Portfolio Changes: EXC, FE Added to Our Preferred List, XEL Removed; POR and SO Added to Concerns List, SCG Removed

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Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com



November 27, 2017

Portfolio Changes:

EXC, FE Added to Our Preferred List, XEL Removed;

POR and SO Added to Concerns List, SCG Removed

Portfolio Manager’s Summary

In our note of Nov. 21, What Is the Floor for Rate Base Growth? And Which Utilities Face the Greatest Challenge to Sustain Their Current Growth?, we changed our list of preferred stocks, as well as added to our list of stocks about which we have concerns. We are publishing this note to summarize the rationale behind each of these changes.


Additions to List of Most Preferred Hybrid Utilities

Exelon (EXC): We had previously included EXC on our list of most preferred utilities due to its discounted valuation and rapid growth in regulated electric rate base, but removed it due to our concerns over the long term outlook for the wholesale power markets. In the short to medium term, however, we now see significant benefits to EXC of recent policy changes, including the introduction of zero emissions credits (ZECs) by the States of Illinois and New York and the likely changes in price formation rules in PJM, which we expect will support earnings and cash flows from EXC’s competitive generation fleet. In addition, EXC will benefit from tax reform, both in its competitive segment and its regulated operations, where the reduction in the corporate tax rate will accelerate the reduction in under earning at the utilities acquired in the Pepco acquisition.

While Exelon is a bit of a consensus buy, our recent research on rate base growth has given us some additional insights that support our positive view. [1]

  • Commonly cited in favor of EXC are management’s commitment to growing regulated utility earnings, the improving ROEs of the Pepco subsidiaries, and the benefit to Exelon Generation’s earnings from ZECs, the new price formation rules in PJM and tax reform.
  • In addition, we would point to EXC’s rapid rate base growth.
    • Based upon management’s disclosed capital expenditure plans, we expect growth in regulated rate electric plant base at Exelon’s utility subsidiaries to average 8.0% p.a. over 2016-2021, well in excess of the industry average of 6.5% p.a.
    • Moreover, it appears that EXC’s growth advantage may be sustainable well beyond the term of management’s guidance. With all of EXC’s rate base growth over 2016-2021 coming from the rapidly growing transmission and distribution segments, we expect EXC’s rate base growth to run at ~6.3% p.a. over 2021-2025, vs. the industry average of 5.3%.
    • EXC’s rates of depreciation for utility plant are well below average, implying that for every dollar of gross plant additions, EXC’s rate base will grow more rapidly than its peers. In EXC’s case, moreover, the adverse impact of lower depreciation on cash flow is made up by the cash generated by Exelon Generation.
    • EXC’s current rate base growth is consistent with only modest increases in the average system rate (estimated at 1.8% p.a. over 2016-2021) and even smaller increases in the average residential bill (1.0% p.a. over 2016- 2021).
  • Finally, tax reform will benefit both EXC’s competitive and regulated operations, in the latter case by accelerating the improvement in ROEs at Pepco’s under-earning subsidiaries.
  • We expect EXC’s share price to recover only as these earnings gains are achieved. Even so, at its deeply discounted current valuation of ~14.5x 2019 earnings, we find EXC to be an attractive long-term opportunity.

FirstEnergy (FE): FE’s earnings and valuation have been eroded by years of poor performance at its competitive generation business. The impending bankruptcy of FE’s competitive generation subsidiary (FES), and concerns about FE’s ability to protect itself against the claims of FES’ creditors, have caused FE to trade at a significant valuation discount versus the primarily regulated utilities as well as other hybrid utilities. By contrast, we believe there will be limited financial impact on FE from an FES bankruptcy and that the remaining, purely regulated utility operations are trading at a 20% discount to other regulated electric utilities. Furthermore, our age of plant and long-term rate base growth analysis suggests that FE may have opportunities to accelerate its current pace of rate base growth, and to grow faster than the industry average well into the next decade.

