Rising Growth and Falling Beta: Electric Utility Rate Bases Show Accelerating Growth Through 2021

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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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September 6, 2017

Rising Growth and Falling Beta:

Electric Utility Rate Bases Show Accelerating Growth Through 2021

In this note, we present our updated electric plant rate base growth forecast for each of the publicly traded regulated electric utilities, and roll forward our forecasts to include 2021. We expect the sector to realize 6.7% average annual growth in electric plant rate base over the next five years (2016-2021), up from 6.3% p.a. over the last five years and consistent with ~4.5% to 5.0% annual growth in earnings per share. Given the sector’s 3.5% dividend yield, regulated utilities offer the prospect of ~8.0 to 8.5% average annual returns, absent a change in PE multiples, which we believe to be competitive with prospective returns on the S&P 500, and compelling given the sector’s historically low beta of 0.26x. Within the sector, the prices of AEP, DTE, and PCG apparently fail to capitalize accurately their attractive growth prospects over the next five years, while ALE, IDA and POR appear over-valued in light of their more limited long term growth.

  • We are reiterating our recommendation to overweight the regulated electric utility sector in light of our updated and extended forecasts of electric plant rate base growth. Regulated utilities combine (i) prospective returns competitive with our expectations for the broader equity market and (ii) historically low betas, including a track record of significant outperformance during major market downturns. In the context of rising U.S. political and geopolitical risk, we note that adding regulated utility stocks to a diversified equity portfolio can reduce portfolio volatility without sacrificing returns.
    • We forecast ~6.7% compound annual growth in the industry’s aggregate electric plant rate base over 2016-2021, up from 6.3% p.a. over the last five years (2011-2016) (Exhibit 2). Allowing for non-plant rate base and historical rates of equity issuance during prior periods of comparable rate base growth, we expect 6.7% annual growth in rate base to drive 4.5% to 5.0% growth in earnings per share.
    • Given the 3.5% dividend yield of the sector, we see regulated electric utilities offering the potential for ~8.0% to 8.5% compound annual returns through 2020 – an expected return that we believe compares favorably with that of the S&P 500. The forward earnings yield of the S&P 500, based on 2018 consensus eps, is currently 5.9%. The expected rate of inflation implied by the difference between the yield on 10 year U.S. Treasury notes and 10 year TIPS is 1.80%, suggesting investors anticipate long run nominal returns of ~7.7% on the equity market as a whole.
    • The relative PE of the regulated utility sector would very likely fall were long term interest rates to rise. However, despite the Federal Reserve having raised its target federal funds rate in June, and the market’s expectation of one more increase by the end of the year, the yield of the ten-year U.S. Treasury bond has dropped by 55 basis points from its March 13th peak of 2.62% to 2.07% as of Tuesday’s close, apparently reflecting declining investor confidence in the Trump’s administration’s ability to enact growth enhancing tax and regulatory reforms or to push forward its infrastructure investment plans.
    • While regulated electric utilities appear poised to offer returns competitive with the S&P 500, the trailing 12-month beta of the sector is only 0.26 (Exhibit 3). Adding regulated utility stocks to a diversified equity portfolio can thus reduce portfolio volatility without sacrificing returns.
  • We favor utilities whose existing rate base and future rate base growth are weighted toward transmission and distribution assets (see Exhibits 10 through 14). These companies offer superior long term growth compared to vertically integrated utilities whose rate base and capital investment are heavily weighted toward generation assets.
  • U.S. electricity demand has not increased over the last decade, curtailing the need for generation investment. The EPA’s Cross-State Air Pollution Rule and Mercury and Air Toxics Standards have forced the U.S. coal fired fleet to install controls for SO2, NOx, mercury, acid gases and particulate matter, similarly limiting the scope of future environmental upgrades. Finally, with the Trump administration’s attempts to withdraw and dramatically scale back the EPA’s Clean Power Plan, we see diminished opportunity for utilities to invest in new, lower emitting generation capacity.
  • By contrast, distribution capex is likely to benefit from the continued rollout of smart meters and other smart grid technologies designed to collect data from and exercise control over the distribution system; investments to enhance grid reliability in response to a declining tolerance for distribution system outages and to storm harden distribution systems in coastal states; preparations for the integration of distributed solar generation and electric energy storage; and the strengthening of distribution circuits to accommodate the charging of a rising number of electric vehicles.
  • Equally important, transmission and distribution investments face much lower construction, operation, regulatory and financial risk than do investments in generation assets.
  • Historically, major generation projects have encountered a combination of risk factors – technical complexity, high cost, long construction periods and focused regulatory oversight – that on occasion have proved crippling to the companies undertaking them. By contrast, transmission and distribution projects are less technically complex, individually less costly and quicker to build. Not only are these projects at lower risk of major cost overruns and completion delays, but their smaller scale and shorter construction periods imply that the delays or cost overruns that do occur are far less damaging to their sponsors.
  • Finally, we note that generation projects, even after they have been successfully commissioned, continue to present much higher operational and environmental risks than do T&D assets.
  • To assist investors in identifying potentially attractively valued stocks that are well positioned for regulated electric rate base growth, we have screened the sector for utilities whose valuations appear at odds with their growth prospects over the next five years. (Our preferences among regulated utilities, set out in Exhibit 1, reflects this assessment, but is based on a broader set of quantitative and qualitative factors.)
  • In Exhibit 7, we have highlighted in green those utilities whose 2019 PE multiples are at or below the average for the regulated electric utilities as a group, but whose prospective rate base growth over 2018-2021 is among the most rapid in the industry: AEP, DTE and PCG. At AEP and PCG, moreover, the contribution of transmission and distribution assets to rate base growth is very high.
  • By contrast, we see ALE, IDA and POR as priced at or above the average for the group, yet offering some of the least attractive growth prospects in the sector.

