Potential Momentum Plays and Inflection Points in ROE and Rate Base Growth

Eric Selmon
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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

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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May 28, 2019

Potential Momentum Plays and Inflection Points in ROE and Rate Base Growth

Shareholder value creation is a function of the pace of growth in invested capital and the earned return on that investment relative to the cost of capital. In this report, we present a comprehensive valuation framework for regulated utilities, based on an assessment of historical earned returns on equity, forecast rate base growth and valuation relative to peers on 2021 consensus earnings. We can thus identify utilities with a historical track record of earning high returns on equity that are adding rapidly to their stock of invested capital, and thus likely to lead the industry in value creation, as well as those whose poor historical profitability may limit the shareholder value created through future rate base growth. Considering these companies in the context of their relative valuation allows us to identify those most and least likely to exceed or lag the market’s expectations for their stocks. In light of PNW’s attractive positioning in this framework and our view of PNW’s long term rate base growth potential, we are adding PNW to our list of preferred utilities.

  • Among regulated electric utilities, whose revenues are periodically adjusted by regulators to avoid persistent over- or under-earning, earned ROEs would be expected to revert to allowed levels over time. Historically, this frequently has not been the case.
  • Over the last 20 years, earned ROEs at certain U.S. regulated electric utilities have persistently lagged allowed ROEs (earnings lag), while others have persistently earned at or even above allowed levels. (See Exhibit 3.)
    • Utilities that have ranked in the bottom two (worst) quintiles on earnings lag for the past ten years or longer are ALE, DUK, EE, EXC, HE, PCG, PNM, POR, and XEL.
    • Utilities that have ranked in the top two (best) quintiles for the past ten years or longer, showing low earnings lag, are AGR, DTE, EIX, ES, IDA, LNT, PEG and WEC.
  • Reflecting the failure of earned ROEs to revert to allowed levels, utilities in the top and bottom quintiles on earned ROE often maintain their relative position for years. (See Exhibit 6.)
    • Utilities ranking in the bottom two (worst) quintiles on earned ROE for the past ten years or longer are AEE, ALE, AVA, EVRG, EXC, HE, PNM, POR, and XEL.
    • Utilities ranking in the top two (best) quintiles on earned ROE for the past ten years or longer include AEP, DTE, EIX, ES, IDA, LNT, NEE and WEC.
  • Electric utilities’ rate base growth and the gap between utilities’ earned and allowed ROEs have historically been inversely correlated, with rapid rate base growth associated with under-earning and slow rate base growth associated with over-earning. This likely reflects regulatory lag in granting utilities revenue relief commensurate with the growth of their regulated rate base. (See Exhibits 9 and 10).
    • The correlation coefficient between (i) the median of our 32 utilities’ rolling three year CAGRs in electric plant rate base plus CWIP, and (ii) the median of the utilities’ gap between earned and allowed ROEs, averaged over the same periods, is a negative 0.76.
  • Shareholder value creation is a function of the pace of growth in invested capital and the earned return on that investment relative to the cost of capital.
  • Given the persistence of earned ROEs among regulated electric utilities, companies that have exhibited high ROEs for extended periods, and whose rate base growth is forecast to be above average, should maximize shareholder value creation over time.
  • Utilities with historically low earned ROEs but rapid forecast rate base growth run the risk that future capital additions will earn a return only marginally above or even below their cost of capital, limiting or even destroying shareholder value. Yet these utilities also offer the greatest opportunity for outperformance if they are able to improve their earnings lag and ROEs, causing earnings growth to exceed growth in rate base.
  • We have forecast the growth in electric plant rate base plus CWIP of the regulated electric utilities, based on their announced capital expenditure plans and our modeling of the consequent changes in deferred tax assets and liabilities. (See Exhibit 11.)
    • Ranking in the top (best) quintile in our forecast of rate base growth through 2022 are AEP, AGR, DTE, ETR, NEE, PCG, and PNM.
    • Ranking in the second quintile in our forecast of rate base growth through 2022 are AEE, D, EIX, EXC, FE, and WEC.
  • Utilities combining above median rate base growth with above median earned ROEs are AEP, AGR, D, DTE, EIX, NEE, PNW and WEC. (See Exhibits 12, 14 and 15.)
