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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This morning (08/06/19) DUK reported 2Q19E of $1.12, beating then-consensus of $0.98 in part due timing of O&M (+$0.07) and better weather than normal (+$0.08). But DUK reaffirmed its FY19 guidance of $4.80-5.20, despite a solid 1H19 because Q3 can be highly variable. Prior-consensus for FY19 was $4.92; our 2019E was $4.93 but is now $5.00 on the new disclosures. Our 2020-22E are unchanged and we still see EPS growth of 4.5% – in the bottom half of DUK’s 4-6% target. The Q2 beat helped DUK stock outperform the UTY by 100bp today, but it still lags by 1100bp YTD and trades at a 14% discount to peers. While steep, we see it trading at a 10%+ discount until there is certainty on NC legislation (this summer), ACP Phase 1 (possibly this year) and Phase 2 (potentially next summer). Plus, DUK is expected to have several material rate cases by yearend: IN (recently filed) and two in NC.
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.
Utilities: PCG, CAL Watch, DUK, Short Interest, PNW, VST, Renewables, Offshore Wind, POR
Midstream: D/DUK/ETRN/NEE, MMP, KMI, WMB, Short Interest
We had DUK management in Canada last week for investor meetings. Our takeaway from the meetings is DUK generally feels good about ultimately lifting some stock overhangs, including ACP, NC legislation, coal ash, SC rulings and levered B/S. Still, DUK set a new relative low last week and is the worst performing utility stock YTD not named PCG. DUK trades at a 3x discount to peers. While steep, we see it trading at 2-3x turns until NC legislation passes (maybe this summer), clarity on ACP Phase 1 (late summer) and certainty on Phase 2 (possibly as late as next summer).
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.
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