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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Quietly our Wolfe Yieldco Index has become the top income sector YTD and the only one beating the S&P 500 (see Ex 1). Yieldcos have overcome the huge uncertainty caused by PCG’s bankruptcy filing in January. Why have they done so well? 1) long-term contracts that are not subject to ROE resets like utilities so should benefit directly as interest rates fall; 2) the neighborhood improved meaningfully as parent companies changed from distressed owners to higher-quality parents (SunEdison to Brookfield, Abengoa to Algonquin, NRG to Global Infrastructure Partners); 3) Its Renewables stupid – the top growth space in energy with huge economic and tax subsidy momentum. While we are a bit wary of competition and financial discipline in renewables, we think the backdrop remains bullish. There is no better way to play all of this than NEP given their connection to industry leader NEE, huge growth backlog, cost-of-capital advantages and visibility on 15% dividend growth for at least the next 5 y
Wolfe Research's Senior Utilities analyst, Steve Fleishman, hosted a webcast to discuss their PCG downgrade, CA wildfire legislation, risks to utility ROEs, and power market concerns.
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.
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.
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).
ETR’s 2019 guidance, which now only reflects its utility net parent (UPO) segment, is $5.10-5.50, twenty cents higher than its previous $4.90-5.30 guidance, as ETR moved to an effective tax rate (22.5%) from a statutory rate (25.5%). For 2020-21, the tax assumption change raised ETR’s outlook by $0.10 from its previous UPO EPS outlook. Other drivers appear largely unchanged from the outlook provided last fall. We are raising our estimates on the tax assumption change in line with ETR’s outlook (see table). ETR beat the UTY by 80bp but trails it by 60bp YTD. The stock is among the most popular names under our coverage on the long-side. We like ETR’s move to a fully regulated utility, which should be complete by YE22.
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.
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