Portfolio Update: We Are Dropping NEE from Our Preferred List & Adding IDA to Our Concerns List

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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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October 17, 2018

Portfolio Update:

We Are Dropping NEE from Our Preferred List & Adding IDA to Our Concerns List

We are dropping NextEra Energy (NEE) from our list of preferred utility stocks due to its premium valuation and average long term growth prospects, which we believe render long term outperformance unlikely. We are adding IDACORP (IDA) to our concerns list, reflecting its substantial valuation premium to the regulated utilities and its below average rate base growth. The two stocks on our preferred list where we have strongest conviction are FirstEnergy (FE) and Entergy (ETR).

NextEra Energy (NEE)

  • While we view NextEra Energy (NEE) as one of the best managed utilities in the sector with excellent businesses, we are dropping NEE from our list of preferred utility stocks due to its premium valuation and average long term growth prospects, which render long term outperformance difficult.
    • NEE’s 2020 PE multiple of 18.9 implies a 17.2% valuation premium to the average of the hybrid utilities as a group and a 12.9% premium to the regulated utilities.
    • NEE’s dividend yield of 2.63% is some 90 basis points below the hybrid utility average and the average of the regulated utilities.
    • Through 2022, we expect rate base growth at NEE’s regulated subsidiary, Florida Power & Light (FPL), modestly to exceed the average of the industry (7.6% p.a. vs. an industry average of 7.2% p.a. over 2018-2022). Thereafter, however, we see a significant risk of a slowdown in rate base growth as FPL’s investment rate (annual capex as a percentage of beginning of year gross plant in service) has been significantly higher than the industry average. Were FPL’s investment rate to revert to the industry mean, rate base growth would slow to 4.9% in the long term, slightly below our expectation for the industry of ~5.0% p.a.
      • Our estimate of the long term growth rate of electric plant rate base at FPL is predicated upon (i) a convergence of FPL’s investment rate with the 30-year industry average by segment (generation, transmission and distribution), (ii) the current breakdown of FPL’s electric plant rate base across these three segments, and (iii) our forecast of the roll-off of existing deferred tax liabilities and accumulation of future deferred tax liabilities.
  • FPL’s marginally more rapid rate base growth over the next four years – 40 basis points above the industry average — seems unlikely to compensate for NEE’s materially lower dividend yield. Unless management is able to continue to find new investment opportunities, FPL’s average long term growth prospect similarly fails to justify NEE’s premium valuation. While we believe this is one of the best management teams in the industry, we question its ability to continue to find investment opportunities that allow growth to significantly exceed the industry average.
  • Historically, FPL has capitalized on massive upgrades to its generation fleet and transmission and distribution system to drive rate base growth well above the industry average and the long term trend for its service territory. Going forward we see few opportunities for investment on a similar scale.
    • FPL’s annual capex ratio averaged 8.8% from 2013-2017, 150 basis points above the industry average over that period, resulting in 7.2% compounded annual growth in electric plant rate base over 2012-2017, 70 basis points above the industry average of 6.5%.
    • Key drivers of FPL’s rate base growth over the last decade have included the storm hardening of its distribution network, the uprate and life extension of its nuclear generation fleet, and the retirement of its oil fired steam turbine generators and their replacement with highly efficient gas fired combined cycle generators. Once complete, these investments cannot be replicated for decades.
    • NEE’s $2.0 billion investment in the Sabal Trail gas pipeline and Florida Southeast Connection project similarly capitalizes on large but one-off investment opportunities.
    • NEE’s ongoing focus on utility acquisitions as an avenue for growth reflects, we believe, the limited opportunities for long term growth in FPL’s service territory.
  • After failing to acquire Hawaiian Electric and Oncor, we believe NEE has made a far less attractive investment in its recent acquisition from Southern of Gulf Power and Florida City Gas for $5.75 billion.
    • 2017 net income at Gulf Power was $138 million and we estimate it was $13 million at Florida City Gas, implying an acquisition P/E multiple of over 30x.
    • Our estimate of Gulf Power’s rate base is ~$2.8 billion and Florida City Gas’s current official rate base (filed in February) is ~$265 million.  SO attributes $5.75 billion of the acquisition price to Gulf Power and $530 million for Florida City Gas, suggesting NEE paid >2x rate base for both companies.
    • The acquisition is accretive to earnings per share primarily due to NEE’s assumption of $5.1 billion in holding company debt to finance the purchase.
    • While we expect Gulf Power’s earned ROE (~9.5% in 2017) gradually to recover its allowed level (10.25%), temporarily enhancing NEE’s earnings growth, in the long run Gulf Power’s rate base is too small ($2.4 billion) relative to FPL’s ($33.9) to make a material difference in the growth rate of NEE’s regulated earnings.
    • We are concerned that the pressure to meet investor expectations for long term growth may force NEE management to continue to seek acquisitions and possibly again to overpay.
  • We are also worried that the very benign regulatory environment that NEE has enjoyed in Florida in recent years may worsen over time.
    • NEE’s planned capital expenditures are expected to drive rate base growth of 7.6% p.a. through 2022, consistent, by our estimate, with an average annual increase in residential bills of 3.1% p.a. over the next four years, well above the industry average (2.1% p.a.) and the expected rate of inflation (also 2.1%).
      • This bill forecast assumes growth in non-fuel O&M expense of 3.2% p.a., based on the industry average rate of increase in real, non-fuel O&M per customer. However, even if FPL were able to hold non-fuel O&M growth constant, the average annual increase in residential bills would still be 2.2% p.a. over the next four years, a meaningful increase.
    • Increases in average residential bills of this magnitude may be problematic. Florida is a state where the ratio of residential electricity bills to median household income (3.0%) is high relative to the national average (2.3%), and where a substantial proportion of residents are retirees living on fixed incomes.
    • We also concerned about a potential decline in the quality of regulation in the state if liberal Democrat Andrew Gillum is elected governor.
      • Under Florida’s current Republican governor, Rick Scott, the quality of utility regulation has vastly improved. The Florida Public Service Commission now comprises five Republican commissioners, all appointed or re-appointed by Scott. The Commission in recent years has been investor-friendly, setting allowed ROEs in electric utility rate cases at a premium of 5% to 8% above the national average.
      • Given the upward pressure on customer bills, a more liberal state government may see reason to restrain the growth in FPL’s electric revenue. If elected, Democrat Andrew Gillum will have the opportunity over the next four years to appoint all five commissioners on the Florida PSC.
    • A Democratic victory in the gubernatorial election is real possibility. Andrew Gillum leads his Republican rival Ron DeSantis by an average of 3.7% in recent polls, according to RealClear Politics, while the PredictIt betting market gives Gillum a 56% chance of victory.
  • Finally, we are concerned about NEE’s ability to maintain the growth rate of NextEra Energy Resources (NEER) beyond 2021. Without multiple acquisitions or a significant increases in NEER’s share of new wind and solar additions in the U.S., growth in EBITDA will likely level off at the current levels of ~$300-400 million per year, slowing NEER’s annual percentage growth rate over time.
    • The U.S. added ~10 GW of new solar and ~7 GW of new wind capacity in 2017. Even an aggressive forecast, such that as from Bloomberg New Energy Finance (BNEF), only sees annual solar additions rising to ~15 GW and wind additions holding steady around current levels.
    • Given the continued declines in the installed cost per MW for solar and wind, even if NEER increases its MW of solar capacity installed by 50% and grows its storage business, NEER’s annual capex will likely remain near its current level of $5-6 billion. Assuming NEER maintains its current margins, this results in flat nominal growth in EBITDA.
    • Growth in EBITDA of $300-400 million per year drives ~6.5-8.5% growth off of NEER’s 2017 EBITDA, but that declines to ~5.5-6.5% of year-on-year growth by 2022 and ~4.5-5.5% by 2025, as the growing denominator drives a declining growth rate.