    • Among these utilities, EIX is in the first (cheapest) quintile based on price to 2021 consensus earnings and PNW is the second quintile when compared to their regulated utility peers. Both could outperform if they can maintain their performance on ROE.
      • EIX faces wildfire risks in California, but, as we have discussed in other notes,[1] we believe the stock is attractively valued even in light of these risks.
    • We are adding PNW to our preferred utilities list based on its long term rate base and earnings growth prospects. Our assessment is predicated upon management’s medium term capex guidance, our analysis of the utility’s long term rate base growth potential,[2] and PNW’s above average ROE.
    • We continue to find AEP attractive, as its valuation is in line with the regulated utility median, but its forecast rate base growth and ROE are well above the industry median.
    • DTE is in a similar position and merits consideration, but the electric utility is a smaller part of the company and we have concerns with some of the other sources of earnings.
    • D and AGR trade at a discount and inline, respectively, to large cap utilities, but investors have concerns about D’s gas operations and AGR’s ability to execute on its unregulated growth and on large projects in their regulated capex forecasts. Given their attractive rate base growth and earned ROEs, these companies merit further examination to determine whether they can address these concerns.
    • NEE and WEC both rank in the fifth or most expensive quintile on price to 2021 consensus earnings. We believe they are fairly valued in light of their forecasted growth and their historically high earned ROEs, however, outperformance will be difficult as it will require the companies to exceed their already high expectations.
  • Utilities that have above median forecasted rate base growth, but subpar ROEs and earnings lag, are at risk of destroying shareholder value. Yet they also offer the prospect of outperformance if they are able to improve their operations and/or change their regulatory framework to reduce their earnings lag and increase their earned ROEs.
    • Further analysis of these companies is warranted to assess whether improvements in operational performance, and a constructive regulatory response, may close the gap between earned and allowed ROEs, raise earned returns and drive earnings growth in excess of rate base growth.
  • Utilities with above median forecast rate base growth and a below median ranking on historical earned ROE or earnings lag are AEE, ETR, EXC, FE, PCG and PNM. (See Exhibits 12, 13, 14 and 15.)
    • EXC and FE rank in the first (cheapest) quintile and ETR ranks in the second quintile among their peers on price to 2021 consensus earnings; all three have been making progress in improving earned ROEs and earnings lag in the past couple of years. If these improvements can be maintained, the stocks should offer attractive returns.
    • PCG is also cheap, but its valuation is driven by wildfire risk and the outcome of its bankruptcy proceeding. As we have discussed in previous notes, we favor the stock based on our assessment of these risks.[3]
    • Less attractively valued are PNM, which ranks in the fifth (most expensive) quintile on price to consensus 2021 earnings, and AEE, which ranks in the fourth quintile.
      • AEE has been successful in the past few years in reducing earnings lag and improving its regulatory framework, so its valuation appears justified, but outperformance will be difficult to achieve.
  • Utilities that combine lagging growth in rate base with historically low earned returns on equity include ALE, EE, EVRG, HE, and POR. Among these stocks, EE, ALE, and POR trade in the fifth (most expensive) quintile on valuation, while HE trades in the fourth quintile. Given their slow prospective rate base growth and poor historical earned ROEs, these stocks seem destined to underperform in the absence of a takeover offer. Among small and mid-cap names, moreover, we view PNW as a far more compelling takeover candidate.

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

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Source: SSR research, analysis and estimates

Details

Earned vs. Allowed ROE

Exhibit 2: Gap Between Earned and Allowed ROE1 (2013-2017 Average)

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

Most publicly traded electric utilities in the United States under-earn their allowed ROEs, often by significant margins (see Exhibit 2). Over the five years 2013-2017, the median gap between earned and allowed ROE among U.S. publicly traded electrics was 60 basis points; however, three utilities (SO, PNM and PCG) posted average gaps over this period of 300 basis points or more, three (EE, EVRG and ALE) posted average gaps between 200 and 300 basis points, and seven (POR, HE, EXC, ETR, FE, XEL, and DUK) posted average gaps between 100 and 200 basis points. By contrast, over-earning is rare: only eight of the 32 publicly traded electric utilities in our sample over-earned their allowed ROEs, on average, over 2013-2017. All eight did so by 100 basis points or less, and seven of the eight did so by 50 basis points or less.

