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.
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On 1/2, Dominion closed the transaction to acquire SCANA. We therefore terminate coverage of SCG. We moved to No Rating from Outperform following regulatory approval of the merger last month. Investors should not rely on our previous ratings, price targets or estimates for SCG.
Utilities eked out a small 0.5% gain for 2018 on the heels of a massive Q4 rally as the market turned decidedly defensive ending the year down 6.2%. Utilities 670bps outperformance came despite a lot of headwinds on the group including higher interest rates (10-yr up 23bps), lack of tax reform benefits, over $15B of equity issuance, and the CA fires impact. Investors were looking for any place to hide and utilities fit the bill especially given their lack of exposure to tariffs and recession fears. Utilities came in second among income sectors for the year trailing only Pharma which was up 5.2%. Interestingly, all other income sectors underperformed the market in 2018 (see Exhibit 1). We remain cautious on utilities going into 2019 given their heavy dependence on a negative macro call and very high relative valuations (20% adjusted P/E premium vs the historic avg of 3%). In our view, buying defensive sectors at historically large premiums is not defensive.
On 12/14, the SC Public Service Commission orally voted to approve the Dominion-SCG merger proposal with moderate conditions. The PSC accepted D’s latest revised rate plan, dubbed Plan B-L, which would cut SCG's electric rates to $125.26/month for the typical residential customer. This is slightly lower than the temporary 15% rate cut (to $125.34) enacted by the state legislature this summer. Given the apparent approval of the merger, we believe SCG no longer trades on fundamentals and are therefore moving to No Rating from Outperform. Investors should no longer rely on our previous rating, price target and estimates for SCG.
On 12/14 at its 1pm EST meeting, the SC Public Service Commission is expected to issue a decision on the Dominion-SCG merger proposal and cost recovery for the now-abandoned nuclear project. D's latest revised rate plan, dubbed Plan B-L, would cut SCG's electric rates to $125.26/month for the typical residential customer. This is slightly lower than the temporary 15% rate cut (to $125.34) enacted by the state legislature this summer. The Office of Regulatory Staff, a key intervenor, has been seeking cuts to as low as $114.57/month, in part by disallowing most of the nuke spend previously approved and by allowing lower returns than requested by D-SCG. We believe the PSC is likely to approve the deal, implying about 9% upside. However, surprises are possible, like adoption of the ORS recommendation (modest downside) or no nuke cost recovery (19% downside).
Market volatility in October caught many off-guard and the hope was things would settle down post earnings. Well they got much worse spurred by the disruption of the CA fires. PCG and EIX ended November down 44% and 20%, respectively, on the heels of the destructive fires. These were popular value names in the utility space and their sharp stock collapses clearly caused investor pain. However, the second derivative impact was just as meaningful. The “Anything but California” trade took over amidst utilities, lifting already expensive low-risk utilities to higher levels. Many investors got just as hurt by being short or underweight these names as being long CA. With investors suffering and year end approaching, the last two weeks have showed signs of portfolios shrinking and extreme risk-aversion which has only exacerbated the problem. Everyone needs a holiday.
Last week, as the California utilities collapsed amidst the fire risks, we saw increasing investor focus on second derivative impacts. One of the obvious ones relates to renewables contracts with the CA utilities, especially PCG who drew down their bank lines last week. The primary concern is what will happen to these contracts in the event that PCG files for bankruptcy due to all the fire-related claims. This primarily impacted NEP and CWEN, given they have the most exposure, though there has been somewhat of a relief rally as investors realized the chance of a PCG bankruptcy in the near-term is low. Importantly, even if there was a surprise filing at some point, we believe these power contracts with the California utilities are likely to hold up. We are buyers on the recent weakness and view NEP as a top idea here.
The annual EEI conference will be held November 11-13. Management from most of our covered companies will be there. This report is a helpful guide for investors attending and includes questions to ask each company and summary model information. Some of the industry topics we will be focusing on include:
SCG shares fell 11% today (10/22/2018) on reports a SC circuit judge may rule the Base Load Review Act unconstitutional on a technicality in a class action suit. SCG confirmed the reports but said no ruling has been issued, and the utility will file its proposal 10/29. The technicality is administrative due process – customers were deprived the right to a hearing on rate increases tied to the now-abandoned nuke. SCG has collected $2B related to it. The possible ruling raises the prospect of refunds, something the SC legislature decided not to pursue when it crafted legislation this year. An unconstitutional ruling would create a mess for SC’s utility industry, particularly when financial-stabilizing solutions are on the table. Importantly, it would not necessarily mean the PSC will order refunds, and any ruling would be appealed.
This week we take a look at power prices ahead of Q3 reports, as generators often mark their guidance to forward curves around the end of each quarter. This is particularly meaningful for both NRG and VST, who are expected to issue / refresh 2019 guidance. Aside from ERCOT 2018, the forward pricing story in Q3 was largely positive when compared to 2Q18, even amidst flattish natural gas. While ERCOT contracts were down 10% in 2018, further out on the curve (2019-2021) was up 5-10%. This dynamic is likely explained by a summer that failed to yield scarcity pricing despite peak demand records, but the recognition that supply/demand conditions are likely to remain tight for the foreseeable future. Gas plant new build has failed to move forward and core demand growth remains robust. In PJM, contracts were up 5-7% in 2019-2020, while 2018/2021 contracts were up only modestly at 1-2%. Finally, out West (NP-15/SP-15/Mid-C) forwards were up 10% for 2019, while more mixed in outer years.
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