  • First, our analysis of a potential bankruptcy suggests that the financial impact on FE will be limited:
    • FE has injected significantly more cash into FES than it has removed in recent years;
    • By choosing the timing of the bankruptcy, FE can optimize its legal position with respect to these transfers;
    • The creditors do not appear to be as well organized or aggressive as those, for example, in the Edison Mission bankruptcy, possibly reflecting a larger proportion of secondary market investors and the more diverse mix of debt (including several pollution control bonds).
  • Once FES is removed, the remaining regulated utility operations will be among the most attractive in the industry, with growth focused in the lower risk and faster growing transmission and distribution segments in jurisdictions where the regulation of T&D capex is relatively efficient.
    • We estimate that FE can earn $2.20 after exiting FES, implying a 15-16x multiple of 2019 earnings vs. the industry average of ~18x and a regulated-only average of 18.8x. This is a substantial discount to the sector, and far exceeds what we think is justified by FE’s below average earnings quality.
    • While FE’s current rate base growth rate is below the industry average, in the longer term rate base growth could accelerate for a number of reasons:
      •  FE’s T&D network is among the oldest in the industry, based on when their customers were added, and its distribution network is older than average based on the ratio of replacement value to book value.[2]
      • Unlike other T&D utilities, however, FE has not been spending aggressively on its distribution network. FE will therefore have the opportunity to accelerate its investments over the next few years.
      • FE’s depreciation rate is among the lowest in the industry, driving above average long term rate base growth even at lower capex levels than their peers. The lower depreciation rate will amplify the effect of any capex increase.
      • At FE’s current rate base growth rate, we would expect to see the average system rate increase by only ~1.5% p.a. and residential bills by 1.3% p.a. through 2021, leaving significant headroom for additional growth.
    • FE’s rate base will receive a 3% boost under tax reform if bonus depreciation is eliminated for utilities in 2018 and 2019.  Unlike many other utilities, where a similar gain would come at the cost of higher cash taxes, FE’s net operating loss position will offset its increased tax liability in 2018 and 2019, implying no erosion of cash flow.
      • In addition, with the reduction in tax expense at each utility, this boost in rate base should add to utility earnings without requiring rate relief.
    • A 3% boost to rate base would drive an increase in earnings almost equal to the impact on earnings of the lower tax rate on the holdco interest expense, which has been one of the concerns regarding FE and tax reform.
  • We expect that the FES bankruptcy will be a key catalyst for FE, allowing for consensus estimates to converge on the utility-plus-parent earnings and encouraging FE to lay out their distribution growth plans more fully. Post-FES EPS of ~$2.20 would be the nadir, with subsequent EPS growth expected to exceed the industry average thereafter.


Additions to List of Least Preferred Regulated Electric Utilities

Portland General Electric (POR): POR trades at a significant premium to the industry despite well below average earnings growth for the next several years. Earnings growth over the last five years has been below 4% and we do not see them growing above 4% for the foreseeable future due to limited rate base growth prospects. Although POR’s premium is partly due to its potential as an acquisition target, we believe there are other, similar sized utilities offering better growth opportunities (e.g. EE, PNM), lower valuations (e.g. OGE) or both (e.g. NWE), that would likely be acquired first.

Even after POR’s recent capex guidance increase, rate base and earnings growth at POR should be well below the industry average over the next five years, and we see limited opportunity for POR to accelerate its growth meaningfully thereafter. We estimate POR’s rate base growth over 2016-2021 at only ~2.0% p.a., as against an industry average of 6.5%. Over 2021-2025, we would expect POR to accelerate its rate base growth to ~2.5% p.a., still well below the industry average, which we estimate at 5.3% p.a. over this period.

While POR has the possibility to add new generation in its integrated resource plan, even a 50% increase in its capex plans will not bring its growth out of the bottom quintile among its regulated utility peers. In part, this reflects POR’s election not to take bonus depreciation, which implies a slower roll-off of deferred taxes over the next decade or more.

  • POR’s updated capex guidance drives rate base growth of only 2% through 2021.
    • Even if POR were to receive approval for their Integrated Resource Plan and be allowed to acquire new conventional and renewable generation, an additional $500-$600 million over the next four years would only increase rate base growth to just under 4% through 2021, well below the industry average of 6.5%.  Moreover, there will be limited opportunities for similar investment beyond 2021.
    • We see POR’s long term rate base growth at 3-4%, well below our long-term industry average forecast of 5.1%.
    • Finally, POR has a relatively young transmission and distribution network, suggesting limited opportunity for accelerated replacement.
  • Our rate base growth analysis has pointed to certain structural differences that reduce POR’s rate base growth rate versus other utilities.
    • POR’s depreciation rate is above average, supporting cash flows, but limiting rate base growth.
    • The choice to not elect bonus depreciation, while helping rate base growth historically, will limit it on a relative basis going forward, as other utilities will benefit from the accelerated roll off of deferred taxes.
    • Furthermore, in the event of tax reform, the other utilities will receive an additional boost to rate base growth versus current forecasts from the removal of bonus depreciation in 2018 and 2019.
  • POR trades at a premium to the utility sector, partly due to the takeover premium on small cap utilities, but limited growth prospects and the availability of more attractive takeover candidates of similar size should result in a revaluation of POR. If market expectations are not reset sooner, the updated guidance after a final decision on the IRP in 2018 could be the catalyst, when updated growth forecasts for the company fall short of consensus.

Southern (SO): Southern has underperformed over the past year due to its issues with the Kemper IGCC in Mississippi and the new nuclear plants at Vogtle in Georgia. Our rate base growth research suggests that SO’s below average rate base growth will continue into the future, reflecting low normalized rates of capital expenditure and a younger than average T&D network. Although trading at a discount, we expect SO to continue to underperform for the next several years, due to the risks from Vogtle, disappointing longer term growth opportunities, and the additional risk of acquisitions as SO tries to find other means to sustain its growth.

