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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ED is currently in the midst of settlement discussions for CECONY’s rate case. Last time around, ED was able to get a filed settlement in September. We get the sense that it may take a little longer this time given that PSC staff currently has other items on its plate as well (e.g., NYSEG rate case). Given recent reliability issues, political pressure has been mounting on ED at an inopportune time. A tail risk that could hamper negotiations is if Gov. Cuomo elects to intervene in the case given his recent criticism of the company. Nonetheless, under the NY PSC’s formulaic approach to awarding ROEs, we see considerable pressure on ED’s future allowed return given that utility valuations are at relative highs and interest rates are now near all-time lows.
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.
With settlement negotiations underway today, we thought it would be helpful to refresh expectations for CECONY’s rate case outcome given the fall in interest rates and continued expansion of utility valuations. As a reminder, the NY PSC awards ROEs using a formulaic approach – 2/3 DCF & 1/3 CAPM. Staff recommended an 8.30% ROE in May using Feb-April data. When looking at the most recent 3-month period, stock prices for the peer group have risen 360bps (on avg) and the risk-free rate has fallen nearly 35bps. An ALJ opinion due in Oct will provide an official updated recommendation.
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.
ED reported 1Q19 EPS of $1.39, matching our estimate and coming in a little above consensus at $1.36. CECONY was up +$0.02 primarily due to rate relief and growth in the number of gas customers; O&R was up +$0.03 largely due to lower storm costs. ED affirmed its 2019 guidance of $4.25-4.45 (WRe $4.36). ED still plans to issue $500M of external equity (in addition to $100M internally) at some point this year; it’s likely this comes in the form of a block rather than a forward or through an ATM program.
Our Q1 investor poll shows investors remain underweight utilities even after the sector has already underperformed by 700bps YTD. The poll has eerily similar results compared to our year ahead poll. Only 22% expect utilities to outperform for the rest of 2019 (down from 29%) and 54% expect them to underperform (up from 51%). There is roughly the same preference of midstream vs utilities (60%/40% vs 62%/38%). Power remains the preferred sector within the space (52% overweight vs 53% last poll) followed by Regulateds (43% overweight vs 52%) and then Yieldcos at the bottom (25% overweight vs 33%). Most investors (59%) expect interest rates to stay in the 2.5%-3.0% area though a lot less see rates rising back over 3% (only 5% vs 22% at last poll).
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