared to 2Q18, even amidst flattish natural gas. While ERCOT contracts were down 10% in 2018, further out on the curve (2019-2021) was up 5-10%. This dynamic is likely explained by a summer that failed to yield scarcity pricing despite peak demand records, but the recognition that supply/demand conditions are likely to remain tight for the foreseeable future. Gas plant new build has failed to move forward and core demand growth remains robust. In PJM, contracts were up 5-7% in 2019-2020, while 2018/2021 contracts were up only modestly at 1-2%. Finally, out West (NP-15/SP-15/Mid-C) forwards were up 10% for 2019, while more mixed in outer years.
Bond yields broke out to a 7-year high last week and we thought that would be the nail in the coffin for already underperforming utilities. Instead, it was the S&P 500 that got buried and utilities have had their best relative month in a long time. The sector is actually up a bit in October and outperforming the market by 700bps. They are still trailing the market YTD but just barely now. So what now? We recommend selling the rally.
Last Tuesday (10/20/2018), PJM filed its initial comments (link) to address subsidized resources in capacity auctions. PJM’s proposal has several key tenents: 1) The MOPR (minimum offer price rule) would be expanded to all fuels/technologies and new/existing resources; 2) A resource carve-out option would be available for subsidized resources and these resources (and associated load) would be removed from the market (no capacity payments); 3) An “extended resource carve-out mechanism” would be used to re-price the residual market’s clearing level based on total load (including carved-out resources). As structured, IPPs appear to benefit from what should be higher clearing prices all else equal. For the Integrateds the implications are less simple.
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