2018 Industry Update: Economic growth should favor commodities-driven businesses in 2018

Warmer than normal winter:
Weak gas prices:
However, 4Q2017 and 1Q2018 power gross profit could be better than expectations:
Similarly, we’d expect natural gas infrastructure businesses to perform well for 4Q2017 and 1Q2018:
We expect economic growth to surpass 4% for 2018:
Strong economic performance should lead to strong power sector performance:
Commensurately, we expect natural gas infrastructure businesses to perform well:
Adjusted for seasonality, we expect natural gas prices to creep up throughout 2018 and, given normal weather, we’d expect natural gas prices to average at or just below $3.50 for 2018 with an exit price of some $3.65-$3.75:
Conclusion: Going into 2018, we believe that natural gas prices will stage a moderate recovery, but power margins should do better benefiting from accelerating economic activity. Individually, we continue to like… . However, the real star may be … . Among the utility names, we like … due to their growth prospects. We also look for … to outperform as … .

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GOP Tax Bill is win for utilities, power, infrastructure, and customers

GOP Tax Bill (GOPTB) looks to be positive for industries and companies in our coverage universe
Key aspects of GOPTB that affect our coverage industries and companies include, but not limited to:
21% corporate tax rate would be expected to reduce deferred income tax liability by some 40%
Interest expense deductibility capped at 30% of EBITDA for 2018-2021 and to 30% of EBIT after
100% investment deduction, except for utilities that would continue to deduct 100% interest
Preservation of existing investment tax credits (ITC) and production tax credits (PTC)
Repatriation of profits tax at 15.5% for cash and equivalent and 8% for non-liquid assets
Base-erosion & Anti-abuse Tax (BEAT) not impactful: If payments to foreign affiliates are 3% or more of a large company’s tax deductions then BEAT is imposed. We do not view this as relevant to companies that we cover, given 100% of PTC would be allowed to offset up to 80% of BEAT
AES Corp. faces large disqualification of interest expense deductibility but given its $3.7B in NOLs, we do not believe this to be an immediate issue; AES has time to remedy the situation:
NRG Energy shouldn’t have any issues with interest expense deductibility:
Exelon Corp. isn’t expected to have any problems with interest expense deductibility:
Cheniere Energy, oddly enough, shouldn’t have any problems with interest expense deductibility:
BKH, CNP, DUK, EIX, PCG, PNM, SRE should not have any issues with interest expense deductibility but may be able to use 100% investment deductibility to create win-win:
We note that the inability to deduct interest expense is limited to $0.21/$1 of lost deductibility
Loss of interest expense deduction could lead to some unexpected corporate behavior

Conclusion: Net effect of GOPTB looks to be positive, more so if utility holding companies are permitted to use non-utility subs to take advantage of the 100% capital investment deduction

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We’re sad CPN got taken out at basement price; A sad last goodbye

CPN looks to be on track to be privatized by 1Q2018 end
CPN is getting taken out at $15.25/share, well below our NIV of some $48/share and ST-Target of $34/share
We would expect an IPO of CPN once the FERC restructures the wholesale power market pricing mechanism to not only properly incorporate the true marginal pricing of renewable generation, but also to properly value ALL ancillary services and reliability and resiliency features
CPN reported 3Q2017 AEPS of some $0.63 and $669MM in AEBITDA vs. our estimate of $0.61 in AEPS and $727MM in AEBITDA, while consensus estimated AEPS at about $0.65
As of this note, while we will continue to monitor the company, we will no longer be publishing on CPN unless the privatization is reversed or another bid is accepted

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As predicted CPN is going private, but at a disappointing price

Terms of the Deal:

CPN announced that it agreed to be acquired by Energy Capital Partners (ECP), and a consortium of investors led by Access Industries and Canada Pension Plan Investment Board (together the “Buyers”) for $15.25/share in cash leading to an equity valuation of some $5.6B
The transaction has a 105 day “go-shop” period that ends 1 minutes past midnight of Friday, December 1, 2017
If CPN receives a superior bid then it may disband the current deal for a break-up fee of some $65MM, otherwise, should CPN choose to cancel the transaction, for whatever reason, then the break-up fee is $142MM.
The deal is expected to be consummated in 1Q2018.
The current management team is expected to remain in place.

Conclusion:

Disappointing selling price:
Potential alternate industry buyers:
Could another PE buyer offer more? Absolutely, in our opinion:
We believe a new bidder would emerge before December 1, 2017: Therefore, we must conclude that there ought to be another PE buyer looking at buying CPN, and we look for a competing bid to emerge before December 1, 2017, possibly in the range of some

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CPN 2Q2017 Earnings Note: We believe CPN is all but privatized; sticking point would be SB100

We believe CPN is all but privatized; sticking point would be SB100 || We feel CPN already has a deal or is close. Key sticking point is likely SB100 in CA that mandates 100% renewable for retail sales. If passed, SB100 would relegate CPN’s CA CCGTs relatively useless or would have to run as peakers, which diminishes CPN’s value. Our preliminary valuation suggests that CPN’s equity value would be about $0/share if all of its CCGTs were shut-down in CA, $15-$20/share, if run as SCGTs, and over $30/share with normal operations. Therefore, we believe that CPN will be privatized between $17-$18/share, in-line with our ST-Target. If the deal fails then we agree CPN should focus on debt repayment – $1 debt repay is at least $1 accretion to equity value – and Retail. But as we previously noted, it seems macro-economic situation is improving, and we feel it would accelerate into 2018. Target debt repayment of $2.7B translates into at least some $7.60/share. Operationally, we believe that expansion of Retail through organic means is correct given that major pieces of the business is in place. We agree accelerated closure of coal plants is coming, industry is moving more towards reliance on renewable energy, and even the slow improving natural gas prices are all tailwinds for ST-to-MT gain for CPN. Strategically there’s little to criticize, and it seems CPN has disavowed share buybacks. But, in improving fundamental market and aggressive debt repayment, we believe CPN’s hedging program is too aggressive. In MT-to-LT, we believe importance of heat rate will likely dominate IPP valuations.

