Greg Gordon: Turn on to Big Utilities, Pt. I Source: Brian Sylvester and Karen Roche of The Energy Report 06/22/2010
Big American utilities pay big dividends, some as high as 8% among regulated utilities, and right now they're as cheap, relative to the bond market, as they've been in about a quarter century. If you like investments as income, few people know utilities equities better than Morgan Stanley Analyst Greg Gordon. In this exclusive two-part interview with The Energy Report, Greg eloquently and frankly explains the utilities market and offers some picks in the regulated utilities space. Part II will focus on Greg's picks among the deregulated utilities.
The Energy Report: Greg, please give our readers an overview of the market for big utilities in the U.S.
Greg Gordon: First of all, in looking at utilities in the U.S., they're a little bit complicated because they're not all homogeneous in terms of business models. In certain regions of the country, state regulators have liberalized the power markets; in other regions they have not. So when you look at the market capitalization of the utility sector, about 45% of the market cap is traditionally regulated utilities that operate regulated businesses where the state government regulator mandates the prices they can charge and gives them a fixed return on their equity investment in the company. Southern Company (NYSE:SO) is like that in the southeast, and so is PG&E Corporation (NYSE:PCG) in California and Consolidated Edison Holding Co. (NYSE:ED), or ConEd, in New York for example.
Now, Southern Co. owns power plants, burns a lot of coal, but their assets are regulated; so, they charge a regulated rate. They buy the coal; they pass the cost on to their consumers. The regulatory model is called Cost Plus. You recover the costs plus a reasonable return on your assets. ConEd is regulated exactly the same way, but ConEd doesn't own many power plants. They sold most of their power plants by regulatory mandate back in the early part of the decade, but like Southern Co., they're still Cost Plus on the wires and the pipes they own. They buy the power on the open market that they need to provide their customers and then they pass it on to their customers at no margin.
And PG&E sold some of its power plants, still owns hydro and nuclear plants and also has a mixture of power purchases and fuel purchases that it uses to generate the power it needs. But it's not earning a margin on the power. It's earning a fixed return on the assets it's got.
That's very different from an Exelon Corp. (NYSE:EXC); that's very different from an Entergy Corp. (NYSE:ETR), which has regulated utility businesses, but also owns merchant power plants in liberalized markets. They earn a deregulated price, and they have to manage their costs. They become basically big cyclical energy companies where their margins rise and fall based on their ability to profit from power market dynamics. Generally speaking, power prices go up when natural gas is rising because natural gas is the marginal fuel for power in the U.S. in most markets. Power prices go up when demand is rising because as demand rises, less-efficient plants have to serve the load and that drives up power.
So the profit margins of the diversified utilities cycle, whereas the profit margins on the regulated side tend to be much more stable and predictable and are set by regulators, not by markets.
TER: What about dividends?
GG: The regulated utilities also tend, because they have more predictable earnings and cash flow, to be higher paying dividend entities. The average regulated utility in the U.S. dividends about 65% of its income to its shareholders. The average diversified utility only dividends about 45% of its net income to shareholders, and that makes sense because the diversified utilities in our coverage universe have a riskier cash flow stream. The dividend has to be lower to reflect the fact that the cash flow fluctuates more.
TER: So regulated utilities tend to be better long-term investments whereas diversified utilities have more upside and more risk?
GG: Let's talk about the regulated investment profile and diversified needs separately because really you would own them for separate reasons. Regulated utilities are perceived sort of as income first, growth second, investment vehicles and they're perceived really to be an alternative to other income-bearing instruments like bonds by most equity investors. They tend to behave in a defensive fashion relative to market dynamics; they tend to be less correlated to what's going on in the market in terms of the S&P. And they tend to be much more positively correlated to what's going on in the bond market.
Right now, the average regulated utility in the U.S. is investing capital in things like transmission lines and distribution grid enhancements like smart meters and putting environmental equipment on their power plants and building renewable energy facilities-more than 30 states in the U.S. have renewables mandates. Through these investments, they're growing their rate base, which is the capital investment on which they're allowed to earn by about 5% per year. When you grow your rate base, you have an opportunity to grow your earnings because you earn on the capital you invest. You actually have to spend money to make money. The risk is that they're periodically going into the regulator to ask for the revenues they need to pay for the investments that they're making.
TER: These are the base rate case rulings?
GG: Yes, you're constantly seeing this kind of activity and it pertains to their ability to earn a return on the capital that they're spending. The two drivers that really differentiate a good utility investment story are demographics and regulation. How much capital are you being asked to invest to keep up with trends in your local service region? And, is the regulator giving you a healthy return over your cost of equity or a skinny return on your cost of equity? I said the average rate-based growth was around 5%, but it varies. In California, the utilities are spending well in excess of that; and, in places like the Midwest, they're spending less because there's less demand growth.
