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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PPL reported 2Q19 of $0.58, slightly ahead of then-consensus of $0.56. PPL affirmed its 2019-21 EPS outlook. PPL also said Ofgem’s recent open letter consultation for RIIO-ED2 was generally in line with expectations. But the elephant in the room continues to be UK political uncertainty, tied to Brexit. The GBP has sunk to near post-Brexit-vote lows ($1.21 last week), and not coincidentally PPL stock fell to 52-week lows relative to peers in the past week. The stock gained 80bp over the UTY after reporting today but trails by ~1000bp YTD. We believe the market will revert to a more reasonable valuation of the stock when the UK uncertainty has abated. Meanwhile, investors are getting paid a juicy yield to wait – a premium in the current market environment.
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
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.
Our annual utilities pension review – still underfunded, not much progress
Our utilities pension review, with help from Wolfe’s Accounting/Tax team and their comprehensive report, takes a look at the state of pensions in the sector using year-end 2018 data. Utilities remain underfunded for their pensions/OPEB – with most companies in the same place amid weak equity markets and higher rates. This dynamic has reversed in 2019, with yields sharply falling. There remains wide disparity in funding levels and accounting assumptions within our coverage.
This report looks at the numbers – CEO pay, stock ownership, change of control info and much more. Overall CEO pay was up 8% vs 2017 and CEOs averaged 143% of their target ST incentive comp. We review the key drivers of executive compensation for each company. For the most part, utility CEO pay is tied to the things investors care most about – EPS and shareholder return. Several companies also include operational, safety and customer service metrics which we think are important for L-T value in the utility sector. A new wrinkle is carbon reduction which has been a big focus for XEL and recently added by SO for 2019.
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.
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.
The fear of a less favorable regulatory environment in the UK persists, and Ofgem is expected to issue a final decision in the RIIO-2 sector specific methodology for transmission and gas distribution this month. Although Ofgem has said that consultation decision should not be a read-across to distribution network operators (e.g., PPL’s WPD), we anticipate the market will do just that. PPL believes it can manage through the RIIO-2 framework (which will be in place Apr 2023 for PPL) and expects incremental investments in the UK to meet policy targets, like electrification. Still, shares have again trailed the UTY recently and are nearing the relative lows reached last Dec; they also trade at a 27% discount to US utilities. We believe when the UK fears stabilize, the market will revert to a more reasonable P/E based valuation. Outperform.
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