In this section, we will focus on identifying those utilities with a historical pattern of under-earning or over-earning their allowed ROEs. Despite a regulatory framework designed to adjust utility revenues periodically to avoid persistent over- or under-earning of allowed returns, we find that the utilities at the top and bottom of the distribution in Exhibit 2 are often the same across multiple time periods.

The right side of Exhibit 3 below presents the difference between and the earned and allowed ROE of the publicly traded electric utilities in the United States, averaged over five-year periods since 1998; the left side ranks the utilities into quintiles during each of the four periods. A first quintile designation is assigned to those utilities with the most favorable gaps between earned and allowed ROE and a fifth quintile designation is assigned to those with the least favorable gaps.

Exhibit 3: Gap Between Earned and Allowed ROE1 of U.S. Electric Utilities, 1998-2017

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

As the quintile ranking makes evident, it is not uncommon for utilities to maintain the same quintile rankings over multiple periods. Over the four five-year periods we have analyzed between 1998 and 2017, each utility in our sample has the opportunity to change its quintile ranking three times. Given the 32 publicly traded utilities in our sample, this implies 96 total potential changes in quintile rankings. As can be seen in Exhibit 4, however, in 64 of these cases (67%), there was no change in quintile ranking or the change in ranking was limited to a single quintile.

Exhibit 4: Frequency of Changes in Quintile Rankings Among U.S. Electric Utilities

When Ranked on the Gap Between Earned and Allowed ROE1 Over 1998-2017

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

The relative stability of the 32 utilities’ quintile rankings is particularly evident in the top and bottom quintiles of the distribution. Given a regulatory framework designed periodically to adjust utilities’ revenues so as to avoid persistent over- or under-earning of allowed returns, the tendency of utilities to remain in the top and bottom quintiles of the distribution is particularly surprising.

If we analyze the 16 utilities that ranked in the bottom quintile of the distribution at least once, we find that five were in the bottom quintile for three of the last four 5-year periods (AVA, EE, EVRG, PNM, POR) and two were in the bottom quintile for two of these periods (HE, PCG). Together, these repeat under-performers account for 44% of the 16 utilities that ranked in the bottom quintile at least once.

A tendency for utilities to repeat in the top quintile is also evident. Of the 17 utilities that ranked in the top quintile in at least once, seven were in the top quintile for two of the four 5-year periods (ES, FE, IDA, LNT, NWE, OGE, WEC) and two were in the top quintile for three of the four periods (AGR, EIX). Together, these repeat out-performers account for 53% of the 17 utilities that ranked in the bottom quintile at least once.

That sub-groups of utilities have persistently over-earned or under-earned their allowed ROEs over the last 20 years, despite a regulatory framework designed to drive earned returns back towards allowed levels, can perhaps be explained by differences in the utilities’ quality of management or corporate culture, characteristics that can be persistent for long periods of time. It is also possible that these differences reflect the quality of the regulatory framework in which the utilities operate. Utilities in states whose rate-setting procedures are characterized by a high degree of regulatory lag will tend to earn ROEs below their allowed levels, while utilities that benefit from forward looking rate cases or riders linking revenues to capex have a better opportunity to earn their allowed returns.

Interestingly, on occasion utilities in the same state appear at opposite ends of the spectrum. Thus northern California’s PCG appears twice in the bottom quintile of the industry, based on the gap between earned and allowed ROE, while its southern Californian neighbor, EIX, appears three times in the top quintile. This suggests that a benign regulatory framework may be a necessary but not a sufficient condition for outperformance, and that high quality management is required to realize potential returns. SO’s last place ranking on the gap between earned and allowed ROE over 2013-2017, after ranking in the top quintile on this metric over the preceding five years, similarly points up the high cost of management errors, in this case with respect to the design and construction of the Kemper and Vogtle power projects.

Earned ROE

Exhibit 5: Earned and Allowed ROE1 of U.S. Electric Utilities (2013-2017 Average)

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

Despite the marked tendency of U.S. regulated electric utilities to under-earn their allowed ROEs, the relatively high allowed ROEs granted by state and federal utility regulators are reflected in earned ROEs that tend to exceed most independent estimates of the industry’s weighted average cost of capital. Thus, of our sample of 32 publicly traded regulated electrics, only five utilities earned ROEs below 8.0%, on average, over 2013-2017 (see Exhibit 5).