The return on equity that these companies actually earn is mandated by the regulator, and the last 12 months the authorized return on equity was 10.5%-11%, but the authorized returns have been as high as 12% and as low as 9%. Again, if you go from state to state, some regulators are more magnanimous than others. As a utility analyst and a utility investor, you try to identify the companies that have the best opportunity for rate-based growth; with the best opportunity to earn healthy returns over their cost of equity. The best opportunities to make investments are in places where there's change taking place, where a state regulator has been historically maybe a little bit tight on the returns that they authorize and we think they're going to start to be a little bit more magnanimous or where a company had not been spending a lot of capital and we think it's capital spending is going to increase, and they'll get an opportunity to earn a decent return on that.
TER: What about regulated utilities?
GG: Again, we think the most money is made in regulated utilities when you invest in positive change; and frankly, the most money is lost when investors fail to perceive the change in dynamics the other way. I'll give you three examples of stocks that I like in that space or that fit that profile: American Electric Power Company, Inc. (NYSE:AEP), CMS Energy (NYSE:CMS), and NV Energy Inc. (NYSE:NVE).
AEP is a big regulated utility that operates in multiple states all the way from Ohio down to Texas. They have a management team that has historically been not tremendously disciplined in allocation of capital. They have spent aggressively to grow the rate base, but they have spent more aggressively than regulatory outcomes have allowed them to earn. So their returns on equity have been low relative to the industry average. What happened is AEP spent so much money on their capital base going into this last recession that they got over-leveraged, and they were forced to issue a lot of equity at very low prices at the bottom of the market. That was very dilutive.
They've since put a new CFO in place and reined in their capital spending. Now that the economy is recovering, the returns on what they have invested should begin to improve as the economy improves. I think they've got some newfound discipline in terms of managing their capital spending and operating costs. I believe that the regulatory outcomes in the states in which they operate will be incrementally constructive.
If you believe that, you've got a company that can earn $3 per share this year and grow earnings at probably 4% a year for the next several years, and it's trading at under 10 times my 2012 earnings estimate of $3.25; the yield is 5.2%. By the way, at around 10 times earnings that's almost a two multiple point discount to other larger cap regulated utilities that, like a Progress Energy Resources Corp. (TSX:PRQ), for instance, are perceived to be more stable. The stock price is basically discounting earnings never going up. There is just skepticism that AEP have their act together. I believe over the next 12 months, as they prove that they've got their act together financially and the economy continues to recover in the Midwest and the regulatory decisions that they get from the multiple states they're in continue to be constructive, that that stock will appreciate because investors will embrace the change that is happening in the company.
TER: Tell us about the other two utilities you mentioned in the regulated space.
GG: CMS is a little utility in Michigan, and when the economy was really contracting, Michigan utilities were really hard hit for what appeared to be fairly obvious reasons. The auto industry went into a tailspin, so there was a perception of Gosh, you know utilities in Michigan serve the auto industry and if the auto industry is in trouble, then their sales must be in trouble. For CMS that was less true because they don't have direct exposure to the auto industry as much as some of the other state utilities.
The other thing that happened is the utility regulators in Michigan really put a regulatory framework in place to protect the utilities' financial performance from suffering as the economy continued to contract. They instituted a rate-making model called Revenue Decoupling. That means is there is a much larger fixed component and much lower variable component, if a customer consumes less, so that fluctuations in demand don't have a huge impact on revenues. They can have a much more predictable earnings stream.
The reason regulators have done so, I believe, is because they see the regulated utilities in the state as partners in economic development. They want healthy utilities to spend on state of the art infrastructure in Michigan so they can attract business. I think that is not fully appreciated by investors. CMS Energy stock trades even cheaper than AEP on our earnings estimates. We think that CMS is going to earn $1.35 per share and will grow its earnings at around 8% a year for the next couple of years.
Again, we don't think that investors believe they will be able to do that, given that the stock is trading at almost nine times earnings. Now, they've got a little bit more debt than the average utility, and their divided yield is a little bit lower; CMS Energy yields 4%. But even taking those two things into account, we see no reason why that stock can't trade demonstrably higher as they execute on their growth strategy and investors begrudgingly come to accept that the regulatory model actually indemnifies them for a lot of exposure to industries about which people are concerned. We believe the regulators will continue to be constructive.
TER: And NV Energy?
GG: NV Energy serves Las Vegas and Reno, Nevada. That stock went down during the economic crisis because they weren't exposed to manufacturing like CMS, but they were exposed to housing and tourism through the casinos and hotels in Las Vegas. The economy did contract quite dramatically in Las Vegas. We think their earnings over the next 18 months will recover for two reasons: one, the economy in Nevada hopefully will start to show some improvement as we get into the first or second quarter of 2011. Analysts here at Morgan Stanley that cover the dominant industries in Nevada think that they will recover a little bit later in the cycle than other areas of the economy.
