Share buybacks do not create value and the notion that a company can invest in its own stock is nonsense

Ever since I graduated business school – which was a long time ago – I’ve been having discussions and arguments as to whether or not share buybacks (SBB) create value. Despite the fact that many impartial studies have demonstrated and many mathematical proofs have been proffered that SBB don’t create value, astonishingly people continue to emphatically argue that SBB create value. This is not to say that SBB cannot be used to return truly unused capital back to shareholders, but we believe that SBB should be an action of last resort. Regardless, the conclusion: SBB cannot and, therefore, do not create shareholder value.
Even CEOs and CFOs of many companies can’t seem to bring themselves to stop SBB despite all of the evidence that companies cannot create value by buying back their own shares. And, even when it is demonstrated to these managements that there are far better ways to utilize the cash, managements still have reservations about ending their SBB program.
Therefore, I’m hoping that I can end this resistance to ending SBB through this editorial tutorial. The following lists arguments that we’ve encountered for why SBB create value for shareholders:
1) The P/E argument: SBB reduce share count, which increases EPS, and given the same multiple, the stock price must go up;
2) Investing in the company’s own stock creates value for shareholders: Companies can buy their stock at a low price and sell it at a higher price, which creates value;
3) Higher ROE means higher valuation: By reducing the amount of equity on the balance sheet, this raises the ROE on the returns from company projects, for which investors give the stock a higher valuation; and
4) Excess cash returned: This point is about returning excess cash to investors not about shareholder value.

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Letter to FERC outlining our thoughts on how to redesign wholesale power market pricing mechanism

For years, I have been advocating for a wholesale change in how power is priced in the wholesale electricity markets. And, I wish to be heard on this matter, because I believe that my views are not only intelligent and cogent, but also on-point to a future grid that is both reliable and resilient.

From my perspective, there are five main issues that must be resolved to maintain a grid that is both reliable and resilient for the long-term:
Renewable power disruption of wholesale power pricing
Proper compensation of reliability and resiliency characteristics of generation
No regression to “cost-of-service” rates
No “freebies” to businesses
Redesign must be based on market principals

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Summary and analysis of the 187 page DOE report titled “Staff Report to the Secretary on Electricity Markets and Reliability” dated August 2017 and summary and analysis of the 6 page PJM report titled “Energy Price Formation and Valuing Flexibility” dated June 15, 2017

DOE report titled “Staff Report to the Secretary on Electricity Markets and Reliability” dated August 2017, and
Summary of the 6 page PJM report titled “Energy Price Formation and Valuing Flexibility” dated June 15, 2017

Following are some of the highlights:

Changing circumstances are challenging current reliability:
Energy efficiency is done:
Retired plants were mostly baseload-type plants:
Grid operators must place and are placing increasing premium on flexible resources
More focus on resiliency is needed:
Current wholesale pricing inadequate for modern grid:
Cooperation between power and pipeline sectors is becoming crucial to reliability and resiliency, especially in winter,
Four issues that threaten grid reliability due to forced early retirements:

Our conclusion: While we believe that the DOE Report is critical to understanding the evolving electricity market, we believe that there are a number of issues that may be challenged:

Natural gas isn’t the main culprit for plant closures, in our opinion
Market forces are enough:
While DOE is concerned about natural gas price spikes, we’re not:
Decoupling of economic output and power demand is not solely a function of efficiency, in our opinion:

We were disappointed by the fact that the DOE did not incorporate analysis from potential accelerated economic activity, which we expect that we believe will accelerate demand

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As expected, the EPA repealed the Clean Power Plan (CPP); asks industry to help write a new regulation

CPP repealed: As expected, the Administrator of the US Environmental Protection Agency (EPA), Mr. Scott Pruitt, repealed the Obama-era CPP regulation aimed at forcing generators to reduce CO2 emissions by 32% from 2005 levels by 2030
CPP was like forcing car manufacturers to pay Tesla: The only way to achieve the CPP objective would have been for coal-fired generators to buy Renewable Energy Credits (REC) to offset CO2 emissions from its own plants, which is tantamount to subsidizing competitors’ generation

This would be equivalent to car manufacturers paying Tesla $X/car for every non-electric car that they sell to the consumers

EPA asks the industry for help in writing new regulations but what could be recommended? This was not expected. Regardless, we would expect that any proposed recommendations would involve inside-the-fence solutions
Conclusion: We are not surprised at the repeal of CPP; however, we are somewhat puzzled by the EPA’s request of the power industry to help it write new regulations regarding CO2.

