Portfolio Changes: AEP and XEL Added to Our Preferred List and SCG and CPN to Our Concerns List; Cautious on DYN

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Eric Selmon Hugh Wynne

Office: +1-646-843-7200 Office: +1-917-999-8556

Email: eselmon@ssrllc.com Email: hwynne@ssrllc.com

SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

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May 25, 2017

Portfolio Changes:

AEP and XEL Added to Our Preferred List and SCG and CPN to Our Concerns List; Cautious on DYN

Portfolio Manager’s Summary

In several notes over the last two weeks we have changed our list of preferred stocks, as well as added to our list of stocks about which we have concerns. We are publishing this note to summarize in one place the rationale behind each of these changes.

  • In a note we published on Monday discussing the case for an overweight position in utilities, we added AEP and XEL to our list of preferred regulated utilities and put SCG on our list of regulated utilities about which we have the greatest concerns. (See Time for T&D? We Reiterate Our Overweight on Regulated Electric Utilities & Add AEP and XEL to Our Preferred List, May 22, 2017.)
  • In a note we published yesterday discussing the results of the PJM capacity auction, we put CPN on the list of independent power producers about which we have the greatest concerns. We also expressed caution on DYN, but did not put it on our concerns list because of a potential merger with VST. (See PJM Capacity Auction Results: PEG, EXC & CPN Win Temporarily, But IPPs Still Lose Going Forward – Downgrading CPN and Cautious on DYN, May 24, 2017.)
  • We view AEP and XEL as the top regulated utility investments at this time, combining rapid rate base growth, and thus strong earnings growth potential, with reasonable valuations. A tailwind to earnings growth at both companies is cost management, where AEP has a strong track record and XEL an improving one. As these companies extend their track records of rate base expansion, cost cuts and earnings growth, we expect both stocks’ valuation to rise to a premium to the sector.

    • AEP’s 2019 earnings multiple of 16.8x is modestly below the regulated utility average of 17.2x, yet we estimate that AEP’s rapid rate base growth over 2018-2020 will put it in the first quintile among its regulated utility peers. Also attractive is the fact that almost three quarters of this growth will come from low risk, high return investments in transmission assets. As AEP’s transmission capex is primarily focused on replacing and upgrading aging transmission infrastructure, we expect the growth in AEP’s transmission rate base to continue beyond 2020. AEP may also have the opportunity in the next decade to accelerate its investment in distribution rate base, which has grown more slowly than the industry average. Ongoing cost control measures and a steadily improving balance sheet imply that AEP should be able to grow earnings with limited equity issuance for several years. AEP is exhibiting all of the characteristics of utilities that have traded at a premium to the sector and we expect it will begin to do so in the next 12-24 months.
    • Xcel trades at 17.6x 2019 earnings, slightly above the regulated utility average, but we believe the stock could be an attractive holding for long term investors. We expect Xcel’s rate base growth over 2018-2020 to be strong, putting the company in the first quintile among its regulated utility peers. Nearly 60% of Xcel’s total rate base growth over 2018-2020 comprises transmission and distribution assets, while generation capex is driven by investments in low risk renewable power projects in supportive regulatory jurisdictions. Finally, we note that over the last fifteen years, Xcel has experienced above average growth in operation and maintenance expense. Management’s new focus on cost cutting therefore has the potential to contribute materially to earnings growth, particularly in jurisdictions where Xcel’s earnings are lagging behind allowed returns or the utility is operating under long term rate settlements. We see XEL to be similar to AEP a few years ago, with a focus on cost cutting providing ongoing support for management’s 4% to 6% EPS growth target. If XEL can execute on cost cutting and rate base growth as we expect, we believe the stock can trade up to a premium to the sector over the next two to three years.
  • We are adding SCANA (SCG) to our list of least preferred companies due to the potential risks from its V.C. Summer nuclear project.

    • While SCANA is trading at a significant discount to the group at 13.8x 2019 consensus earnings, we see little opportunity for investors in this stock while the fate of the V.C. Summer nuclear project is unresolved. Following the bankruptcy of Westinghouse, its construction contractor for the project, SCANA must now decide whether to take over responsibility for construction, with the option of completing one or both new units, or to abandon the project and seek recovery from regulators for its investment to date. The safer option would be to abandon the project and seek recovery for construction work in progress, which totaled $4.2 billion at the end of 2016 and should total around $4.8 billion by the middle of 2017. However, this path could dramatically reduce future earnings growth, especially if SCANA’s current investment in the project were securitized, removing it from rate base.