And the company will file a base rate case for the Las Vegas jurisdiction next year. One of the things that is happening in that rate case is not only will they ask for revenues to compensate for the decelerated economy, but they also have a big power plant investment that will be completed early next year. That's going to add assets to their rate base. When that happens, we think the earnings power of the company rises from around $1 per share this year (and it will probably earn a $1 per share next year, which is kind of a 7% return on equity), to about a $1.35 per share in 2012, which is closer to 9%. The stock is trading on that $1.35 estimate at under nine times earnings; so, there's clearly a complete lack of belief that they will be able to drive their earnings back to a more reasonable return on equity. Remember, I said before that the average utility has been authorized closer to a 10.5% return on equity in the past year.
TER: A lot of the profitability of these companies seems to hinge on positive outcomes in base rate case rulings. It seems like shareholder success at least in terms of NV Energy is directly tied to the regulator, no?
GG: Well, you can never say with certainty that a regulator is going to act in any particular way, but you can look at the history of their decision making and look at the mosaic of activity in any particular state to gauge the level of risk. The regulators asked NV Energy to build this power plant; so when they put it into rates, we believe the regulator will do its best to allow NV to earn a reasonable return on that investment.
The last several rate reviews that the company went through they were actually treated reasonably by the commission in Nevada; they were given decent rate decisions. They've just filed a small rate increase for their Reno-based utility, which is the smaller of their two utilities; it only represents about one-third of the company's earnings. That rate decision will be resolved before they file the next one, so it will be sort of an indicator of the level of constructiveness or lack there of between the company and its regulator.
TER: So sometimes you get an early indicator as to the outcome of the crucial base rate case rulings?
GG: Yes, the other thing that's interesting about NVE is that it's the only utility that I cover that is trading at a discount to its tangible book value. I said earlier that utilities earn a return on their capital investments (i.e., their book value). That means that if you believe that it's got the ability to earn a return in excess of its cost of equity on its capital investments, by definition it should trade at a premium to book. So, the fact that this one trades at a discount to book means either that investors believe that they're going to never achieve a return in excess of their cost of equity or that their cash flows are insufficient to fund their growth, so they're going to have issue shares of common equity and dilute their current shareholders. I think both those fears are unfounded.
TER: Alright, NV Energy is building a new plant in Nevada. They clearly have some fixed costs of just running facilities and power lines and such, and, in an environment like Nevada, the revenues must have dropped dramatically with the economy. How do they have any return in the years before a rate increase?
GG: The answer is yes; by our measure, they earned a 5% return at their Las Vegas utility. In 2009, the company earned $0.78 per share on a consolidated basis. We think they're going to earn around a $1.05 this year, which is an improvement to around 7.5% return in Las Vegas. Then, we think they can get to sort of an 8.5%-9% return by 2012, after they receive the rate decision we're expecting next year and, hopefully, go from there.
We think it's an interesting investment because we think the stock can go up even if they continue to have a sub-par return; it just has to improve from where it is today.
TER: It seems like the regulator is all-powerful in some cases. What are some jurisdictions, as some of the top jurisdictions as far as regulators go in the U.S.?
GG: That's a good question. Many of the utilities that are perceived to be very stable and well-regulated companies don't look like interesting investment opportunities to me because that's appreciated already. As a value investor by training, I am always looking to invest in something that's underappreciated or misperceived. Those were three examples of regulatory jurisdictions that may be perceived as being more difficult than they really are. If you look at a jurisdiction like California, I think some of the utilities in California are trading a bit cheap to where their fair value is. But that is a jurisdiction that since the California Power Crisis in the early part of the decade has demonstrated itself to be highly constructive in the way it regulates its utilities. Those stocks are trading almost like there is this sovereign risk discount being applied to some of those companies. PG&E's got a great history of getting constructive regulation after coming out of bankruptcy in 2004, but what happens if the California government defaults on its debt? Are they going to be somehow indirectly exposed to that?
I think the regulatory environment in the U.S. is actually pretty good. If you look at the regulatory activity over the past 18 months and you think about what's happened as we've gone through the depths of this recession, the vast majority of utilities that asked their regulators for revenue increases got some meaningful amount of the money that they asked for despite how difficult the economy was.
I am a little bit concerned that it's going to be more difficult as we start getting into an inflationary cycle because when interest rates start to go up, cost of capital starts to rise, the operating costs start to go up, and the physical cost of capital expenditures start to go up. Then the rate increases that become needed start to stress the ability of the regulator to be dispassionate. Then they start to cap the amount they raise rates and that can cause problems.
TER: Thanks so much for your time today, Greg.
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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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