The range of earned ROEs across the industry is quite marked: the five utilities with lowest earned ROEs over 2013-2017 earned, on average, only 7.2%, while the five utilities with the highest earned ROEs over this period earned an average of 10.7%, a difference of 350 basis points. While the latter are clearly earning returns well in excess of their cost of capital, the returns realized by the former are marginal at best, implying that further capital investment will fail to add to shareholder value.

Given the 350 basis points gap between the highest- and lowest-earning utilities in the distribution, the relative position of individual utilities along this range can have important implications, in the long run, for utility stock performance. In this section, we examine whether certain regulated electrics persistently appear at the high or low ends of the distribution of earned ROEs.

The right side of Exhibit 6 presents the earned ROEs of the publicly traded electric utilities in the United States, averaged over five-year periods since 1998; the left side ranks the utilities into quintiles during each of the four periods. A first quintile designation is assigned to those utilities with the highest earned ROEs and a fifth quintile designation is assigned to those with the lowest earned ROEs.

Exhibit 6: Average Earned ROE1 of U.S. Electric Utilities, 1998-2017

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

As Exhibit 6 illustrates, utilities’ rankings on earned ROE also tend to be persistent over time. Over the four five-year periods we have analyzed between 1998 and 2017, each utility in our sample has the opportunity to change its quintile ranking three times. Given the 32 publicly traded utilities in our sample, this implies 96 total potential changes in quintile rankings based on earned ROE. As can be seen in Exhibit 7, however, in 67 of these cases (70%), there was no change in quintile ranking or the change in ranking was limited to a single quintile.

Exhibit 7: Frequency of Changes in Quintile Rankings Among U.S. Electric Utilities

When Ranked on Earned ROE1 Over 1998-2017

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

The relative stability of the 32 utilities’ quintile rankings is particularly evident in the top and bottom quintiles of the distribution. For example, if we analyze the 14 utilities that ranked in the bottom quintile on earned ROE at least once, we find that five were in the bottom quintile for three of the four five-year periods (AVA, EVRG, HE, PNM, POR) and four were in the bottom quintile for two of these periods (AEE, EE, EXC, PCG). Only five of the fourteen companies appearing in the bottom quintile did so during only one of the four five-year periods.

A tendency for utilities to repeat in the top quintile is also evident, although it is less pronounced. Of the 18 utilities that ranked in the top quintile on earned ROE at least once, six were in the top quintile for two of these five-year periods (AGR, EXC, FE, LNT, NWE, WEC) and two were in the top quintile for three of these periods (EIX, SO).

Exhibit 8 lists the tickers of the utilities that have appeared for the last ten years or more in the top or bottom quintile when ranked on earned ROE or the gap between earned and allowed ROE. Not surprisingly, there is considerable overlap between the two groups. Thus ALE, EXC, HE, PNM, POR and XEL appear repeatedly in the bottom quintile on both earned ROE and the gap between earned and allowed ROE. Similarly, DTE, EIX, ES, IDA, LNT, and WEC appear repeatedly in the top quintile on both earned ROE and the gap between earned and allowed ROE.

Exhibit 8: Utilities Appearing for the Last 10 Years or More in the Top or Bottom Quintiles

on Earned ROE or the Gap Between Earned and Allowed ROE1

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

The tendency for utilities to appear repeatedly in the top or bottom quintiles of the earned ROE distribution does not imply that the rankings of these utilities cannot change markedly over time. Three utilities that ranked twice in the top quintile on earned ROE but whose rankings have since fallen significantly are FE (now in the middle quintile), NWE (now in the middle quintile) and EXC (now in the bottom quintile, reflecting in part the introduction of less generous mechanism for the calculation of allowed ROEs in Illinois and its acquisitions of the under-performing Mid-Atlantic utilities owned by Constellation and PEPCO). (See Exhibit 6.)

On the other hand, it has been less common for companies that appear repeatedly in the bottom quintile on earned ROE to achieve a marked improvement in ranking: only EE, which was ranked twice in the bottom quintile, was able to do so, subsequently rising to a first quintile ranking.

