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.
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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.
Utilities eked out a small 0.5% gain for 2018 on the heels of a massive Q4 rally as the market turned decidedly defensive ending the year down 6.2%. Utilities 670bps outperformance came despite a lot of headwinds on the group including higher interest rates (10-yr up 23bps), lack of tax reform benefits, over $15B of equity issuance, and the CA fires impact. Investors were looking for any place to hide and utilities fit the bill especially given their lack of exposure to tariffs and recession fears. Utilities came in second among income sectors for the year trailing only Pharma which was up 5.2%. Interestingly, all other income sectors underperformed the market in 2018 (see Exhibit 1). We remain cautious on utilities going into 2019 given their heavy dependence on a negative macro call and very high relative valuations (20% adjusted P/E premium vs the historic avg of 3%). In our view, buying defensive sectors at historically large premiums is not defensive.
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:
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