SCG: As Rate Base Outlook Crumbles, How Will SCANA’s Earnings Grow?
Eric Selmon Hugh Wynne
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August 2, 2017
SCG: As Rate Base Outlook Crumbles, How Will SCANA’s Earnings Grow?
While the decision of SCANA (SCG) to abandon Summer Units 2 & 3 will significantly reduce shareholder risk, we continue to view SCG as one of the least preferred regulated electric utilities given (i) the difficulty SCG faces in achieving its guidance of 4-6% growth off of 2016 normalized EPS over the next 3-5 years and (ii) the significant risk of further downside if the unrecovered investment in Summer were to be securitized or if there were disallowance on a prudency review. Our revised base case forecast is consistent with 2021 earnings power of $4.11, or an 0.7% CAGR off of normalized 2016 EPS of $3.97. SCG’s resulting multiple of price to 2021 earnings is line with the regulated electric utility average, suggesting it is trading at fair value. However, in a downside scenario that envisions securitization of SCG’s unrecovered investment in Summer, 2021 earnings power falls to $3.70, or a -1.4% CAGR off of normalized 2016 EPS, implying SCG is ~11% overvalued compared to the average regulated electric utility on 2021 consensus earnings forecasts. Finally, were the South Carolina Public Service Commission to disallow the $1.5 billion in Unit 2 & 3 costs which have not yet undergone prudency review, we estimate SCG’s 2021 earnings power would fall to $2.96, a -5.7% CAGR off of 2016, implying SCG is ~38% overvalued compared to the industry average.
- Over the next five years, SCANA’s (SCG) decision to abandon Units 2 and 3 of its V. C. Summer nuclear power plant will cut $2.7 billion from the company’s current rate base and eliminate $2.2 billion in previously planned capital expenditures over 2017-2019 to complete the plant. Together, these ~$4.9 billion in reductions to forecasted rate base are equivalent to over 40% of SCG’s current rate base of ~$11.2 billion
- SCG expects to realize $2.0 billion in tax savings from its decision to abandon Units 2 & 3 and to receive an additional $0.7 billion after tax in payments from Toshiba, allowing it to recover $2.7 billion of its $4.9 billion investment in the abandoned units by 2021. The decision also eliminates $2.2 billion in planned capex over 2017-2019 to complete the plant.
- SCG has opportunities to offset in part these $4.9 billion in rate base reductions through incremental capex, although by our estimate these are unlikely to exceed $1.5 billion.
- In its July 31st call, management increased its forecast of SCG’s non-Summer capex by $200 million over 2017-2019, relative to the capex forecast released with its Q1 earnings.
- Management also noted that by 2021 it will require additional generation capacity to offset the loss of Summer Units 2 & 3. If SCG builds a 1,000 MW combined cycle gas turbine unit, it may add ~$1.0 billion to capex over 2019-2021.
- While management plans to cut costs, and stated on its July 31st conference call that it plans to reduce the growth rate in operation and maintenance expense from 6% to 1% p.a., any resulting increase in
earned ROEs above allowed levels will be offset by rate cuts in future rate cases. SCG’s long run earnings power will thus remain a function of its rate base, equity ratio and allowed ROE.
- Only ~$45 million of non-fuel operation and maintenance expense resides at the SCG’s holding company and unregulated operations, leaving little opportunity for savings outside of the regulated utilities.
- To estimate SCG’s long run earnings power subsequent to the decision to abandon Summer Units 2 & 3, we have forecast rate base growth through 2021 at its regulated utility subsidiaries, South Carolina Electric & Gas (SCE&G) and Public Service Company of North Carolina (PSCNC).
- Our forecast is based on 2016 year-end gas and electric rate base at SCE&G and PSCNC and SCG’s update capital expenditure forecast for 2017-2019. Our estimate of capex over 2020-2021 continues SCG’s planned capex for 2019 but adds ~$325 million annually in 2019-2021 for the construction of an additional 1,000 MW of combined cycle gas turbine capacity.
- Our forecast assumes that by 2021 SCG has completed the realization of the $2.0 billion in tax benefits arising from the abandonment of Units 2 & 3, and has collected the $1.1 billion due from Toshiba ($0.7 billion after tax), reducing its rate base in V.C. Summer to $2.2 billion.
- In our base case we assume that SCG’s unrecovered investment in Summer remains in rate base, earning an 8.24% after-tax return, and is recovered over 60 years, as management proposes. Per management’s guidance, we assume that $1.0 billion is allocated to share repurchases at the currently prevailing share price.
- Our forecast carries forward SCG’s historical depreciation rates of ~2.6% and assumes an average annual rate of retirements of 0.5% of gross PP&E.
- We have assumed no change in the allowed ROEs and equity ratios at SCE&G and PSCNC’s gas and electric segments, nor with respect to construction work in progress at Units 2 & 3.
