Tax reform has been a big relative drag on utilities vs the market. Why? It’s a windfall for the market, and its complex mixed bag for utilities. We expect the tax reform discussion to dominate earnings season with a focus on 5 key impacts: 1) Earnings – some good, some bad; 2) Cash flow and credit metrics - negative for the most part; 3) Financing needs - we expect more equity; 4) Ratebase and capital plans - a nice positive due to less deferred taxes and more rate headroom to invest capital; and 5) Regulatory strategy on tax – some may simply pass it through, others may seek cash flow protection, higher equity ratios, and using rate headroom to accelerate investments. Following is our latest view of winners/losers on tax into earnings:
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This morning (01/23/2018) FE announced that a group of investors including Elliott Mgmt, Bluescape (John Wilder), GIC, and Zimmer Partners had invested in a $2.5B equity offering by the company. Both the $1.62B convertible preferred and $850M common priced at discounts of $27.42/sh and $28.22/sh respectively, which will be used to reduce holdco debt and shore up the pension. This essentially clears the deck, with no incremental equity needed through 2020. Further, it adds an experienced group of investors to lead the looming FES restructuring process. Finally, FE was able to reaffirm its 5-7% EPS growth through 2019 at the utilities despite tax reform and equity dilution headwinds. We view this as a turning point for FE, which now has a cleaner path in its transition to be a pure play utility. The stock jumped 10% ($3) on the day.
Investors lost patience with NRG last week punishing the stock for missing the YE asset sales target and likely coming in well below initial proceeds targets. We get the frustration but we also view this as a great buying opportunity. This company will have more cash than they know what to do with (even with lower asset sales) and is very committed to return it to shareholders.
We are upgrading our rating on VST to Outperform from Peer Perform, as the pro forma company trades at an attractive valuation with meaningful upside plus potential incremental catalysts. Since announcing the acquisition of Dynegy the stock has traded sideways, despite several favorable events. As confirmed in today’s 8K, the free cash flow benefits from the passage of tax reform is significantly accretive. We’ve refreshed our pro forma estimates and valuation to reflect this (see Exhibits 7-9), resulting in a new Price Target of $22 (from $19) that implies nearly 20% upside. With the broader market in the midst of a bull run with rising valuations, we see a value opportunity in a stock that trades at ~6.5x EV/EBITDA, a ~15% Free Cash Flow yield, and sub-3.0x Net Debt/EBITDA
Last week, we learned that Halyard Energy had awarded an EPC contract for its ~400 MW Wharton peaker located in Texas. The plant has now received all of its permits and is set to begin construction, with a target in-service date of 2019. The news is notable, as it is the first gas plant new build in Texas (excluding EXC’s new CCGTs) in some time. It’s also slightly bothersome given the fact that Halyard executives noted that the company has 4 other Texas peaker projects in progress totaling up to 2,000 MW. We see its ~450 MW Henderson plant as the only other one included in the ERCOT CDR report. The good news is that these plants won’t be online for the upcoming summer and were already factored into the ERCOT CDR. The bad news is that summer 2018 is now looking like a small window of opportunity that may be closed by 2019 if additional new build enters the market. Further, we didn’t include either of these plants in our own proprietary supply database and had previously pointed to the potential for even tighter conditions if certain projects didn’t come to fruition. While single digit reserve margins were never going to last forever, the fact that new build is starting to move forward again before anything is reflected in pricing is worth mentioning. We will be monitoring this going forward.
In mid-December, we made a big sector shift downgrading Utilities to Underweight and upgrading Midstream to Overweight. For Utilities, the call was specifically tied to tax reform, which we viewed as a negative game changer for the sector. Utilities 1) are a relative earnings loser; 2) lose cash flow and need more equity; and 3) are a bond proxy exposed to higher interest rates fueled by tax reform. Our Midstream upgrade was based on reasonable valuation after a horrible 2017 and better fundamentals in 2018 with commodity tailwind, less equity needs, and improving DCF/unit growth. So far, these calls have worked very well, very fast. YTD, the AMZ is already up 9.2% outperforming the market (up 4.2%) while Utilities have dropped -4.5%. Most of the questions we are getting on both sectors is whether there is more room left to go. The answer is yes for both in our view.
On Tuesday (1/9/2017) Sempra closed on $5B of debt (average rate of 3.1%), following up on last week’s $2.5B in common equity issued at $107 and $1.5B of converts at 6%. SRE has now fully funded the Oncor acquisition. Importantly, the completion of the financing removes the key overhang on the stock since the deal was announced last summer. We believe the stock should do well from here as the story shifts to an execution story: getting PUCT approval for Oncor and moving Cameron from a project delay risk to a highly visible cash flow stream starting next year. California remains a risk on fires but SRE has much less exposure than the other CA utilities. We reiterate Outperform.
Earlier today (01/08/2018) , FERC published its long-awaited response (link) to the DOE’s notice of proposed rulemaking regarding grid resiliency / reliability. The order effectively terminated the proceeding and opened a new docket to further explore resiliency. The ISOs/RTOs have a 60-day period to post comments, after which others parties can respond within 30 days. In its order, FERC found there wasn’t evidence of unjust/unreasonable rates, failing to satisfy the requirements of a 206 filing. While FERC appeared supportive of the work already underway at the ISO level to understand resilience, the order decided very little and essentially kicked the can. Commissioner Chatterjee filed a concurrence, but expressed the need for interim solutions to preserve coal/nuclear, while Commissioners LaFleur/Glick concurred and pointed to the NOPR as an unnecessary subsidy to specifically save coal/nuclear. The process now continues to drag on and absent some form of expedited action from FERC, it seems unlikely that PJM price formation changes will be implemented without what could be a lengthy stakeholder process. On balance this is slightly disappointing for PJM generators. Allowing re-regulation was unlikely, but there was a hope that FERC would put forth a more explicit process than what appears to be more fact-finding. That said, the door remains open for PJM to work towards its price formation reforms. Overall, likely the most disappointing for FE, which hoped its FES coal/nuclear plants would receive some form of support. EXC and VST are most levered to any PJM market reforms, but the implementation timeline remains unclear. We now wait to see if there is any response from Secretary Perry, as the DOE previously indicated it would explore options to take matters into its own hands if FERC did not implement the NOPR.
Wolfe Research's Senior Utilities Analyst, Steve Fleishman, joined by Senior Midstream Analysts Keith Stanley & Alex Kania hosted a webcast to discuss their outlook for 2018.
Tax reform is a relative earnings and cash flow loser for utilities vs the market. More importantly, the chance for a break-out in long-term interest rates is the highest it’s been in years – a key macro risk for utilities. After a long period of low-risk utilities performing well, we expect the hare to hop ahead of the tortoise this year.
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