  • Our electric rate base growth analysis suggests that rate base growth will average ~5.2% through 2021, below the industry average of 6.5%, and long term growth of only ~4.0%, well below our long term industry average forecast of 5.1%.
  • After dilution by non-plant rate base and equity needs, earnings growth from the electric utilities should average less than 3%.
  • SO are targeting 5% EPS growth long term, relying on the gas business and Southern Power to drive the growth, but we believe that the lack of growth opportunities in their core electric utility business, combined with additional cost overruns at Vogtle, will force them to seek additional acquisitions to avoid a slowing in their growth rate.
  • Key headwinds to growth include the following:
    • SO’s T&D network is younger than average on all metrics, including vintage of customer additions and replacement value to book value, suggesting limited opportunities for accelerated replacement capex.
    • Furthermore, we do not see a significant opportunity for retiring coal fired generation and replacing it with lower cost gas.
      • Much of their coal-fired generation is less than 40 years old and the vast majority is less than 50 years old.
      • The coal-fired generation is still a large part of rate base, which would need to be recovered if the plants were retired and replaced, reducing the benefits of such a strategy
      • The capacity from Vogtle and Kemper should meet their needs for several years given slow demand growth
      • With the roll back of the Clean Power Plan, there is no compelling regulatory reason to undertake such a costly transition to gas
    • When Vogtle goes into service, SO will also face a drag on earnings and cash flow as, according to SO, there will likely be a 1-2 year period before Vogtle will go into rates, during which SO will be paying O&M expense, amortizing D&A and no longer recognizing AFUDC in earnings. For an investment of this size, the impact, while temporary, will be meaningful.
  • Southern Power is driving 35% of SO’s earnings growth through 2021 and is forecasted to grow at 10-12%, but we do not believe this growth rate is sustainable after tax credits for wind drop post-2020.
    • In addition, in order to reduce capital needs, SO will be relying more heavily on tax equity going forward, hurting the economics of new renewables deals for SO, and could seek to sell some of the assets.
  • In summary, we are skeptical of SO’s ability to maintain its long run EPS growth guidance without resorting to accounting gimmicks and acquisitions, resulting in likely continued underperformance. Even if SO is able to maintain its guidance, there is little chance of sustained outperformance versus the group.

Removal from List of Most Preferred Regulated Electric Utilities

Xcel Energy (XEL): We upgraded XEL on the expectation that the company’s cost management efforts would deliver earnings growth not anticipated in consensus estimates. Since our upgrade, however, consensus earnings estimates have increased to reflect most of these opportunities and are now closer to our estimates. Moreover, XEL’s outperformance since we added them to our most preferred list has brought its valuation into line with our earnings expectations. Finally, our analysis of age of plant and long-term rate basis growth suggest that it could be challenging for XEL to maintain its growth rate into the next decade. While we do not expect XEL to underperform versus the sector, and there is still some potential upside from approvals of additional wind projects, we now see limited room for outperformance.

Removal from List of Most Preferred Regulated Electric Utilities

SCANA (SCG): Since we added SCG to our list of least preferred electric utilities in May due to our concerns about the VC Summer nuclear project, SCG has abandoned the plant, multiple concerns have arisen about how the project was run, and the stock price has declined by over a third. While there is still the risk of a complete write-off of the project and roll-back of prior rate increases that could result in additional downside of 25-30%, we believe this is unlikely. We believe the most likely scenarios, involving additional write-offs and some form of recovery of the remaining investment without return, allow additional upside, although the most recent offer by SCG caps the upside to 20-25%. Therefore, although the risk of a large drop of 25% or more is limited from here, the upside is also limited, preventing us from supporting an investment in SCG at this time.

Recent Upgrade PG&E

Finally, we recently upgraded PG&E to our list most preferred regulated utilities (see our note of October 17th, Upgrading PCG to Our List of Most Preferred Regulated Utility Stocks: The Stock Now Fully Discounts the Sonoma County Fires). Below we summarize our investment case for the stock.

PG&E Corp. (PCG):  Our recent upgrade of PCG[3] reflects what we believe to be an excessively discounted valuation of a fundamentally attractive utility franchise. We had previously included PCG among our favorite utilities, but removed it because of the risk around California’s upcoming cost of capital proceedings. The discount in the valuation created by the fires caused us to return PCG to our list of favorite utilities.

