Greg Gordon: Big Deregulated Utilities, Pt. IISource: Brian Sylvester and Karen Roche of The Energy Report 6/29/10
Big deregulated utilities pay solid dividends and offer investors a means to leverage the ongoing economic recovery. But it's a complicated business; that's why we asked Morgan Stanley Analyst Greg Gordon to break it down in this exclusive interview with The Energy Report. In this second half of our two-part interview, Greg explains the difference between deregulated utilities and their regulated counterparts and shares some of his favorite names in the space. (Read Turn on to Big Utilities, Pt. 1.)
The Energy Report: As an investor in today's unpredictable economic environment, you don't really know what part of the economy might be taking off and what part might continue to be sluggish. Do non-regulated utilities represent a better general investment strategy than regulated utilities?
Greg Gordon: If you're looking to get more leverage to an economic recovery, you can own companies in the deregulated universe like Entergy Corporation (NYSE:ETR), a Gulf states utility that also happens to own a 5,000 MW fleet of deregulated nuclear power plants in New York and New England. Their earnings are exposed to the power price in that merchant portfolio and to a fairly significant degree.
The earnings profile of Entergy looks like it's going to decline over the next several years. They're going to earn about $7 a share this year. We think that declines to about $6.75 in 2012. But they're highly leveraged to a very small change in the power price. If I change my power pricing assumption by $5 per MW hour, it boosts their 2012 earnings nearly $0.45 a share. So if the economy is up in that region, their earnings stand to benefit; and right now, the stock is trading at just $74/share-not a very high multiple relative to what I consider cyclically depressed earnings.
TER: What is $5 per MW in terms of a percentage increase?
GG: In their region, that would be between 5% and 10%.
TER: What does that increase translate to in percentage of earnings?
GG: That would increase it $0.45 on $6.75; about a 7% increase. So they've got a lot of leverage to recovery and power markets; and the stock is certainly not expensive compared to where power prices are today, given that they could still earn $6.75 at current forward curves for power. And the stock is not at a very high PE multiple on that number-it's at 11x those earnings. It's also a very well-run company that's actually buying back stock right now; they've got extra cash flow, and they're buying back stock. It's now got a dividend yield of 4%.
TER: What are some other deregulated utilities you like?
GG: There are two that I really like. The first one is PPL Corporation (NYSE:PPL). The company's based in Pennsylvania, but they're actually quite diversified. They own utilities and power plants in Pennsylvania, some power plants in the Pacific Northwest and a distribution utility in the UK. PPL just announced the acquisition of regulated utilities in Kentucky- E.ON U.S. LLC (PKSHT:EONGY; Fkft:EOA), the parent company of Louisville Gas and Electric Company and Kentucky Utilities Company.
PPL stock has declined quite dramatically on the back of the acquisition announcement, because investors were initially unhappy with that decision. At around $25.50/share, the stock is overly discounting people's disappointment with the decision to buy those assets. In fact, the acquisition is reasonably strategic in that they're moving the business more toward being regulated and less diversified in order to mitigate earnings volatility. They're also buying assets in a region where a lot of capital spending is needed, and that means a lot of base rate opportunities.
The earnings power at PPL is declining much like Entergy's because commodity prices are low currently. So, the earnings power at PPL declines from about $3.40 in 2010 to about $2.50 in 2013; that sounds pretty bad, except the stock is trading at about $25; it's trading at 10x that number. The stock yields 5.5%; and, in this particular case, they also have exposure to recovery in the power price. So, a $5 change in power price, which would be around 10% in their market, would change the earnings power by $0.30 off of $2.55, or 12%. I think the overhang on the stock right now is that they have to finance these transactions, so they will be issuing equity between now and year-end. It looks very interesting to me, even if power prices don't go back up.
TER: You mentioned two that you like. What was the other?
GG: Sempra Energy (NYSE:SRE) is even less exposed to commodity prices. It is more of a de-risking story in that one of its biggest businesses is a joint venture (JV) European bank, the Royal Bank of Scotland (RBS). The company had a commodities trading JV wherein they traded gas and power domestically and oil internationally. How they wound up in those businesses is a long story, but the bottom line is government regulators forced RBS to divest of the trading businesses; Sempra had to divest as well, and is now in the process of selling them.
