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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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.
Our utility financial “checkup” examines projections for utility balance sheets and credit metrics. Tax reform was the overarching theme in 2018 for utility balance sheets and precipitated a large portion of the equity deals completed this year; in total, we saw +$19B completed across our coverage via blocks, forwards, or internally. Since our mid-year review, we now project slightly better FFO/debt in 2020 (+0.5%) due to equity issuances and asset sales. EV/EBITDA is now a half-turn higher given the run-up in equity valuations. Overall, we continue to see utility financial metrics stagnating with higher leverage at certain companies leading to wide P/E dispersion.
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.
EEI was held in San Fran this week with the Camp Fire still burning and the host utility PCG unable to attend. EIX attended but there was not much they could really say. The CA situation cast a pall over many investors and it made every other utility story sound pretty darn good relative. The other big event was the FE coming out party as a fully regulated utility with an earlier than expected dividend growth resumption. As the CEO said, after 40 years of digging out of holes, FE is finally out and plans to never dig a new one. Higher capital plans, renewables growth, rising equity ratios, and portfolio restructuring were other key themes at the conference.
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:
Utilities rose 1.9% in October beating the market by 880bps. This was the 9th best relative month for the sector since the S&P GICS were formed in 1995. It was the second best in the last 17 years. The month started with bond yields breaking out to a new 7-year high and we thought it would put the nail in the coffin for utilities. But rising bond yields ended up killing the market instead while utilities actually rallied hard. This defensive trade was evident in other sectors as well with Staples rising 2.1% for the month, slightly ahead of utilities. We view this utility rally as a trick, not a treat. Bond yields are still near 7-yr highs and would not be here if a recession was coming. The relative valuation of the sector is well above average on both a P/E and yield basis. We continue to recommend fading this rally.
FE’s Q3 update was largely positive, yet the stock fell over 300bps Friday in a weak overall tape. We believe this was primarily due to misguided expectations around a cost cutting initiative that lost sight of the forest for the trees. The bigger picture here is that FE has been a fully regulated pure play utility for just one month. The EPS CAGR of 6-8% appears well supported, but the story isn’t about perennial earnings and capex upsides. FE simply needs to execute on its plan. Above-average earnings growth, with T&D focused operations, and the eventual resumption of dividend growth – will ultimately garner a multiple re-rating. Outperform.
Utilities are on a hot streak this month recapturing all of their underperformance for the year in just 2 weeks. While we expect neutral to positive Q3 and Edison Electric Conference (EEI) updates, we remain skeptical that the recent rally can be sustained. We project Q3 up 6.4% driven by favorable summer weather, rate relief and better core sales growth. Our bottom-up 2018/2019 EPS forecasts are 5.7%/6.1% respectively. Several companies will be updating their capital plans – AEP, FE, LNT, WEC, XEL, POR, DTE – with a further upward bias to capex but not much change to EPS growth rates (except XEL). Midterm elections will also be a key topic given importance of state politics for utilities; AZ (PNW) and GA (SO) will be in focus with both having tight commissioner elections and the renewables ballot initiative in AZ.
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