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

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Source: FERC Form 1, company reports, SNL, SSR analysis

Details

The last four months have seen a marked increase in U.S. political risk, and unusually elevated levels of geopolitical risk, even as the stock market has hit new highs. Key domestic developments have included the failure of the Republican-controlled Congress to repeal and replace Obamacare; rising friction between the Trump administration and the Republican leadership in Congress as a result; the growing political isolation of the president following his remarks on the violence at Charlottesville, as evidenced by the resignation of prominent business and labor leaders from several of the administration’s advisory councils; and the increasingly aggressive investigation by independent counsel Robert Mueller into allegations of collusion between Trump campaign officials and the Kremlin. These events have eroded confidence in the ability of the administration to guide the GOP policy agenda through Congress, and thus diminished expectations for corporate tax reform and infrastructure investment. Internationally, critical free trade agreements such as NAFTA and Britain’s trade relations with the European Union are subject to re-negotiation with uncertain results, while the prospect of unilateral trade action by the United States against China has materially increased. Finally, military tensions between the United States and North Korea have escalated markedly as North Korea has aggressively and successfully tested both thermonuclear warheads and long range missiles. The growing potential for domestic policy paralysis, the erosion of critical free trade agreements and trading relationships, and the ongoing confrontation with North Korea pose material risks to the U.S. equity market, where valuations remain at historically high levels.

In this context, we are reiterating our recommendation to overweight the regulated electric utility sector. Regulated utilities combine (i) prospective returns competitive with our expectations for the broader equity market and (ii) historically low betas, including a track record of significant outperformance during major market downturns. In the context of rising U.S. political and geopolitical risk, we note that adding regulated utility stocks to a diversified equity portfolio can reduce portfolio volatility without sacrificing returns.

Within the sector, we favor utilities that trade at or below average valuations, based on forward PE multiples, but where rapid prospective rate base growth can drive significant long term earnings growth. Among these firms, we particularly favor those whose current rate base and future rate base growth are weighted toward transmission and distribution assets, which in our view offer not only superior long-term growth potential but also lower construction, operation, regulatory and financial risk.

Regulated Electric Utilities Combine Steady Growth with Historically Low Betas

As set out in our note of September 13, 2016, Is This the Golden Age of Electric Utilities? A Primer on Historical and Forecast Rate Base Growth, our positive outlook on the regulated electric utility sector as a whole reflects the following considerations:

    • Based upon an analysis of U.S. regulated utilities’ capex plans, depreciation rates and prospective deferred tax liabilities, we forecast ~6.7% compound annual growth in the industry’s aggregate electric plant rate base over 2017-2021 (Exhibit 2). This forecast rate of growth is in line with the 6.7% compound annual growth in aggregate electric rate base over the last ten years (2006-2016), but up from the 6.3% CAGR realized over 2011-2016. It also exceeds the 6.6% growth that we forecasted for 2015-20 based on utilities’ capex guidance at the end of 2016.
    • This growth in rate base should, in the medium term, drive commensurate growth in regulated earnings. Based on historical rates of earnings dilution during periods of similar rate base growth, and the slower growth from non-plant components of rate base, we expect our forecast growth in electric plant rate base of 6.7% p.a. over 2016-2021 to drive 4.5%-5.0% compound annual growth in earnings per share.
    • Given an average dividend yield of 3.5% across the sector, we would expect 4.5-5.0% annual growth in earnings per share to be consistent with ~8.0%-8.5% compound annual shareholder returns, absent a change in the sector PE. While a re-rating of the sector would be expected were long term interest rates to rise, we note that, despite the Federal Reserve having raised its target federal funds rate in June, and the market’s expectation of one more increase by the end of the year, the yield of the ten-year U.S. Treasury bond has dropped by 55 basis points from its March 13th peak of 2.62% to 2.07% as of Tuesday’s close. The ongoing decline in the yield of the ten-year U.S. Treasury apparently reflects eroding investor confidence in the Trump’s administration’s ability to enact growth enhancing tax and regulatory reforms or to push forward its infrastructure investment plans.