We think they're going to raise about $2 billion, buy back a $1 billion of stock and reinvest the remaining $1 billion into their core businesses, which are utilities in California and San Diego, pipeline systems, gas storage and liquid natural gas (LNG) terminals. So Sempra becomes this very complicated higher-risk sort of energy conglomerate, and it converts into a simpler infrastructure growth story.
We estimate earnings growth from around $3.50 per share to $5/share between 2010 and 2013; and the stock is trading at $46. Pipeline assets tend to trade at pretty good multiples, and their utilities earn very, very good returns and have a good earnings visibility. So, when the announcement of the asset sales comes out-and people believe that they've, fundamentally, got a window to de-risk the business-the stock will trade back up into the low $50 range. Right now, they're trading at this big discount because people are afraid they won't be able to find a buyer for those assets. I am confident that they will find a buyer. But, for the sake of argument, even if they couldn't find a buyer and had to wind down those businesses, the company could still get something close to $1.5 -$1.6 billion just winding them down. I like the risk-rewarded Sempra a lot. Again, it's more of a special situation that isn't that exposed to commodity prices but is more of a de-risking story.
TER: So, if you were a financial planner, it seems like you could effectively put investors into a utilities-only portfolio that would give them consistent earnings with limited risk-and still have fairly high growth potential. Would you agree with that?
GG: You can buy growth at a reasonable price in the utility space, and I think that's underappreciated. Utilities investors tend to gravitate towards big, liquid companies that simply pay high dividends but don't offer much growth.
Con Edison Inc. (NYSE:ED), for instance, trades at a 5.6% dividend yield and pays out 75% of its earnings. It has been a predictable dividend payer but doesn't offer much growth. Yet, it trades at 12x PE multiple just because it offers a fat yield. You can buy American Electric Power Company, Inc. (NYSE:AEP), which offers a 5.2% yield, not much less, and you can buy that under 10x earnings and get almost the same total return at a much better price. You could get CMS Energy (NYSE:CMS), which gives you 8% growth with a 4% yield and at a 9x multiple. While that is a little bit lower income, it is more than offset by the above-average growth you get.
So, yes, within regulated utilities, I think you can get pretty consistent total return without a lot of risk, and I do think that is underappreciated. They also look very cheap vs. other market alternatives, such as bonds. They're trading as cheap in the bond market as I've seen since the mid-1980s. From an absolute and relative perspective, they look like good return investments.
In the diversified names, you are making more of a cyclical investment decision regarding where we are in the power cycle. Are the stocks poised to benefit from a recovery, or do they stand to be hurt in a downturn? The diversified utilities have suffered mightily in the last 18-24 months-they have all declined dramatically. Many of them look poised to rebound, especially if the economy continues to improve and power prices go back up.
TER: Many people out there who believe inflation is just around the corner, some even argue hyperinflation. If investors believe we're moving into an inflationary environment, would returns from these regulated utilities vs. non-regulated utilities be relevant?
GG: Regulated utilities are generally perceived as poor performers in an inflationary environment because it's very difficult to get the regulators to provide timely and effective recovery of costs when their costs are rising rapidly. In an inflationary environment, you'd want to be much more exposed to the diversified utilities (presuming that you were also getting inflation in commodity prices). That way, they would benefit from the rise in gas and power prices. If you were to make a bet on hyperinflation, you'd want to be overweight with diversified utilities and less exposed to regulated utilities.
That being said, I think that a lot of expectation for rising inflation is somewhat built into those regulated stocks. We use a macro model that compares the dividend yield on the utility stocks in the regulated universe to yields in the bond market to see where they're trading vs. bonds. And because they haven't traded this cheap to the bond market on a spread basis since the mid-1980s, investors are implicitly discounting them because they're afraid of rising rates and/or higher inflation. So, I think a lot of that fear is already discounted into the PE multiples.