  • PCG’s is a fundamentally attractive franchise with some of the strongest prospective rate base growth in the country and a regulatory framework that minimizes regulatory lag. We expect PCG to realize ~9.5% compound annual growth in electric plant rate base over 2016-2021, as against an industry average of only 6.5%.
  • While we still have concerns about the cost of capital proceeding 18 months from now, that had already created a moderate discount in PCG’s valuation before the fire.
  • Critically, our legal analysis suggests that the drop in PCG’s market cap since the fires far outweighs their potential impact on the value of the stock.
    • Since October 11, the UTY is up ~3% and PCG is down ~22%, resulting in a change in market cap of ~$8.5 billion versus where PCG would be today. A loss in market cap of this magnitude would imply the market is expecting $13 billion in pre-tax losses stemming from the fire.
    • We estimate PCG’s maximum exposure from all fires, including property and economic losses, life and limb and the cost of the firefighting to be ~$7.5-$9.5 billion.  After insurance recoveries and tax deductions, we estimate that these damages might cost PCG ~$4-$5 billion. This would suggest the potential for ~13% to 16% upside on PCG’s current market cap of $27.8 billion, even in a worst-case scenario.
  • We believe the risk of punitive damages is minimal because of the stringent legal standard for their award: “willful misconduct” by PCG.
    • PCG exercised increasing diligence in vegetation management as the drought worsened, particularly following the Butte fire.
    • If evidence of willful misconduct existed, we believe it would have been produced already.
      • Willful misconduct in maintaining the equipment, all of which is above ground, would have already been evident.
      • Moreover, unlike San Bruno, the relevant utility programs have been reviewed multiple times in recent years with no evidence of major deficiencies, let alone willful misconduct.
  • Similarly, potential CPUC fines should be limited.  CPUC fines are based on the number and duration in days of the violations. PCG’s fire prevention policies have been reviewed frequently by the CPUC in recent years, and PCG conducts its vegetation management every 6 to 12 months, so the number of violations should be small and their duration cannot be long.
    • To the risk of CPUC fines in context, we note that in September, 2015, the Butte Fire in Amador County burned 71,000 acres, destroyed 549 homes and killed two people. The CPUC found that PCG’s negligence in pruning trees nears its lines had contributed to the fire and fined the utility $8.3 million.
    • In 1994, PCG was found guilty of 739 counts of negligence in connection with a fire in the Sierra foothills that destroyed twelve homes.  PCG was fined $30 million by state regulators, or the equivalent of ~$50 million in 2017 dollars.
  • As noted above, we estimate PCG’s maximum exposure from all the fires at ~$7.5-$9.5 billion, comprising $3-$4 billion of property damages, $3-$4 billion of economic damages, ~$1billion for life and limb and ~$500 million for the firefighting and legal costs.
  • While PCG may be held liable for property damage caused by its equipment under the strict liability standard of California’s inverse condemnation principle, it will only be held liable for consequential damages – economic losses and loss of life and limb – if it was negligent.
    • PCG would thus face the maximum loss of $7.5-9.5billion only if they were negligent in causing all 25 fires.
      • Even if PCG were the cause of every fire, it is unlikely they were negligent in causing every one.
      • In fact, we know that PCG are only under investigation for fewer than 20 fires.
  • In fires where PCG were the cause, but through no fault of their own (e.g. their wires caused the fire when a tree 50 feet away was blown down by the wind), PCG could be held liable for property damages under inverse condemnation. If a court or the CPUC makes a finding that PCG were not negligent, however, they would be able to recover from ratepayers the damages paid out.
    • Even if PCG had to pay $5 billion for property damage, and was unable to recover this from ratepayers, after insurance coverage and tax deductions, we estimate there would be ~20% upside in the stock.
    • We believe PCG will likely fully litigate cases where they believe they were not negligent in order to have a court determination as to the absence of negligence. This would then reduce the ability of the CPUC to deny recovery from ratepayers of any damages paid out in these cases.
  • The risk to this thesis is the length of time before a potential resolution, due to the probability of extended litigation, and the return of PCG to its pre-fire valuation, so this investment would need to be timed properly, preferably in advance of the results of the CalFire investigations, which will likely be completed in 7-11 months (i.e. 8-12 months after the fires)

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology

Source: SSR analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

  1. Please see our research on the outlook for electricity utility rate base growth, particularly, Antiquated Power Grids: What Can Age of Plant Tell Us About Future Rate Base Growth? (October 25, 2017), If This Is the Golden Age of Electric Utilities, What’s Next? Or, How Fast Can Rate Base Grow in the Long Term and on What Will Utilities Spend? (October 2, 2017), and Rising Growth and Falling Beta: Electric Utility Rate Bases Show Accelerating Growth Through 2021 (September 6, 2017).
  2. See our note of October 25, 2017, Antiquated Power Grids: What Can Age of Plant Tell Us About Future Rate Base Growth?
  3. See our note of October 17, 2017, Upgrading PCG to Our List of Most Preferred Regulated Utility Stocks: The Stock Now Fully Discounts the Sonoma County Fires. 
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