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.
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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.
NRG and VST were down 440bps and 375bps respectively today, putting them both down close to 10% since the day before NRG reported earnings less than a week ago. Today’s semi-annual ERCOT CDR (link) likely exacerbated the negative momentum, as investors focused on the influx of solar new build that could loosen reserve margins in 2021 and beyond (+3% in each year). However, ERCOT forwards moved only slightly, many of these projects may never come to fruition, renewables only add to grid volatility, and the companies are more diversified than ever. We’re still buyers here.
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.
VST got off to a quick start in 2019 – posting Q1 EBITDA that easily beat our above-consensus estimate, while reaffirming the full-year outlook. Both the retail and generation businesses seem to be operating well, while merger synergies execution is on track. Buybacks since the Q4 call were modest, with $700M in firepower still left to use in 2019. On top of all this VST has a number of upcoming catalysts with a positive skew – Crius deal closing with guidance boost (~$60M), tight ERCOT summer, and MISO shutdowns ($50-100M accretive). Perhaps even more important are the upcoming 13-F filings in mid-May where we expect selling shareholders (Apollo/Oaktree) will show meaningfully lower stakes (below 5% each) – moving closer to an overhang removal. Despite an overall positive update the stock fell 213bps on Friday. We see attractive value in this free cash flow story. Remains our top pick.
NRG’s 1Q19 EBITDA of $333M came in above lowered expectations due to a $27M legal settlement. Generation results were solid, while Retail was weaker on higher supply costs and G&A. NRG attributed this to seasonality and the dynamics of inter-company sales using avg. annual pricing, while reiterating the FY 2019 outlook across the board. NRG aggressively repurchased a large $750M of stock from January through mid-April. This shows strong conviction. The problem is NRG has underperformed the market by 16% and peer VST by 19% YTD despite this technical support. With further capital allocation decisions not due until the Q3 call, we expect the pace of buybacks to now slow, albeit to a still strong pace of around $500M over the next 6 months.
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).
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