- Our base case forecast is consistent with 2021 earnings power of $4.11, or an 0.7% compound annual growth rate off of normalized 2016 EPS of $3.97. At its current price, SCG is trading at ~16.5x our estimate of 2021 EPS, or in line with the regulated electric industry average valuation of 16.5x 2021 consensus earnings forecasts.
- We have modeled a downside case where legislation is passed to amend South Carolina’s Base Load Review Act to require the securitization of SCG’s unrecovered investment of $2.2 billion in Units 2 & 3. We assume that the proceeds of the securitization will be applied pro rata to SCE&G’s debt and equity, permitting the stock buyback to be increased to ~$2.1 billion. In this case, 2021 earnings power falls to $3.70, or a -1.4% CAGR off of normalized 2016 EPS. This would imply SCG is currently trading at 18.3x 2021 EPS, or ~11% above the industry average for 2021.
- A second downside case assumes that the South Carolina Public Service Commission (SCPSC) disallows recovery of the $1.5 billion in Unit 2 & 3 costs that have not undergone prudency review. In this case, there would be no share repurchases and SCG would need to issue an additional $500 million of equity. Under this scenario, we estimate SCG’s 2021 earnings power would fall to $2.96, a -5.7% CAGR off of 2016. This would imply SCG is currently trading at 22.8x 2021 EPS, or ~38% above the industry average for 2021.
- While we believe that SCG’s management is making the right decision in light of the massive risk of continuing to construct Summer 2 & 3, the difficulty SCG faces in generating sustainable EPS growth of 4-6% over the next 3-5 years under the assumptions the company has presented
and the potential for significant downside from securitization or disallowance compels us to retain SCG on our list of least preferred regulated electric utilities.
- The only way we are able to forecast an outcome in line with management’s EPS growth guidance is to assume that the reduction in rate base from abandonment does not occur until 2020 or 2021, allowing three years of earnings growth in the interim; that savings from reduced growth in operating and maintenance expense are retained at the utilities; and the utilities over-earn significantly versus their allowed ROE. These would be temporary benefits and therefore should not be incorporated into the fundamental long-term value of SCG.
The Alternative Regulatory Outcomes Underpinning Our Three Scenarios
- Having reviewed South Carolina’s Public Utilities Law and Base Load Review Act, we agree with SCG management that, upon abandonment of Units 2 & 3, “the capital costs and AFUDC related to the plant shall nonetheless be recoverable…provided that… the decision to abandon construction of the plant was prudent.” The law also stipulates that “the utility’s cost of capital associated with [these costs] may be disallowed only to the extent that…the utility…was imprudent considering the information available at the time….” Furthermore, there are no provisions that appear to grant authority to the SCPSC to require securitization of the abandoned investment. Our base case forecast therefore assumes that SCG should be allowed full recovery of its remaining $2.2 billion investment in Units 2 & 3, and to earn its weighted average cost of capital on the investment until it is recovered.
- It remains possible, however, that the SCPSC will find that the $1.5 billion in Unit 2 & 3 costs that have not yet undergone prudency review were imprudently incurred, given the information available at the time regarding the risk of continued cost overruns, the inability of Westinghouse to honor its financial commitments under the construction contract, the potential for further completion delays, and consequent uncertainty regarding the availability of federal production tax credits for the project. Given that the construction of the abandoned units has driven an ~18% increase in average residential bills in South Carolina, we expect this line of argument to be pursued aggressively by consumer advocates. As SCG will have already recognized a tax loss on the abandoned property, the full amount of any disallowance would be deducted from SCE&G’s equity balance, requiring an equity injection of an equal amount to maintain its capital structure.
- Finally, we note that allowing SCG full recovery of its Unit 2 & 3 costs through the securitization of its unrecovered investment, as opposed to allowing recovery through its inclusion in rate base, would offer significant rate relief to South Carolina ratepayers. Were SCG’s $2.2 billion in unrecovered investment to be included in rate base and recovered on a straight-line basis over 60 years at SCE&G’s allowed return on rate base of 8.24% — equivalent to 13.34% on a pre-tax basis – the corresponding revenue requirement would be $325 million in year one, falling to $260 million in year 15 and $185 million in year 30. By contrast, the recovery of the $2.2 billion through a securitization, assuming a 15-year mortgage style amortization schedule and a 3.5% financing cost, would translate into a revenue requirement of only $191 million annually, falling to zero in year 16. (See Exhibit 1.) Year one savings would equal ~5% of the average electric customer bill. The cumulative savings for ratepayers would amount to over $1.5 billion in the first 15 years and over $8 billion over 60 years. The much higher cost to South Carolina voters of capitalizing SCG’s unrecovered investment in rate base may drive the state legislature to amend the Base Load Review Act to require securitization.
Exhibit 1: Revenue Requirements Associated with the Inclusion in Rate Base of SCANA’s Unrecovered Unit 2 & 3 Costs vs. Their Recovery Through a 15 Year Securitization at 3.5%
Source: SNL, SSR estimates and analysis
Exhibit 2: Heat Map: Preferences Among Utilities, IPP and Clean Technology
Source: SSR analysis
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