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While NextEra’s analyst day was an upbeat event overall, we thought that the story on NEP was the highlight. The distribution growth outlook was extended to 2024 with cushion from the embedded potential growth as well as the macro tailwinds of continued renewables penetration in the US. We are not aware of another income vehicle with NEP’s visible distribution growth potential and duration – 12-15% through at least 2024 – with such a strong parent and exposure to the significant growth from renewables. We reiterate our Outperform rating.
We expect NEE to follow what has been a successful playbook from the last few meetings. This will likely include an extension of the 6%-8% growth rate another year, to 2022, and a deep dive into the factors driving that growth. NEE is verging on being the first US utility to hit a $100B market cap and we doubt there are few companies that size with 8% growth visibility for the next 3-5 years. We also view NEP as an under the radar way to be exposed to record renewables growth alongside the best renewables developer. We reiterate Outperform on NEE/NEP and raise our NEE PT to $210 from $200.
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.
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.
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.
NEP shares underperformed the group by 1.9% on the day after reporting a weaker than expected Q1 from extremely poor wind conditions. Despite this the full year outlook remains on track, especially with the increased certainty from the recent asset dropdown. We are not aware of another income vehicle with the distribution growth potential and duration of NEP – 12-15% through at least 2023 – with such a strong parent. We reiterate our Outperform rating.
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).
This week NEP put the question of California risk to the sidelines following the 600 MW asset drop and attractive portfolio financing announced on Monday (see details in note). The cash flow from these transactions will more than offset the ~$100M of CAFD at risk from PCG-exposed projects and drive the 15% distribution growth in 2019. We continue to see NEP as highly attractive, especially with the increased certainty from the asset dropdown. We are not aware of another income vehicle with the distribution growth potential and duration – 12-15% through at least 2023 – with such a strong parent. Outperform.
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