TER: What is the impact of government incentives for alternative energy capital investment? How does that impact these big utilities or is it so small it's irrelevant?
GG: No, it's very relevant. You've got over 30 states that have their own independent renewable portfolio standards, which require utilities to procure a certain amount of power from non-fossil-based sources on deadline. A lot of capital investment is being made on the margin in these areas; so, utilities in many states are participating in that capital spend.
Obviously, the government has stimulated that by granting tax credits for wind and solar. They've also stimulated spending on what we call smart grid investments through Department of Energy (DOE) grants. They've granted money to defray the cost of installing smart meters in some states and other new technologies on the transmission grid, etc. There's absolutely been a benefit.
We talked about CMS. Well, part of their rate base growth is driven by the fact that they must comply with the mandate to build renewables in Michigan. And they're going to be constructing wind farms as part of their regulated assets-that's a growth opportunity for them.
A piece of Sempra's rate base growth in their core utilities is from infrastructure they're building to accommodate wind and solar investment. While they're not a direct owner of many of these projects, they have to build transmission that brings the power to their customers, which is a rate base growth opportunity.
A lot of capital spending is going directly into renewable energy-or infrastructure that supports renewable energy-which is part of that 5% rate base growth profile we talked about. The risk there is that these wind and solar resources are expensive. It costs a lot more money to make power from the sun and wind than it does currently with cheap natural gas. You worry that, somewhere down the line, investor appetite for such investments could wane if commodity prices stay low.
TER: Do you see any one type of renewable energy as being out in front of the others-geothermal, solar, wind?
GG: Wind and solar are growing resource bases in the U.S., but they still represent small fractions of the supply. Geothermal is also a minuscule fraction because, obviously, you can only harness it where there is volcanic activity. The problem is a lot of these resources are where people aren't. The big challenge is not just harvesting them but delivering that power to the population.
Greg Gordon joined Morgan Stanley as a Managing Director in July 2009. He has over 17 years' experience analyzing the power and utility industries. Before joining Morgan Stanley, he spent over six years at Citigroup covering the power and utility industries. Prior to that, he spent over three years at Goldman Sachs covering Electric Utilities and Independent Energy. Institutional Investor recognized Greg as one of the top research analysts in his field for the past four years, and he was ranked as the top research analyst in his field by Greenwich Associates for the past three years.
Before joining Goldman Sachs, Greg was managing director at CIBC World Markets in the power and utilities group. Prior to joining CIBC in 1993, Greg was an analyst at Regulatory Research Associates for the electric, gas, and telecommunications industries. He graduated magna cum laude from Drew University with a major in economics and holds the CFA designation.
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DISCLOSURE: 1) Brian Sylvester and Karen Roche of The Energy Report conducted this interview. They personally and/or their families own shares of the companies mentioned in this interview: None. 2) The following companies mentioned in the interview are sponsors of The Energy Report: None. 3) Greg Gordon: See Morgan Stanley disclosure that follows.*
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Important U.S. Regulatory Disclosures on Subject Companies
As of April 30, 2010, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in Morgan Stanley Research: American Electric Power Company, Inc, CMS Energy Corporation, Entergy Corp, PG&E Corporation, Sempra Energy, Wisconsin Energy Corporation.
As of April 30, 2010, Morgan Stanley held a net long or short position of US$1 million or more of the debt securities of the following issuers covered in Morgan Stanley Research (including where guarantor of the securities): American Electric Power Company, Inc, CMS Energy Corporation, Entergy Corp, NV Energy, Inc., PG&E Corporation, PPL Corporation, Progress Energy Inc., Sempra Energy, Wisconsin Energy Corporation.
Within the last 12 months, Morgan Stanley managed or co-managed a public offering (or 144A offering) of securities of PG&E Corporation.
Within the last 12 months, Morgan Stanley has received compensation for investment banking services from American Electric Power Company, Inc, CMS Energy Corporation, Entergy Corp, PG&E Corporation, PPL Corporation, Progress Energy Inc., Sempra Energy, Wisconsin Energy Corporation.
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