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.
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:
PPL reported 3Q18 EPS of $0.59, beating consensus by $0.03, and raised the bottom end of FY18 guidance a $0.05 to $2.30-2.40. PPL reaffirmed its 5-6% EPS growth target through 2020 off the original $2.30 midpoint of 2018 guidance. There was little newly disclosed on today’s earnings call, as management plans to give more detail about the post 2022 UK rate plan and its potential impact on PPL’s UK business at next weekend’s EEI conference. We also anticipate more from discussions management had with British lawmakers last month. PPL stock has recently outperformed the UTY, including 160bp of relative gains today as the GBP rallied on hopes of a Brexit deal and a signal of faster interest rate hikes by the Bank of England. However, PPL still trails the UTY by 200bp YTD and trades at around a 25% discount to US utilities. We believe when the UK fears stabilize, the market will revert to a more reasonable P/E based valuation. Reiterate Outperform.
FERC issued an order for paper hearings on its new proposed transmission ROE methodology. The proposal responds to an Apr 2017 Appeals Court ruling that vacated and remanded FERC’s 2014 order in the first New England ISO transmission ROE challenge. In the 2014 order, FERC reduced the base ROE to 10.57% from 11.14% and capped the total ROE (with incentives) at 11.74%. The NE ROE was challenged three more times. Two complaints were made against transmission owners in MISO, with FERC reducing the base ROE and cap. On 10/18, FERC will discuss its proposal. Our initial take is neutral to slightly negative. Although the ROE cap could rise, new base ROEs could be lower than those set in recent years using the upper midpoint of a zone of reasonableness (ZoR).
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.
Bond yields broke out to a 7-year high last week and we thought that would be the nail in the coffin for already underperforming utilities. Instead, it was the S&P 500 that got buried and utilities have had their best relative month in a long time. The sector is actually up a bit in October and outperforming the market by 700bps. They are still trailing the market YTD but just barely now. So what now? We recommend selling the rally.
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