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The Logic NY Fed Court Decision to Uphold ZECs is Spurious

The US District Court of the Southern District of New York (Fed District Court) yesterday ruled through New York Southern District Judge Valerie Caproni dismissed all challenges to New York’s Zero Emissions Credit (ZEC) program
The decision by Judge Caproni, though seemingly logical, is actually spurious, in our opinion. The decision was based on the following logic and comparison:
While we do appreciate Judge Caproni’s position and interpretation of the law, we note several inconsistencies in the Judge’s arguments

By acknowledging that financial subsidies do allow otherwise uncompetitive sources of generation to be built, Judge Caproni is acknowledging that financial subsidies do distort market pricing because it increase supply into the market relative to demand, which by definition, ALWAYS NEGATIVELY affects pricing

Conclusion: Therefore, we continue to believe that as the case is appealed to higher judicial authority, we maintain that the most rational outcome is the reversal of both NY and IL subsidies for nuclear power. However,

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Power Company Privatization will Lead to Unintended Consequences

Lately there has been talk about privatizing power companies, including both CPN and NRG, and while we believe that the most rational course for these companies may be to go private – given the lack of “enthusiasm” for these names in the public markets – we are certain that the end result will not be either what the market expects nor what the regulators, politicians and, most of all, what the consumers desire
The assumptions we are making in our analysis are as follows:
Private equity (PE) investors are not unintelligent and will act in their own self-interest
Virtually all of the market (public and private) believe in the theory of “all else being equal”
Market forces move along least resistant path absent paradigm shift, typically externally imposed
As reserve margins dip below 12% market prices become more volatile and margins begin to expand at an accelerated rate
PE investors will be betting on the reduction of debt from internally generated free cash flow and asset sales, supplemented by cost reductions, to increase the equity value of its investments with the option value of changing market dynamics to further boost its rate of return
The first thing that PE investors are likely to do is to make the assumption that the underlying market forces and conditions don’t/can’t/won’t change for the foreseeable future
Based on these underlying assumption, PE investors will be able to figure out which plants they buy will remain profitable, which won’t and which are on the margin

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CPN 1Q2017 Earnings Note

Rightly, debt repayment is priority with Retail holding steady ||

Market appreciation for power stocks is lacking with CPN trading near its book value. In face of apathy, we agree CPN should focus on debt repayment – $1 debt repay is at least $1 accretion to equity value – and Retail. But, we feel macro-economic situation may improve in 2017, accelerating into 2018. Target debt repayment of $2.7B translates into at least some $7.60/share, which leads to our ST-Target. Operationally, we believe that expansion of Retail business through organic means is correct given that major pieces of the business is all in place. We believe Cal-ISO decision to grant 2 RMR contracts to CPN peaking units are but tip of iceberg for shareholder benefit. Decision to use PPA in place of building Guadalupe is in-line with our expectations and right thing to do, in our opinion. We continue to believe CPN’s story is about LT future of power. We agree accelerated closure of coal-fired generation is coming, industry is moving more towards reliance on renewable energy, and improving natural gas prices are all tailwinds for ST-to-MT gain for CPN and credit metrics likely to improve rapidly. Strategically there’s little to criticize, and it seems CPN has disavowed share buybacks. But, in improving fundamental market, we believe CPN’s hedging program is too aggressive. Improving commodity prices should continue, at least through 2017, but beyond depends on economy, which we believe may surprise. In MT-to-LT, we believe importance of heat rate will likely dominate IPP valuations.

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CPN 4Q2016 Earnings Note

ST Value Creation through Debt Repay, but Economy may Surprise ||
We feel CPN is focused on debt repayment to create value – $1 debt repay is at least $1 accretion to equity value – which we agree is correct in unexciting market/economy. But, we feel macro-economic situation may change fairly quickly for better in 2017, accelerating into 2018. Target debt repayment of $2.7B translates into at least some $7.6/share, which leads to our ST-Target. Operationally, acquisition of Noble Americas Energy Solutions (NAES) introduced CPN Retail to customers in 8 states in which CPN has no-to-low generation, but we believe this isn’t an issue. Decision on Guadalupe construction expected in 2H2017, but likely to be renegotiated. Rejection by Nevada PUC for acquisition of South Point doesn’t mean CPN shuts it down. In our opinion, we continue to believe CPN’s story is about LT future of power. We agree accelerated closure of coal-fired generation is coming, industry is moving more towards reliance on renewable energy, and improving natural gas prices are all tailwinds for ST-to-MT gain for CPN and credit metrics likely to improve rapidly. Strategically there’s little to criticize, but we’d like CPN to disavow share buybacks, and in improving fundamental market, we believe CPN’s hedging program is too aggressive. Improving commodity prices should continue, at least through 2017, but beyond depends on economy, which we believe may surprise. Also, over MT-to-LT, we believe importance of heat rate will likely start to dominate IPP valuations.

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