We’re publishing our utilities pension review a bit earlier this year, as this has come into sharp focus amid the market volatility. We now have the data available from Wolfe’s Accounting/Tax team, who published a comprehensive report earlier this week. We look at the state of pensions in the sector using year-end 2019 data. Overall funding levels improved and accounting assumptions became more conservative. However, weak equity market returns could be a pressure in 2020.
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Last week, the corporate bond market largely shut down and even a couple investment grade utility deals did not get done (ETR, AEP). Commercial paper markets have also been under stress and utilities are an active user. These events combined with existing worries over weaker sales and higher bad debts started raising more investor questions on utilities’ liquidity positions. This report provides a detailed rundown of company specific liquidity information. The overall takeaway is that utilities have ample liquidity to get through a temporary crisis period in capital markets, but it will be more difficult if it sustains for an extended period.
Both VST and NRG have seen their stock prices cut nearly in half this year, with a lot of pain experienced during the March market volatility (much worse than S&P 500). IPPs have seen their share of tough times and even though we’ve been highlighting the businesses are much better this time around, we’re now sitting in uncharted territory from a valuation perspective. The average MTM EV/EBITDA multiple is sub-6x (4.8x!) for the first time since we started tracking it in 2010 (see Exhibit 12).
We’re updating our commentary on U.S. power demand in accordance with updated EIA data, as well as the latest weekly weather data from NOAA. Within our tables, we’ve now switched to a weekly approach, where we will be tracking demand relative to the prior week on a rolling-basis and the same week one year ago. On those metrics, U.S. power demand actually increased by 1% WoW and is down only 1% YoY for the week-ended 3/21. Additionally, demand is only down 3% relative to the 4-year average. This is despite the continued mild weather, which according to NOAA is down 8% relative to last year and 7% relative to normal when looking across the U.S. in aggregate. So thus far, we’re not sure there has been a meaningful impact from the coronavirus just yet…but we’ll continue to monitor it closely. See more detail within our report that features various charts and tables, as well as the slides that we will continue to update regularly.
On Thursday (3/19/20), in lieu of its cancelled open meeting, FERC issued a press release and commissioner commentary on its proposal to reform its ROE policy for transmission – link (full order here). On balance, we view the notice of proposed rulemaking (NOPR) as positive, given it could double RTO adders to 100bps, use a consistent 250bps cap on incentives, and provide other opportunities for ROE enhancements based on economic benefits. Most positively impacted would be utilities with large transmission businesses in ISOs – FTS, PEG, FE, and ES. However, the rule is not yet finalized and base ROEs remain in flux. This is just the latest in a process that has spanned many years, with various twists and turns to both the positive and negative.
With the coronavirus spread continuing to dictate markets, one of the most frequently asked questions from investors is the potential impact on power demand. This could also be a real-time signal of the virus impact on broader economic growth. We’ve aggregated this data from EIA for the U.S. as a whole, as well as key regions. There is a 1-2 day lag on the data, but we plan to publish updated thoughts on a weekly-basis during this time and will also regularly update the charts as new data is available. Importantly, there are a number of other factors at play in determining power demand, but one of the obvious ones that must be looked at in context is weather. We include this data in Exhibit 3, which we’re able to update weekly from NOAA.
While this is certainly a focus area within the broader energy complex, we wanted to highlight that the mark to market outlooks of the IPPs (as seen in the table on the right), should be generally reflective of the current commodities environment and paint a still solid financial outlook. The stocks are trading like its game-over, but we’re simply not seeing that in the numbers. Hedging in 2020 basically negates all near-term pressure. In out-years, VST is still essentially within its $3B+ EBITDA target and NRG sees only modest degradation on a mark-to-market given retail and ERCOT exposure. Furthermore, we wanted to reiterate that credit risk is not an issue for the IPPs. They are both comfortably Free Cash Flow positive, with no near-term debt maturities (2024 at the earliest), and plans to pay down debt further to 2.5x leverage. We’re still comfortable owning these stocks.
The IPPs both fell in excess of 10% today (3/9/20), reflective of the market sell-off (-7.60%), but not quite at the extent of energy (down over 20%). This now puts the IPPs down ~20% this year. Investors concerns are twofold: 1) IPPs’ sensitivity to weaker oil/energy; 2) exposure to recessionary conditions (in the form of power demand). The former is easy – oil was down nearly 25% today, but IPPs’ direct exposure is nil. While these stocks have historically traded with some correlation to energy stocks and its primary commodity, we’ve highlighted time and again that today’s IPPs are much lower risk, better diversified, and not directly exposed.
Last month, we highlighted the convergence between Utilities and Energy as a weighting within the overall S&P 500. Well, we reached the crossover point on Wednesday of last week. Utilities now make up 3.52% of the index, just ahead of Energy’s 3.51% weighting. This reflects market trends – ESG mania, momentum and sustainability investing – and the fundamental shift that has started toward renewables/electrification from conventional energy.
Utilities fell 10.4% in February which was worse than the S&P 500’s 8.4% collapse. Bond yields hit new multi-decade lows which would normally boost utilities. Then utilities lead today’s market rally. Why? We have been talking the last few months about utilities as momentum stocks and becoming a bigger piece of momentum indices. Well the sector clearly seems to be trading that way these days. Despite a disappointing February, utilities are still beating the market by over 600bps YTD and should hold up better than most sectors if coronavirus leadWheres to a recession.
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