The Relationship Between Earned ROE and Rate Base Growth

In analyzing historical patterns in electric utilities’ rate base growth and the gap between utilities’ earned and allowed ROEs, we found a tendency for these two variables to be inversely correlated, with rapid rate base growth associated with under-earning and slow rate base growth associated with over-earning. Statistically, the correlation coefficient between (i) the median of our 32 utilities’ rolling three year CAGRs in electric plant rate base plus CWIP and (ii) the median of the utilities’ gap between earned and allowed ROEs, averaged over the same periods, was a negative 0.76. This presumably reflects regulatory lag in granting utilities revenue relief commensurate with the growth of their regulated rate base.

Exhibit 9 compares (i) the median of the utilities’ rolling 3-years CAGRs in electric plant rate base plus CWIP to (ii) the median of the gap between earned and allowed ROEs, averaged over the same three year periods. As can be seen there, the industry’s slow rate base growth over the ten years from 1992 to 2002 was associated with a positive median gap between earned and allowed ROEs, or over-earning. The much more rapid rate growth realized by the industry over the last 15 years, by contrast, has been associated with a negative median gap between earned and allowed ROE, or under-earning. (See Exhibit 10.)

Exhibit 9: Three-Year Change in Rate Base Plus CWIP vs. Median Gap

Between Actual & Allowed ROE, 1992-20171

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

Exhibit 10: Three Year CAGR in Rate Base Plus CWIP and Median Gap

Between Earned & Allowed ROE, 1992-2002 vs. 2003-20171

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1. Return on equity is calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

The impact of accelerating rate base growth on the profitability of the electric utilities was dramatic, particularly over the period from the late 1990s to the late 2010s. Over the ten years from 1998 to 2008, for example, the industry’s median gap between earned and allowed ROE dropped from a positive 40 basis points to a negative 170 basis points, as rate base growth accelerated from 0.5% to 9.1% p.a.

Over the period from 2010 through 2017, by contrast, the industry’s median gap between earned and allowed ROE has been compressed, averaging only 70 basis points over the period, implying a lesser degree of under-earning despite continued rapid rate base growth. We believe this reflects the success of the industry in implementing strategies to offset the headwind caused by regulatory lag. One important success has been the widening adoption by state utility regulators of riders linking utility revenues to the growth in regulated rate base in the years between formal rate cases. Another has been the implementation of strategies to curtail the growth of operation and maintenance expense, either through mergers between utilities or the substitution of capital for labor, allowing the same level of utility revenues to support a higher earned return on equity.

Implications for Stock Selection

Shareholder value creation is a function of the pace of growth in invested capital and the earned return on that investment relative to the cost of capital. Given the persistence of earned ROEs among regulated electric utilities, companies that have exhibited high ROEs for extended periods, and whose rate base growth is forecast to be above average, should maximize shareholder value creation over time.

Utilities with historically low earned ROEs but rapid forecast rate base growth run the risk that future capital additions will earn a return only marginally above or even below their cost of capital, limiting or even destroying shareholder value. Yet these utilities also offer the greatest opportunity for outperformance if they are able to improve their earnings lag and ROEs, causing earnings growth to exceed growth in rate base.

We have forecast the growth in electric plant rate base plus CWIP of the regulated electric utilities, based on their announced capital expenditure plans and our modeling of the consequent changes in deferred tax assets and liabilities. (See Exhibit 11.) Ranking in the top (best) quintile in our forecast of rate base growth through 2022 are AEP, AGR, DTE, ETR, NEE, PCG, and PNM. Ranking in the second quintile in our forecast of rate base growth through 2022 are AEE, D, EIX, EXC, FE, and WEC.

We compare utilities’ performance on forecast rate base growth with their earned ROEs and earnings lag in Exhibits 12 through 14. In Exhibit 12, we compare the performance of the 32 electric utilities in our sample on the basis of (i) average earned ROE over 2013-2017 and (ii) our forecast of compound annual growth in electric plant rate base plus CWIP over 2018-2022. Exhibit 13 presents a similar analysis, comparing (i) the average gap between earned and allowed ROE over 2013-2017 to (ii) our forecast of compound annual growth in electric plant rate base plus CWIP over 2018-2022. Exhibit 14 lists the companies in each quadrant of Exhibit 12 and provides a color coded overlay indicating the quintile ranking of each stock on price to 2021 consensus earnings. Finally, Exhibit 15 provides a quintile ranking of the 32 electric utilities in our sample based on forward PE multiples of 2020 and 2021 consensus earnings.

