After a months-long political saga, the nuclear ZECs bills passed out of the Senate and Assembly floors in New Jersey last Thursday (04/12/18). Governor Murphy is expected to sign the bills, but has 45 days to do so, after which the BPU will begin an 11-month process to see who qualifies for the subsidies. We estimate the nuclear payments end up totaling roughly $300M/yr with the split being two-thirds PEG / one-third EXC. New Jersey is now the fourth state to provide support for nuclear power, as Illinois and New York led the way, and Connecticut followed suit late last year. The ZECs thematic has primarily benefitted EXC as the largest nuclear generator, but now PEG and D (in CT) have joined the party. Most recently, PEG and D didn’t even have to officially announce shutdowns to force the issue (as we had seen in NY/IL).
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We have refreshed our annual utility financial “checkup” to reflect the impacts of tax reform, company financing plan changes, and 2017 10Ks. Tax reform exacerbated the weakness in utility financial metrics that we had seen over the last few years. It also further widened the dispersion among utility balance sheets and credit metrics. As a result, companies with weaker balance sheets and credit metrics trade at P/E discounts (PPL, SO, DUK, D, ETR, etc) as investors remain concerned whether they have done enough to stabilize their credit.
The merger of Vistra Energy (VST) and Dynegy (DYN) closed today (04/09/18), as expected. As such, we are withdrawing coverage of DYN.
The VST/DYN merger closed today (04/09/18), following recent FERC/PUCT approvals that lacked material conditions. We maintain our positive stance on the pro forma entity for several reasons: attractive valuation, balanced retail/wholesale business mix, and strong free cash flow. Further, the upcoming Q1 earnings call in early May, Analyst Day in June, and ERCOT summer should all be positive catalysts, as we see several upside opportunities (see below). We’ve now published our pro forma model, which forecasts EBITDA/Free Cash Flow run-rates of roughly $3.0B/year and $1.5B/year respectively. We’re taking our Price Target up to $23 (from $22), while pointing to upsides that could boost estimates materially. Outperform.
In Q1, power prices were down across the curve in most of the country with the notable exception of ERCOT, which was up big. ERCOT was up +30% in 2018, 20% in 2019, and 10% in 2020, given the potential for summer scarcity pricing. Meanwhile, PJM was up a modest 3% in 2018 and flattish further out on the curve. New England forwards were down modestly across 2018-2020. Forwards in other markets (West / Midwest) were mostly down. Natural gas moved up in 2018, but was down modestly in 2019/2020 – shifting the curve back into backwardation from contango. Notably, VST/DYN (90 TWh/yr ERCOT) and NRG (40 TWh/yr ERCOT) guidance ranges are based on power prices from last year. Please see forwards (link) file.
In what has essentially become a game of chess in recent months, as different competing interests argue over proper market structure, FE made a strong move late last week. The company announced plans to retire its 3 nuclear plants totaling over 4 GW in OH/PA by 2021. FE then promptly followed that up by filing an application with the Department of Energy urging Secretary Perry to use its Section 202 authority to effectively subsidize FE’s (and others) nuclear/coal plants in PJM. The DOE balked at using its emergency authority last year and deferred to FERC, who subsequently kicked the can and had the RTOs embark on a resiliency/reliability study that could take some time. However, FE has decided to up the pressure as it pushes for market structure changes. We’ve seen this before at the state level (ie: ZECs), but what FE has proposed would be sweeping and shift the market dynamic toward re-regulation.
We hosted investor meetings with NEE CFO John Ketchum last week. NEE stock has been the Energizer bunny of utilities consistently outperforming peers for weeks, months, years. The differentiation in 2018 has been tax reform and the balance sheet. While several peers faced earnings hits, credit pressure and equity needs from tax reform, NEE raised guidance $0.45 and has $5-$7B of excess balance sheet capacity that could be additive to their 6-8% growth target.
Like the Loyola (Chicago) of the market, the underdog Utilities got hot in March rising 3.4% and beating the S&P 500 by over 600bps. Bond yields reversed course amidst the Trump trade wars and tech bashing with the 10-year ending at 2.73% down from 2.86%. REITs rose about the same as utilities so we think the rally was mainly driven by this bond reversal. For the year, utilities are still underperforming the market by 300bps. With bond yields up 27bps and the impact of tax reform, credit pressures and rising equity issuance (big deals by SRE, FE, DUK, D and more to come), we think the skew from here is negative though it will be highly dependent on long-term interest rate direction. We still think with tax reform kicking in and a strong global economy that 2018 is the year that long-term rates will break-out, or they possibly never will. Utilities are now trading at only a 2% discount to the market, which leaves little cushion.
On Tuesday (03/27/18) afternoon Dominion announced a set of initiatives to address its credit pressures - $1.5B in a forward equity deal, planned asset sales (Blue Racer and others) and a plan to project finance Cove Point once it is commercial (expected any day now). This is meant to address two goals – the reduction of parent debt to 30%-40% of total debt and getting overall FFO/debt up to 15%. Importantly, D reiterated 2018 guidance of $3.80-$4.25 and the 6%-8% long term EPS growth rate including these actions, though where D will be in that growth range is still uncertain. The plan means that D is no longer dependent on the use of DM dropdowns to get its balance in good shape. We see the announcement as a key step in resolving questions on the balance sheet though we are looking for execution on the asset sales. Peer Perform.
We liked NRG’s message at the Analyst Day. While there weren’t a lot of new financial disclosures, management reiterated a disciplined approach to capital allocation and leverage. There is a preference for buybacks with an expected $5.3B of excess cash through 2020 (56% of mkt cap), as dividends take a backseat at least until the stock moves much higher. That said, there was also some new focus on growth and reinvestment in the business, including a modest retail acquisition. This is positive and may be a necessary addition to the capital return story to get new long-term investors.
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