Utilities have rallied over 20% in the past 9 months and are near all-time highs. The huge decline in interest rates and investor concern over tariffs, geopolitical risks and recession fears are key drivers. In general, we sense that many buyers of utilities are worried about an impending market collapse. To that end, we decided to look back at history to see how the market and utilities perform after huge utility stock rallies. The answer may surprise you - it’s a bullish sign for the market, not bearish.
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As midstream investors shift their focus to 2020, there have been a lot of questions regarding production growth and what volumes will look like into next year. In this week’s report, we break down the Wolfe Energy team’s recently updated production model, which expects incremental production to decelerate some over the next year and a half. At the basin-level, the Permian is expected to provide the bulk of the growth, though volumes may underwhelm the slew of takeaway projects near completion and recently announced. In response to lower production growth, we expect midstream capital spend to decrease materially into 2020, which should help midstream screen much more favorably in terms of positive FCF yields next year. We show our projections for capex and FCF outlooks for 2020 vs. 2019 for our coverage in the report.
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.
POR reported 2Q19 EPS of $0.28 – missing us/consensus considerably at $0.48/$0.51 and was down from $0.51 a year ago. The largest drags on the quarter were significantly lower than average hydro production, lower PTCs and higher O&M. POR seems to routinely be on the wrong side of weather / wind / hydro conditions. That said, POR affirmed FY19 guidance of $2.35-2.50. We see the company tracking in the lower half of the range and are reducing our 2019E by $0.06 to $2.39 as a result. Two important variables to monitor over the balance of the year will be improving net variable power costs (PCAM) and sales / customer growth, both of which are embedded in POR’s guidance. POR underperformed the UTY by 190bps today (8/2/19).
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
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.
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