      • If the capex for Summer were removed from rate base and securitized, and the securitization proceeds used for share buybacks, we calculate that the earnings of the utility would fall to the point where SCANA’s current share price would imply a 19x multiple of 2019 EPS, equivalent to a 10% premium to the regulated utility average for a stock with limited earnings growth prospects.
      • Abandoning the project also raises the risk of a prudency review and potential disallowance of any expenditures since the financial troubles of Westinghouse and its parent Toshiba came to light.
    • The riskier option would be to complete the project without Westinghouse or Toshiba, seeking recovery from them for future cost overruns in court, but maintaining a path to modest rate base growth (~4.1% p.a., by our estimate, over 2018-2020). Our view, however, is that it is highly likely that there will be delays and cost overruns in completing Summer beyond what is currently forecasted, that the recovery from Westinghouse and Toshiba will be limited, and that any unrecovered cost overruns would be subject to a prudency review for disallowance by regulators. Given the large size of the project (>70% of SCANA’s market cap, at the current cost cap under its contract with Westinghouse), the possibility of a multi-billion dollar write-off will be an overhang on the stock.
  • We are adding CPN to our list of least preferred names due to its high leverage (~6.3x Debt/ 2017 EBITDA) and valuation (8.8x EV/2017 EBITDA) and its exposure to negative trends in the power markets, particularly in California.

    • The benefit from the 2020/21 PJM capacity auction may be temporary and is mostly offset by lower pricing in the 2020/21 New England capacity auction run this past February.
    • Even if the uplift were permanent, CPN would still be over-levered at 6.0x Debt/EBITDA and 8.3x EV/EBITDA
    • Over the next several years we expect the output of existing gas fired power plants to fall in most competitive markets as new CCGTs and renewables come online and demand continues to stagnate.
    • With almost 65% of its generation capacity located in ERCOT, CAISO and ISO New England, CPN is the most vulnerable to increased renewable generation, particularly solar. The potential deployment of storage in these markets could aggravate the revenue loss to CPN by suppressing peak hour prices.
    • Furthermore, we do not see CPN’s current exploration of a sale of the company as likely to be successful.

      • The buyer would probably have to be a private equity investor because market power and leverage issues will prevent other IPPs from acquiring CPN’s assets.
      • CPN’s currently high leverage and the potential deterioration in cash flows from lower generation output would limit an acquirer’s ability to lever up CPN further.
      • All of the available cash would have to go to paying down debt for the next several years, limiting near term distributions and reducing returns.
      • Finally, the probability of continued weakness and potential deterioration in the power markets limits the exit opportunities for any acquirer.
  • Given our expectation of persistent weakness in the competitive power markets going forward, we would also avoid DYN, whose leverage is even higher than CPN, although we are not adding DYN to our list of least preferred names due to the potential for acquisition by Vistra Energy (VST).

    • DYN currently trades at ~8x EV/EBITDA and ~7x Debt/EBITDA with a free cash flow yield of ~30%, but post-2018 we see cash flows and EBITDA declining due to lower generation output and capacity revenues in the key PJM and New England markets.
    • More importantly for a private buyer, due to its high leverage, all of the declining excess cash flows will need to go to paying down debt.
    • However, DYN and VST are reported to be in merger talks and we believe VST has the balance sheet capacity to make a temporarily accretive deal at a 20-30% premium to DYN’s current share price. This deal could still fall through due to limited synergies (DYN already has very lean operations) and more attractive acquisition opportunities for VST in acquiring individual generating assets.
  • Finally, we recently removed Edison International (EIX) and PG&E Corp. (PCG) from our preferred list. (See California Cost of Capital Proposed Decision: A Year’s Reprieve Before ROEs Drop for EIX and PCG.)

While we view both stocks as fundamentally attractive long term investments, the uncertainty as to the companies’ allowed ROEs, due to the pending cost of capital proceeding in California, is likely to keep them from outperforming the regulated utilities as a group over the next 12-18 months.

    • Edison’s multiple of price to 2019 earnings (16.8x) is slightly below the regulated utility average of 17.2x, yet the company should see rapid rate base growth through the end of the decade, ranking in the first quintile among its regulated utility peers. Even beyond 2020, the electrification of transportation in California, combined with the growth of distributed generation and storage, means there is a need for sustained investment in distribution grid modernization at levels materially higher than today. Given Edison’s conservative dividend payout ratio of ~50%, the utility is expected to fund this growth primarily with retained earnings, with very limited if any access to external equity and should offer above average dividend growth, as well. Finally, Edison also benefits from California’s highly supportive regulatory framework, with its forward looking rate setting proceedings, decoupling of allowed revenues from volume sales and tracking mechanisms for the prompt recovery of fuel, purchased power and other costs.
    • Broadly the same advantages and risks attend PG&E, whose forward PE multiple of 16.4x also falls below the regulated utility average but whose rate base growth through the end of the decade ranks in the first quintile among its regulated utility peers. A key differentiating characteristic of PG&E relative to Edison, however, has been its historically inferior quality of management, resulting in greater operational and regulatory risk for shareholders, as exemplified by the San Bruno gas pipeline explosion and its aftermath. On the other hand, the recent installation of a new senior management team may be reflected over time in an improvement in operational efficiency and regulatory relations at PG&E, and a consequent recovery in earned ROEs relative to allowed that could cause growth in regulated earnings to exceed that in rate base. Also differentiating it from Edison, PG&E’s earnings growth is likely to be diluted through new share issuance, reflecting the company’s more generous dividend payout and historical practice of issuing equity to fund rate base growth. Finally, PG&E faces the risk of a reduction of its allowed equity ratio from its current 52% in the cost of capital review next year.

Exhibit 1: Heat Map: Preferences Among Utilities, IPP and Clean Technology


Source: SSR analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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