It seems that EXC is setting up for Generation optionality || We think we finally see EXC’s endgame: Creating optionality for its Generation business (GenCo). Until then, EXC plans to use GenCo as an ATM to fund utility growth that would power CAGR in AEPS of some 7%-9% through 2020, while dividend grows only at a 2.5% CAGR. This enables the six utilities (Utilities) combined dividend payout to go from almost 100% to about 77%. This gap makes it possible for Utilities to self-fund equity for future growth projects beyond 2020, largely negating need for GenCo ATM. This then gives EXC optionality with GenCo, in our opinion. Key to this strategy is to ensure GenCo cash flow, which in turn drives need for very high levels of hedging well in advance. This sacrifices upside potential and sub-optimizes GenCo, but enables EXC to execute on its LT vision. This strategy changes who EXC pursues next, which we thought would be another hybrid. Instead, it may pursue more pure utilities. Still we’d like EXC to buy nuclear, gas and renewable generation, while cheap, so we applaud acquisition of Fitzpatrick nuclear plant in NY. Regardless, we like EXC’s plans for the Utilities and believe it will eventually help drive valuation to the upside, but we reluctantly support its strategy for GenCo, given Utilities need for equity funding. We maintain our $72/share NIV and $46/share ST-Target.
We feel like EXC is moving away from its core competency || We still like EXC as a generation company, but understand the pivot towards utilities, even though we’re not thrilled about it. We still expect EXC to be leading candidate to roll-up assets, even utilities in Northeast US. Acquisition of PepCo Holdings (PHI) has closed, but cost $508MM of “giveaways” to make it happen. EXC reaffirms strategy of “harvesting” Generation cash flow and investing in utilities, returning capital to shareholders and investing in contracted assets. Plans dividend increase of some 2.5% per year starting with 2Q2016 dividend for 3 years, ahead of our schedule by about 2 quarters. By 2018, EXC expects utilities to cover dividends and seeking payout to increase dividend payout from utilities to some 65%-70%. Still, we’d like EXC to buy nuclear, gas and renewable generation, while cheap. In this regard, we don’t like that EXC is making decision to close Quad Cities & Clinton (QCC) at bottom of commodity cycle. New York nuclear assets still under pressure and EXC expects to shut-down without long-term solution. When commodity prices turn and environmental regulations get tighter, we believe EXC is very well situated to deliver LT-shareholder value, almost exclusively through its Generation subsidiary. Raising ST-Target to $46/share from $43 and NIV to $72/share from $69.
No new revelations; EXC’s still a thoroughbred waiting || We still like EXC as a generation company, but understand the pivot towards utilities. We still expect EXC to be leading candidate to roll-up assets, even utilities in Northeast US. Acquisition of PepCo Holdings (PHI) appears to remain on track for early March close, despite DC “redmailing.” EXC reaffirms strategy of “harvesting” Generation cash flow and investing in utilities, returning capital to shareholders and investing in contracted assets. Plans dividend increase of some 2.5% per year starting with 2Q2016 dividend for 3 years, ahead of our schedule by about 2 quarters. By 2018, EXC expects utilities to cover dividends and seeking payout to increase dividend payout from utilities to some 65%-70%. Still, we’d like EXC to buy nuclear, gas and renewable generation, while cheap. Combined capital expenditures with PHI is estimated at $25B over 5-years. BG&E rate case decision expected in June and ComEd’s formula rate-base filing expected in April. New York nuclear assets still under pressure and EXC expects to shut-down without long-term solution. When commodity prices turn and environmental regulations get tighter, we believe EXC is very well situated to deliver LT-shareholder value, almost exclusively through its Generation subsidiary. EXC turned in about $0.38/share on an AEPS basis for 4Q2015 vs. our estimate of some $0.35/share.
EXC: Thoroughbred ready to race || We like EXC’s generation portfolio, which consists heavily of nuclear energy; however, we’re concerned about direction EXC’s is taking with its purchase of Pepco Holdings Inc. (PHI). We’d rather see EXC buy more nuclear plants and generation assets in general while prices are relatively cheap. At least, we’d like to see EXC buy utilities with competitive generation. EXC was using utilities as a sort of long-term hedge for generation but PHI doesn’t fit this mold, so we wonder about ulterior motives such as lead into other acquisitions. We are concerned with “redmailing” by DC regulators regarding PHI acquisition. We believe EXC should continue with nuclear uprate program and enter into more operating agreements. We look for synergy upside and agree with PHI deal being accretive to AEPS. We believe EXC should grow its marketing and trading business, given its footprint, access to information, balance sheet and visibility. We believe EXC has room to raise its EXC 2020 goal of GHG reduction. Utilities generally have good rate structures and appear to have good relations with regulators. However, we are not sure if EXC is still focused on generation or is starting to shift towards utilities with an eye towards exploring alternative strategies. ST per share target of $43 is predicated on realization of good PHI integration, commodity upside starting 2H2016, and $69/share NIV is based on improving business fundamentals.
• 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:
• 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
• 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
Somewhat surprise BRXIT vote has little long-term consequences || Having lived in England for over six years during my early years, it’s not surprising that UK voted to exit the European Union (EU)
However, this has little consequences for the US utility, power, energy infrastructure, and LNG in the long-term
If the US and UK come to a quick free trade agreement (impossible with current administration) in 2017 under a new administration, there may not even be short-term negativity
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.
Cyclical upside around the corner ||
Lowered our capacity price expectations, which lowered our NIV/share to $41 from $56. Even as recent fundamentals seem weak, we believe that 2017 is turnaround year. CPN reduced top end of guidance by another $50MM to $1,850MM, but, market fundamentals are clearly improving and weather continues to be cooperative. So, we continue to believe that CPN’s still well-poised to deliver strong returns for shareholders over NT-to-MT. Also, in our opinion, in LT CPN’s story is about future of power and well beyond just macro effect of economy and commodity prices. 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 are solid. 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 largely continue, in our view. However, over ST-to-MT, we believe importance of heat rate will likely start to dominate IPP valuations. Environmental issues that continue to plague others present opportunities for CPN. We’d like to see CPN develop Glass Mountain Geothermal. Noble acquisition feels right, but separate management from Champion makes little sense to us. We like CPN’s balance sheet management.