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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ES’ 2Q19 of $0.74 was in line with prior-consensus, and ES reaffirmed 2019 guidance of $3.40-3.50. ES also reaffirmed its 5-7% EPS growth target through 2023, though some investors interpreted management’s comments as suggesting a key driver of 2023 earnings is offshore wind projects being developed by ES and its JV partner Ørsted. While some projects come online in 2022-23, the earnings contribution is not meaningful. The bulk of offshore wind earnings kick in post 2023, when EPS growth could top ES’ current target. There has been an increasing focus on ES’ business mix as the company and Ørsted win projects (S&P recently downgraded ES ratings to A- from A+ on it). We understand but still see the business being mostly T&D for many more years and warranting a premium in line with low-risk, high-quality utilities. ES slightly trailed the UTY after its call in the morning (8/1/19), but it is ahead by nearly 350bp YTD, even after a $1.3B equity deal in May.
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.
CAL Watch – Sen Dodd hints at a wildfire fund of $25-50B
CAL Watch – Bill states property losses from fires; costs for 2018 fires appear higher than last update
PCG – Settles with 14 public entities for $1B related to past wildfires; good step
PCG – CPUC seeks comments on proposals to improve safety culture
EIX – Debt issuance pricing reflects wildfire, downgrade risk
SO – GA Court of Appeals hears arguments from advocacy groups against Vogtle
ES – Settlement on temporary rate increase in NH rate case
PEG – Gas explosion at Ridgefield New Jersey home causes 1 fatality; under investigation
POR – OR bill to boost EV adoption heads to Gov; Cap-and-trade bill passes House, heads to the Senate
AWK – AWK in Europe…like selling water in a desert
ENB – Minnesota agencies slow Line 3 Replacement permit review process; not a big surprise
Midstream – Canadian Prime Minister Trudeau approves Trans Mountain pipe expansion; expected
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.
Utility earnings rose 5.0% in Q1, slightly above our 4.9% estimate. No companies changed guidance for 2019 but the same companies that disappointed at year end had issues again such as AGR, CNP, and NI (not EVRG, phew). Earnings quality stuck out to us as weak with tax or other gains driving numbers at SRE, DUK, NRG among others. AEP may have been the most incrementally positive with increasing confidence in the upper half of their 5-7% growth rate. Mega project risk continued to overhang D and DUK (ACP) and SRE (more Cameron delays), though SO kept Vogtle on schedule (for now). Finally, weak renewables conditions hurt in Q1 causing misses at AGR, CWEN, and NEP, but the influence of renewables keeps accelerating overall.
ES’ 1Q19 of $0.97 beat consensus of $0.91, but ES affirmed 2019 guidance of $3.40-3.50 and its 5-7% EPS growth target through 2023. Investor focus remains on timing of equity issuances; ES said in Feb it would need $2.0B to fund its 5-year $13B capital plan and known offshore wind projects in the outer years. ES said it would be opportunistic on the equity, monitoring cash needs and the equity market. ES also reminded investors that its 5-7% growth target includes the $2B equity but no material earnings from offshore wind; the latter will be significant in 2024 when the two wind projects are in-service. ES has trailed the UTY by over 200bp since Feb’s announcement and is in line with it YTD. Despite the equity overhang and offshore risk, we continue to like to ES’ high-quality T&D/water utility business. Our new 2022E reflects 6% EPS growth and ~$2B of equity. At a 2% premium to peers, we believe ES has room to go once equity is done. Outperform.
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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