Greg Gordon: Turn on to Big Utilities, Pt. I
Source: Brian Sylvester and Karen Roche of
The
Energy Report
06/22/2010
http://www.theenergyreport.com/pub/na/6598
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 (
SO
)
is like that in the southeast, and so is
PG&E Corporation (
PCG
)
in California and
Consolidated Edison Holding Co. (
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. (
EXC
)
; that's very different from an
Entergy Corp. (
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. (
AEP
)
,
CMS Energy (
CMS
)
, and
NV Energy Inc. (
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. (
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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The Energy Report
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