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.
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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.
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:
CWEN’s Q3 EBITDA came in $20M above our expectation as the wind resource was 106% of normal. The company did not raise FY 2018 guidance due in part to below normal wind in October, and possibly some conservatism. There were some small incremental growth developments with a new thermal project in Puerto Rico and an initial agreement to buy the rest of Agua Caliente solar from NRG at reasonable terms. Other acquisitions remain on schedule, albeit with a small delay for Carlsbad, while Clearway Group made progress in adding another 600 MW of projects to the development pipeline.
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.
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