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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DTE reported 2018 adjusted EPS of $6.30 that fell in-line with consensus and our estimate. This also matched guidance, which was revised upward on several occasions throughout the year. The 13% increase relative to $5.59 last year was driven by a combination of favorable weather and rate relief at the utilities, strong performance across the board at the midstream and P&I segments, and lower taxes. DTE also reaffirmed 2019 guidance of $5.97-6.33, with our unchanged $6.16 estimate near the midpoint. Finally, the 5-7% long-term EPS growth target was reiterated (off 2019 guidance). Mgmt. came across as highly convicted in its ability to execute this year and beyond.
PCG’s threat and subsequent filing of bankruptcy kept utility investors very occupied in January. Even if investors did not own PCG itself they had to deal with knock-on effects on other CA utilities like EIX and on the renewables suppliers NEE, NEP, CWEN, ED, etc. These names dominated the worst performers of the month and were part of the reason why utilities only rose 3.4% in January trailing the market rally by 450bps.
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 DTE to Peer Perform from Outperform, simply because the stock has hit our Price Target and we maintain a negative view on the utilities sector. DTE’s track record of exceeding expectations is one of the best in the sector and mgmt. is high quality. However, the stock is effectively at all-time highs in a higher interest rate environment. See more in our sector note.
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