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Our Expectations for 2H2017 is Better than would be Expected

NATURAL GAS

Soft winter weather (warmer than normal) has not helped natural gas prices currently, nor the prospect for strong natural gas prices in 2H2017
However, due to declining production, storage levels have continued to remain below record levels seen last year

LNG IN KOREA

There was an article in the Central Daily News Agency (CDNA) of South Korea that predicted a large shortage of global LNG supply by some 2024 that would have a strong impact on pricing

In a related article, the CDNA is contending that India is set to renegotiate its contract with Cheniere Energy (LNG), also due to high pricing

POWER SECTOR

Given our natural gas outlook, it is natural that investors may think that our view on the power sector is negative; however, it is not, particularly given the developments at NRG Energy
We believe that the power sector is at the cusp of another paradigm shift in which unprofitable assets finally exit stage left (or right, we don’t care which as long as they do)

UTILITY AND INFRASTRUCTURE SECTORS

We believe that the flight to safety is over and a general migration towards a “risk-on” portfolio started in 1Q2017, which we expect to continue into 2018
Also, we expect interest rates to continue rising, which isn’t going to do any favors for the utility and infrastructure sectors in terms funding costs and comparative investment profile relative to fixed income instruments

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US Withdrawal from Paris Accord may be Ideologically Meaningful, but Practically Meaningless

Outline of Paris Climate Accord (PCA):

Much of the PCA is voluntary
Unlike the Kyoto Protocol that differentiated between developed and undeveloped nations, the PCA blurs the line and doesn’t discriminate as distinctly
Find an agreeable way to measure so called “loss and damage” that results from climate change, but these so called “loss and damage” would not translate into, provide for, or be the basis for any compensation or liability
Establish progressively more restrictive binding targets every 5 years for each nation – known as the Nationally Determined Contributions (NDC) – to reduce greenhouse gas (GHG) emissions
Developed countries are expect to establish objectives and drive towards absolute declines in GHG emissions
Developing countries are expected to move towards economy-wide objectives
International trading of emissions credits would be allowed, which would allow one country to purchase credits from another to meet their NDC

Conclusion: Withdrawal of the US from the Paris Climate Accord is a non-event, in our opinion

By making most of the objectives, processes, procedures and methods voluntary and self-selective, at least for the US, the objectives and goals would change with a change in Washington, DC, which makes a global climate agreement almost useless

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REIT tax advantage is an illusion

REIT tax advantage is an illusion ||

One advantage of converting a utility into a real estate investment trust (REIT) is the supposed tax advantage in that the REIT no longer pays taxes but through rates, taxes continue to be collected.
One argument that was put forth to justify for collecting money for taxes that are not paid by the company from consumers is that regulators routinely allow for collection of taxes that are not paid by other forms of pass-through entities such as limited partnerships.
We are of the opinion that taxes being collected by other pass-through entities is for the taxes that would be paid by the recipients of the distribution to ensure after-tax equivalency across corporate structures.
We would also argue that the after-tax “return-on” portion of the pass-through distributions is competitive with other forms of business entities, but the “tax-advantage” comes in the form of the “return-of” capital portion, which, by definition, would be free from tax burdens.
Therefore, we’d argue that taxes collected by the Oncor-REIT would be to allow for tax-equivalency as compared to other business structures, but not to reward investors with cash that they did not earn.

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Corp. tax cut from 35% to 15% leads to 20%-30% upside; 2017 Outlook

• President-elect Trump has promised a corporate tax cut from 35% to 15%; if this tax cut is enacted, we believe that share prices should rise by some 20%-30%, but not likely for utilities
• Even if non-utility companies don’t change their growth/investment plans, we believe that the change in tax rate would accelerate their growth profile by giving these companies the ability to take the excess cash to pay-down debt faster or by earning interest income on the higher cash balance; however, we feel that it would be difficult to quantify the acceleration in growth profile unless specific plans are known
• If companies invest more than their depreciation expense then their P/E-multiple are likely to increase with a cut in tax rate, while investing less than their depreciation expense looks to reduce their P/E-multiple with a cut in tax rate; however, we feel that it would be difficult to quantify the actual change without knowing specific investment plans and depreciation expenses
• We set up a simple example to demonstrate our thesis:

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What we think Trump Presidency means; energy industry give & take

• In a historical upset Donald J. Trump will be our 45th president of the United States (POTUS) of America
• Energy industry is likely to see some benefits but also incur some detriments, in our opinion
• We believe that a Trump presidency is bad for commodity prices (except coal), so good for consumers
• We look for some specific energy policies to be instituted that would drastically change US energy policy instituted over the last 8 years, in particular, we believe that Clean Power Plan (CPP) is dead
• Infrastructure spending looks to be increasing
• We look for Yucca Mountain to be relicensed to accept nuclear waste

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Natural gas: Tailwind; Interest rate: Mild headwind; Election: Tornado

• As expected, natural gas prices started to rally, but about a month ahead of expectations in June
• We expect natural gas prices to generally move upward through 2H2016 and for 2017
• The impact of 1-3 rate increases should not be significant for valuations, but the portend for further rate increases is what would drive valuations down, in our opinion
• We expect that the global migration towards using more natural gas will continue and favor US energy companies, including energy infrastructure companies
• Power industry move towards renewables and natural gas is unlikely to abate, but there are a plethora of issues that would determine whether this is good or bad for investors depending on the industry, pricing mechanism, use of storage and back-up power, and development of new or refurbishment/replacement of old infrastructures
• Regardless, we look for heat rates to become more central in determining power economics moving forward, and likely grows in importance with higher percentage of generation delivered from intermittent renewable power sources

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