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 past Thursday (8/1), a gas explosion leveled a Franklin County home in Pennsylvania and NI’s Columbia Gas was at fault. We saw little news coverage following and don’t believe many investors were aware last week. Thankfully there were no deaths / life-threatening injuries sustained as a result, but the incident is alarming given what transpired in the Merrimack Valley last year. At a high-level, the cause of the explosion appears to have closely mirrored that in MA. Columbia crews were replacing a low-pressure gas system and failed to recognize that the home was connected to the system. Thus, when re-activating the line, there was no regulator in place to moderate the pressure going into the home, leading to the explosion. This was the one thing NI could not let happen – Downgrade to Peer Perform.
NI reported 2Q19 EPS of $0.05, matching us/consensus. NI reaffirmed its FY19 guidance range of $1.27-1.33 and its expectation for 5-7% annual EPS/div growth from 2019 through 2022.
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.
Today (6/17/2019) during market hours, Bloomberg reported that NI has received bids and is considering a sale of its MA subsidiary. The report indicated that a sale of Columbia MA could fetch up to $2B (~2x total rate base). In our view, a sale of MA makes sense and was the primary reason we stuck with our Outperform rating following the gas explosions last fall. A sale would remove the MA overhang on an otherwise solid investment story. We believe a natural suitor to be ES who could buy the property at a decent price, making it a win-win for both parties. NI outperformed the UTY by 180bps on the day following the news.
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.
Heading into the Q1 call, we expected a much more modest cost increase; our expectation proved optimistic as NI now expects a 20% increase from the amount provided just a couple months ago. NI recently reached a settlement on what is likely one of its larger claims, thus taking some risk off the table for large future increases. But there is still a fair amount of uncertainty that remains concerning what’s embedded in estimations for claims yet to be settled / litigated (class action, wrongful death, municipalities); footnote language related to the possibility for further increases makes us a bit weary as well. We would be remiss if not admit that mgmt’s credibility is taking a bit of a hit with respect to this issue.
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