It’s now been over a month since PJM decided on its path forward to hold the annual capacity auction under existing rules in August, absent further guidance from FERC. Meanwhile, FERC has issued a number of orders on other energy related topics, even those specific to PJM like fast-start pricing and a recent IMM complaint on default market offer caps. Yet despite PJM’s (and its stakeholders’) plea for at least acknowledgement that if the auction is run under old rules FERC will refrain from requiring it to be re-run, FERC has remained silent. We’re now almost a year removed from PJM’s original order declaring the capacity auction unjust/unreasonable – surely there has been enough time to contemplate this issue. At this point, we believe it simply comes down to a deadlock along party lines, making it impossible to issue a majority-opinion order. To that end, it appears that we are waiting on a fifth commissioner or commissioner LaFleur to leave (whatever comes first).
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The sell-off in IPPs has continued – NRG and VST are both down over 10% in May. The situation has been exacerbated by last week’s ERCOT CDR report. At this point it’s beyond an overreaction and bordering on irrational. We think it’s helpful to provide better context on the CDR, namely that the threshold for capacity inclusion is relatively low. While the report saw 5.6 GW of renewables additions and reserve margins popped up 3%/year in 2021-2023, this merely indicates an interconnection agreement is in place. In reality, many of these projects fail to reach operation.
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.
We’ve pointed to a few potential items as likely driving weakness in the IPPs over the last few trading sessions. For NRG, it may have been the slow start to the year relative to expectations and a sizable portion of its current buyback authorization already being used up ($750M). For VST, we believe it was tied to a stock trading dynamic related to selling shareholders, consistent with prior quarters on the day when the company reported. To those points though, we see NRG as still having $500M left of its current repurchase program, with the potential for another $1B on the come. For VST, we expect 13-F filings next week to show reduced ownership stakes for the selling shareholders – helping to remove an overhang as their exits come nearer.
EXC reported in line 1Q19 EPS of $0.87 and affirmed its 2019 guidance of $3.00-3.30 (vs $3.15 consensus). EXC still sees utility EPS growth of 6-8% through 2022, as earned returns continue to improve at not only the PHI utilities, but also EXC’s legacy utilities. EXC’s outlook for ExGen gross margins were net flattish from last quarter, using 3/31/19 marks. Despite decent results, EXC trailed the UTY by 85bp, likely on lower chances of getting energy legislation in IL or PA by the end of this month that would favorably impact EXC’s nuclear fleet. As we saw in our recent investor poll, EXC is a popular name. We see IL and PA legislation as a free option in the stock and would be buyers on weakness induced by the political process. Reiterate Outperform.
Utilities rose only 0.9% in April, while the market rallied another 3.9%. Utilities are now underperforming the market by roughly 670bps YTD; they have given back their entire 2018 outperformance. So, what should investors do now? The stock market rally in 2019 is becoming historic - this is only the 3rd time in the last 40 years the S&P 500 rose more than 15% in the first 4 months. One of them ended badly - the 1987 crash during which utilities outperformed. The other year was 1983 - the market flattened out the rest of the year while utilities continued to underperform. We also looked at years where utilities underperformed 650bps or more in the first 4 months as well. This has happened 16 times in the last 40 years. Interestingly, 10 of those 16 years utilities continued to underperform into year-end by an overall average of 200bps.
We’re previewing Q1 earnings for the power names this week – with NRG, EXC, and PEG all reporting Thursday; followed by VST on Friday. Guidance ranges for the year look to be on track. Focus topics will be the status of the PJM capacity auction and the upcoming ERCOT summer for the IPPs; and New Jersey ZECs aftermath and IL/PA legislative prospects, for PEG and EXC respectively.
Last Thursday (04/18/19), FERC passed fast start pricing changes in PJM with implementation expected by July 31. On the surface, the changes appeared watered down somewhat relative to PJM’s proposal, but were a positive step forward in the price formation initiative nonetheless. At a high level, the change is expected to allow for prices to more accurately reflect the marginal cost of serving load. That said, the PJM forward curve actually was unchanged on Thursday, and is modestly down since the FERC agenda including the fast start docket was initially posted. This seems to indicate that the change was already reflected in forwards or was insignificant (or both). We remain hopeful that the broader price formation initiative, expected to play out over the course of 2019, will yield more meaningful changes. Finally, we also found it noteworthy that FERC decided to take up this issue before capacity market reform. Clearly, resolving the capacity market debate on handling subsidized units is more time sensitive given the upcoming August auction. Perhaps this suggests there simply isn’t a majority vote to do anything on that front at this point.
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).
This Thursday (4/18), the New Jersey BPU is set to vote on zero emissions credits for PEG’s (and EXC’s) nuclear units in the state. Recall that ZECs legislation was signed into law by Governor Murphy last May and maintaining the nuclear units appear to be a big part of his vision for a cleaner energy future. That said, this is still subject to BPU approval every three years. We estimate the subsidy is worth about $300M in total – ~$0.30/sh for PEG and ~$0.06 for EXC. PEG mgmt. has been very clear that in the event that any of its nuclear units fail to qualify for ZECs, it will shut down the entire fleet. We view approval as highly likely, given its alignment with Governor Murphy’s plan. However, PEG mgmt’s cautious tone in investor meetings earlier this year likely caused some concern, such that the stock likely sees a small relief rally if ZECs are approved.
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