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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LNT reported 2Q19 EPS of $0.40 that missed consensus/us at $0.44. The quarter fell versus $0.43 last year on milder weather, higher depreciation, and taxes timing; offset by rate relief in both Iowa and Wisconsin. LNT also reaffirmed its 2019 guidance range at $2.17-2.31 and indicated it is tracking toward the top-half given weather benefits (+0.03 in 1H19 and +0.02 in July).
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.
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.
LNT reported 1Q19 EPS of $0.53 that matched us and finished slightly ahead of consensus at $0.51 and $0.52 last year. The quarter was driven by cold weather (+$0.05 vs. normal) and rate relief in both Iowa and Wisconsin; offset by higher depreciation / interest, and taxes timing. LNT also reaffirmed its 2019 guidance range at $2.17-2.31, with the year appearing well on track.
On Friday (2/22/2019), LNT reported 2018 EPS at $2.17 – just edging us/consensus and finishing in the top-half of upwardly revised guidance. Relative to $1.93 last year, drivers included favorable weather, rate relief and higher AFUDC. Weather was a $0.12/sh swing factor year-over-year, and on a normalized basis 2018 reflected 6% growth. Additionally, guidance for 2019 of $2.17-2.31 was reaffirmed. Going forward, LNT expects continued 5-7% EPS growth off a temperature-normalized base of $2.11 in 2018.
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.
We are upgrading our rating on LNT to Peer Perform from Underperform, following the stock’s recent underperformance and the alleviation of an equity issuance overhang. We took a more negative view on LNT back in August, as valuation had crept up to amongst the highest in the sector and there was still $400M in equity needs on the come. Trading at only a modest premium to the group average, we see this higher quality utility as reasonably valued. Our Price Target moves up to $44 (from $42) on higher group multiples. That said, we remain relatively cautious on the utilities sector given a lofty valuation relative to the market that seems to imply a looming recession.
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.
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