Utilities combining above median rate base growth with above median earned ROEs

Utilities combining above median rate base growth with above median earned ROEs are AEP, AGR, D, DTE, EIX, NEE, PNW and WEC. (See Exhibit 12, where we have labeled with their tickers those utilities that have appeared in the top two (best) quintiles on earned ROE for the past ten years or longer: AEP, DTE, EIX, NEE and WEC.) Given the persistence of earned ROEs among regulated electric utilities, companies that have exhibited high ROEs for extended periods, and whose rate base growth is forecast to exceed the industry median, should maximize shareholder value creation over time. These utilities combine the characteristics sought by Warren Buffet in his investments: the capacity to invest large amounts of capital behind a competitive moat while earning a return on this investment that significantly exceeds the cost of capital.

Exhibit 11: SSR Forecast of Growth in Electric Plant

Rate Base Plus CWIP, 2018-2022 & 2022-2026

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Source: FERC Form 1, company reports, SNL, SSR analysis

Exhibit 12: Average Earned ROE, 2013-2017, vs. Forecast CAGR in Rate Base Plus CWIP, 2018-2022

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1. Return on equity calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

Exhibit 13: Average Gap Between Earned and Allowed ROE, 2013-2017, vs. Forecast

CAGR in Rate Base Plus CWIP, 2018-2022

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1. Return on equity calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

Exhibit 14: Regulated Electric Utilities Classified on the Basis of Rate Base Growth, Earned ROE1 & Valuation (brown indicates fifth or most expensive quintile on P/2021E, dark green first or least expensive quintile, orange fourth quintile, and light green second quintile)

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1. Return on equity calculated on tangible net worth, excluding goodwill.

Source: FERC Form 1, company reports, SNL, SSR analysis

Exhibit 15: Forward PE Multiples and Valuation Quintile Rankings of U.S. Regulated and Hybrid Electric Utilities

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Source: FERC Form 1, company reports, SNL, SSR

Among the utilities combining above median rate base growth with above median earned ROEs are two stocks that stand out for their attractive valuation: EIX and PNW. EIX is in the first (cheapest) quintile based on price to 2021 consensus earnings and PNW is the second quintile when compared to their regulated utility peers (see Exhibit 15). Given their discounted valuation and rapid forecast rate base growth, both stocks could outperform if they can maintain their performance on ROE. (EIX faces wildfire risks in California, but, as we have discussed in other notes,[4] we believe the stock is attractively valued even in light of these risks.)

We are adding PNW to our preferred utilities list based upon its long term rate base and earnings growth prospects. Our assessment is predicated upon management’s medium term capex guidance, our analysis of the utility’s long term rate base growth potential,[5] and PNW’s above average ROE.

We continue to find AEP attractive: its valuation is in line with the regulated utility median, but its forecast rate base growth and historical ROE are well above the industry median.

Although not on our list of preferred utilities (see Exhibit 16), we believe AGR, D and DTE merit consideration. DTE trades at a slight discount to the industry median, yet its forecast growth in electric plant rate base and its historical ROE are well above the industry median. Importantly, however, the electric utility is a smaller part of the company than at most of its peers, and we have concerns with some of the other sources of earnings. D and AGR also offer above-median rate base growth and historical ROEs, and trade at a discount and in line, respectively, to the large cap utilities. Investors have concerns, however, regarding D’s significant gas operations and AGR’s ability to execute of large projects that are key to their unregulated and regulated earnings growth. Given their attractive rate base growth and earned ROEs, these companies merit further examination to determine whether they can address these concerns.

NEE and WEC both rank in the fifth or most expensive quintile on price to 2021 consensus earnings. We believe they are fairly valued in light of their forecasted growth and their historically high earned ROEs, however, outperformance will be difficult as it will require the companies to exceed their already high expectations.

