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.
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.
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.
With an uneventful Q1, we expect investor focus to be on pending legislation on several key issues: 1) California – Gov Newsom announced a goal of passing legislation to fix the utility wildfire risks by July 12. While not sure on the timeline, we think this will get done and remain constructive on PCG. 2) Nuclear support legislation has been proposed in PA, OH and IL and all 3 states could address it during the spring sessions. We think IL has the best chance followed by OH and PA but all could potentially slip into later in the year. EXC has the most upside from these while the IPPs could face pressure depending on PJM’s ultimate capacity structure. NJ will decide tomorrow whether to give legislatively approved nuclear ZECs to PEG and EXC. 3) Other states to watch include NC on multi-year rate plans (DUK); TX on expanded AMI (ETR, XEL) and FL on an undergrounding rider (NEE, DUK).
This Thursday (4/18), the New Jersey BPU is set to vote on zero emissions credits for PEG’s (and EXC’s) nuclear units in the state. Recall that ZECs legislation was signed into law by Governor Murphy last May and maintaining the nuclear units appear to be a big part of his vision for a cleaner energy future. That said, this is still subject to BPU approval every three years. We estimate the subsidy is worth about $300M in total – ~$0.30/sh for PEG and ~$0.06 for EXC. PEG mgmt. has been very clear that in the event that any of its nuclear units fail to qualify for ZECs, it will shut down the entire fleet. We view approval as highly likely, given its alignment with Governor Murphy’s plan. However, PEG mgmt’s cautious tone in investor meetings earlier this year likely caused some concern, such that the stock likely sees a small relief rally if ZECs are approved.
We met with the CEOs of the 3 largest independent power companies - NRG, VST and privately-owned Calpine - during our Houston bus tour this week. The tone was constructive with Calpine coming off its best year ever and NRG and VST executing well on the new IPP model - better balance sheets, more balanced business mix and shareholder focused capital allocation. Both companies see a re-rating opportunity from their current mid-teens free cash flow yields as credit metrics move toward investment grade and they prove out the stability of their wholesale/retail business mix. VST is our top overall idea in our coverage with a $34 price target. Our NRG price target is $46. Below are key takeaways with more meeting comments in the full report.
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