Idacorp (IDA)

  • We are adding Idacorp (IDA) to our list of least preferred utility stocks due to its below average rate base growth and 19% valuation premium to the regulated utilities on 2020 EPS.
  • We see average rate base growth of only 3.9% p.a. for 2018-2022, well below the industry average of 7.2%, driven by a below average investment rate (annual capex as a percentage of beginning of year gross plant in service) of 4.5% over that period.
  • While many investors look at the longer term rate base growth opportunities from large planned transmission projects and the potential for new generation capex from accelerated retirement of the coal-fired Bridger plant, we see only limited upside that falls far short of justifying the current valuation.
    • Our rate base growth forecast for IDA of 4.3% p.a. for 2022-2026 is based on an increase in its investment rate by segment to long run industry averages, and thus assumes a 25% increase in capex over that period, equal to about $100 million per year. Given the composition of IDA’s rate base, however, and our forecast of its capex-related deferred tax liabilities, we estimate that IDA’s rate base growth over 2022-2026 will remain well below that of the regulated utility industry, which we forecast at 5.2% p.a. over the same period
    • Even increasing their annual capex by $200 million annually, similar to what could be expected over 5 years if Boardman to Hemingway, Gateway West and a replacement for the Bridger plant were needed, rate base growth would only increase to 5.8% p.a. until the projects were complete.
  • While the potential for an acquisition can justify some premium, IDA trades at one of the highest premiums among small-to-mid cap utilities. Less expensive utilities with better growth prospects will likely prove more attractive to potential acquirers.

FirstEnergy (FE):

We continue to find FE attractive even after recent outperformance. With the disposition of FE’s competitive generation subsidiary (FES), the strengthening of FE’s balance sheet over the past year and the strong rate base growth at its regulated utilities (estimated at 7.8% p.a. through 2022), we believe FE’s 13% discount to other regulated electric utilities is not justified. Furthermore, FE has been underinvesting in its transmission and distribution grids for many years and, according to our age of plant analysis, has one of the oldest grids in the sector. Even after the increases in management’s capex guidance over the past year, FE’s investment rate (annual capex as a percentage of beginning of year gross plant in service) remains more than 50 basis points below the industry average through 2022. To offset these years of under-investment, we believe FE has the potential to sustain rate base growth above the industry average for many years to come.

 

Entergy (ETR):

We also maintain our favorable view of ETR. We see the stock’s 17% 2020 PE discount relative to the regulated utilities gradually closing as ETR (i) retires it merchant nuclear fleet and evolves to a fully regulated utility and (ii) enters a period of strong rate base growth, estimated at 8.7% p.a. over 2018-22 and above the industry average for some time thereafter, driven in part by the need to replace aging generation plant. While ETR’s leverage is above the industry average, the issuance of equity earlier this year and the growing earnings at the regulated utilities will be reflected in improving credit metrics over the next few years.

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

©2018, 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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