Utilities combining above median rate base growth with below median earned ROEs

Utilities that have above median forecasted rate base growth, but subpar ROEs and earnings lag, are at risk of destroying shareholder value. Yet they also offer the prospect of outperformance if they are able to improve their operations and/or change their regulatory framework to reduce earnings lag and increase earned ROEs. Further analysis of these companies is warranted to assess whether improvements in operational performance, and a constructive regulatory response, may close the gap between earned and allowed ROEs, raise earned returns and drive earnings growth in excess of rate base growth.

Utilities with above median forecast rate base growth and a below median ranking on historical earned ROE or earnings lag are AEE, ETR, EXC, FE, PCG and PNM. (See Exhibits 12, 13, and 14.)

Within this group, EXC and FE rank in the first (cheapest) quintile and ETR in the second quintile among their peers on price to 2021 consensus earnings. All three utilities have been making progress in improving earned ROEs and earnings lag in the past couple of years. If these improvements can be maintained, the stocks of these utilities should offer attractive returns.

PCG is also cheap, but its valuation is driven by wildfire risk and the outcome of its bankruptcy proceeding. As we have discussed in previous research reports, we favor the stock based on our assessment of these risks.[6]

Less attractively valued are PNM, which ranks in the fifth (most expensive) quintile on price to consensus 2021 earnings, and AEE, which ranks in the fourth quintile. AEE has been successful in the past few years in reducing earnings lag and improving its regulatory framework, so its valuation appears justified, but outperformance will be difficult to achieve.

Utilities combining below median rate base growth with above median earned ROEs

The utilities in the upper left hand quadrant of Exhibit 12 combine historical ROEs that have exceeded the industry median with forecast rate base growth that lags behind it. Three of these companies, ES, IDA and LNT, are among the industry’s consistent outperformers when ranked on earned ROE, having appeared in the top two (best) quintiles on earned ROE for the past ten years or longer. Should these utilities find additional rate base growth opportunities, they may well join their peers in the upper right quadrant, combining rapid growth with superior returns.

Utilities combining below median rate base growth with below median earned ROEs

Finally, the lower left hand quadrant of Exhibit 12 we find utilities that combine lagging growth in rate base with historically low earned returns on equity, such as ALE, EVRG, HE, and POR. In the absence of a material improvement in profitability, the return on these companies’ investment is barely enough to offset their cost of capital, constraining their ability to add shareholder value even if rate base growth were to improve.

Among the stocks in the lower left quadrant of Exhibit 12, EE, ALE, and POR trade in the fifth (most expensive) quintile on valuation, while HE trades in the fourth quintile. Given their slow prospective rate base growth and poor historical earned ROEs, these stocks seem destined to underperform in the absence of a takeover offer. Among small and mid-cap names, moreover, we see PNW as a far compelling takeover target.

Exhibit 16: Heat Map: Preferences Among Utilities, IPP and Clean Technology

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Source: SSR research, analysis and estimates

©2019, 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. See our research reports of December 3, Are PCG & EIX Still Hot Stocks? We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation; Maintain PCG & EIX on Our List of Preferred Utilities; Feb. 28, PCG, EIX, SRE:Why California Will Engage with the State’s Utilities to Contain Wildfire Risk & Restore Utility Credit; and April 24, EIX, PCG, SRE: How California’s Cost of Capital Proceeding Will Materially Mitigate Wildfire Risk
  2. See our research report of October 2, 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?
  3. See our research report of April 22, PG&E – We See Equity Value of $54 in Our Base Case, $63 Upside, $26 Downside As Potential Post-Bankruptcy Outcomes Skew Further to the Upside.
  4. See our research reports of December 3, Are PCG & EIX Still Hot Stocks? We Assess the Risk of Repeated Catastrophic Wildfires & Its Implications for Valuation; Maintain PCG & EIX on Our List of Preferred Utilities; Feb. 28, PCG, EIX, SRE:Why California Will Engage with the State’s Utilities to Contain Wildfire Risk & Restore Utility Credit; and April 24, EIX, PCG, SRE: How California’s Cost of Capital Proceeding Will Materially Mitigate Wildfire Risk
  5. See our research report of October 2, 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?
  6. See our research report of April 22, PG&E – We See Equity Value of $54 in Our Base Case, $63 Upside, $26 Downside As Potential Post-Bankruptcy Outcomes Skew Further to the Upside.
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