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.
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The MLP and Energy Infrastructure Conference (MEIC), will be held May 14-16. Many MLP management teams will be in attendance with a larger number of C-corps this year as well, notably ENB, KMI, TRGP, and LNG. We’re looking forward to it. Four of us Wolves, running around the desert together in Las Vegas. This report is a helpful guide for investors attending and includes lots of questions to ask companies, as well as summary model information. Key industry topics are discussed below with company-specific topics in the body of the report.
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.
CWEN reported 1Q19 EBITDA of $191M, which was above our $180M estimate but below $206M consensus. The wind resource was only at 87% of expectations and solar was at 85%. Overall, the Q1 result was better than we feared after poor reports from NEP and AGR, although CWEN was helped by some O&M / timing benefits during the quarter.
CWEN cut its dividend by 40% this morning (02/14/190 to $0.80/sh annualized (5.7% yield). This was at the high end of our expectations for the size of the cut. CWEN sees $90M/yr of potential cash flow as trapped due to the PG&E bankruptcy. The new dividend is sized to preserve an 80-85% payout ratio on CAFD when excluding potentially trapped cash. We like the conservative approach. The 5.7% yield is now solely covered by the non-PG&E assets such that any progress on PG&E projects will improve the dividend outlook – i.e, upholding of contracts, negotiations with lenders, etc. We continue to think CWEN’s contracts are likely to ultimately be upheld, which would enable the company to reinstate the dividend near prior levels. We also see somewhat of a floor from the potential for GIP to take CWEN private if the stock stays weak.
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.
CWEN typically announces its Q1 dividend around 2/15 and we think a cut is likely. The company derives 23% of parent-level cash flow from contracts with PG&E which is now trapped as the projects enter technical default. To be clear, our confidence that contracts will ultimately be upheld and value to CWEN preserved has increased over the past few weeks. However, mgmt and the Board may not have clarity for several years and they seem skeptical of borrowing money to pay a dividend in the interim. Likewise, the equity funding drop-down model is not currently viable anyway, so stock price weakness from a dividend cut is less impactful to the near-term financing and acquisition strategy. Our sense is a dividend cut to $1/sh from $1.32 would make sense. It implies a 24% dividend cut to match the 23% reduction in cash flow from PG&E, while CWEN would still yield a solid 6.6%.
PCG’s threat and subsequent filing of bankruptcy kept utility investors very occupied in January. Even if investors did not own PCG itself they had to deal with knock-on effects on other CA utilities like EIX and on the renewables suppliers NEE, NEP, CWEN, ED, etc. These names dominated the worst performers of the month and were part of the reason why utilities only rose 3.4% in January trailing the market rally by 450bps.
CWEN stock has fallen 11% this week and 28% since November as key customer PCG spirals toward a likely bankruptcy filing this month. We estimate PCG contracts account for 23% of CWEN parent-level cash flow before corporate interest. As CWEN pays out 85% of free cash (CAFD) as a dividend, the PCG risk is real. When PCG files for bankruptcy, we expect PCG-tied projects to enter technical default where PCG likely keeps paying, but dividend payments to the CWEN parent become restricted at the project level. We update our valuation based on 3 scenarios – 1) Contracts are upheld ($20/sh); 2) Extreme downside case ($11); and 3) a reasonable downside case ($14). We cut our target to $17 from $22 using a wtg avg of these scenarios – implying a positive risk/reward skew. We also see downside support from sponsor GIP potentially taking strategic action.
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.
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