We hosted our annual investor meeting with the Moody’s team to get their latest credit views on the utilities, power and midstream sectors. For utilities, things have quieted down (ex California) as tax reform impacts have largely played out as expected. FFO/D metrics have dropped 150-200bps on average due to lost deferred tax cash flows and currently sit in the 15-16% area and likely stay there. Companies have taken actions to support their metrics (lot of equity) and have better visibility on regulatory treatment of tax reform. So 2019 is about executing on plans, hitting metrics and sticking to balanced funding plans (ie more equity). Moody’s still has a negative outlook on the sector but will likely go back to stable with good 2019 execution.
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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.
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:
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.
NEE’s quote above reflected the sentiment at the conference. Renewables growth is exploding fueled by favorable tax credits, improving economics and state standards getting more stringent. But there were warnings signs of too much competition. Utility buyers like XEL and POR noted plummeting p
Utilities fell 0.9% last month underperforming the S&P 500 by 130bps and they now trail the market by 900bps YTD. This is actually better than feared given that bond yields jumped 20 bps last month and remain near multi-year highs; plus the sector saw more equity issuance with CNP’s $2.5B of equity/converts at the end of the month. Other income sectors performed worse led down by REITs (-3.0%) and MLPs (-1.6%). We remain cautious utilities right now mainly as we sit on the edge of bond yields potentially breaking out to 7-year highs. Short interest remains subdued at the moment and valuations are still just slightly below the market multiple. The one positive is that the large equity deals appear to be near the end with only ED left (estimated $1.2B). Q3 earnings season for the broader market and the midterm election reaction will likely be key events to see whether the bond market and utilities break down. We remain Underweight.
We look forward to seeing you at our Wolfe Utilities & Energy conference next week. Participating utilities/power companies are on the right and there is still time this week to register (here). The conference provides a unique mix of company presentations via panel discussions and guest speakers that provide industry insights. This report is focused on the utilities and power companies with a list of questions to ask companies, model summaries and industry themes below. See separate reports with questions for energy companies (here).
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