We view the 8.0%-8.5% expected return on U.S. regulated electric utilities to be highly competitive with prospective returns on the S&P 500. The forward earnings yield of the S&P 500, based on 2018 consensus EPS, is currently 5.9%. Adding the expected inflation rate of 1.80% implied by the difference between the yield on 10 year U.S. Treasury notes and 10 year TIPS, investors appear to expect long run nominal returns of ~7.7% on the equity market as a whole, again assuming no change in P/E.

    • While regulated electric utilities thus appear poised to offer returns competitive with the broader market, the trailing 12-month beta of the sector is only 0.26 – a historically low level and just over half the 30-year beta of 0.48 (Exhibit 3).[1] Adding regulated utility stocks to a diversified equity portfolio can thus reduce portfolio volatility without sacrificing return.
  • Finally, we note that, across all the major market downturns since 1994, regulated utilities have outperformed by the S&P 500 by an average of 860 basis points, while outperforming other traditionally defensive sectors (consumer staples, health care and telecoms) by 340 to 640 basis points (Exhibit 4). (See Utilities and Other Defensive Sectors During the Trump Era: Which Perform Best – Particularly Against Tweets?, April 6, 2017.)

Exhibit 2: Historical and Estimated Growth of the Aggregate Electric Rate Base of U.S. Investor Owned Utilities (2007-2021E) (1)

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1. 2017-2021 growth estimates reflect the announced capital expenditure plans of the publicly traded investor owned utilities in the U.S. that have provided such forecasts in their SEC filings and investor presentations. The aggregate electric rate base of the companies providing such capex forecasts is equivalent to approximately 80% of the aggregate electric rate base of the U.S. investor owned utilities as a whole.

Source: FERC Form 1, SEC 10-Q, SNL, SSR analysis

Exhibit 3: Historical and Estimated Growth of Aggregate Electric Rate Base of U.S. Investor Owned Utilities (2007-2021E) (1)

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1. 2017-2021 growth estimates reflect the announced capital expenditure plans of the publicly traded investor owned utilities in the U.S. that have provided such forecasts in their SEC filings and investor presentations. The aggregate electric rate base of the companies providing such capex forecasts is equivalent to approximately 80% of the aggregate electric rate base of the U.S. investor owned utilities as a whole.

Source: FERC Form 1, SEC 10-Q, SNL, SSR analysis

Exhibit 4: Beta of the Philadelphia Utility Index Relative to the S&P 500 (1)

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1. The Philadelphia Utility Index is comprises primarily regulated electric and regulated electric and gas utilities.

Source: Bloomberg and SSR analysis

Exhibit 5: Average Outperformance vs. the S&P 500 of Indices of the Principal Defensive Sectors (1) During the Largest Market Downturns, 1994-2017

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1. NASDAQ PHLX Utility Index (UTY); Dow Jones U.S. Telecommunications Index (DJUSTL); Dow Jones U.S. Heath Care Index (DJUSHC); Dow Jones U.S. Consumer Goods Index (DJUSNC); Dow Jones Equity All REIT Index (REI); Alerian MLP (AMLP)

Source: Dow Jones, Bloomberg and SSR analysis

We Expect Investment in Distribution to Accelerate, While Generation Capex Will Lag

Within the sector, we favor utilities whose current rate base and future rate base growth are weighted toward transmission and distribution assets, which we expect to offer superior long-term growth compared to vertically integrated utilities whose rate base and investment are heavily weighted toward generation assets.

  • Over the period 2000-2016, the aggregate generation rate base of U.S. investor owned utilities has expanded at a compound annual rate of 7.0%, far exceeding nominal GDP growth of 3.8% over the period (Exhibit 5). Critically, however, the drivers of this growth – the need to augment the reserve margin of the bulk power system in the early years of this century, followed by a decade of environmental upgrades to the coal fired fleet – are now behind us. Looking forward, the prospects for growth in generation rate base are less enticing. U.S. electricity demand has not increased over the last decade, rendering capacity expansion unnecessary. The EPA’s Cross-State Air Pollution Rule and Mercury and Air Toxics Standards have forced the U.S. coal fired fleet to install controls for SO2, NOx, mercury, acid gases and particulate matter, severely limiting the potential scope of future environmental upgrades. With the Trump administration’s attempts to withdraw and dramatically scale back the EPA’s Clean Power Plan, little additional expenditure on environmental compliance will be required.
  • By contrast, over 2000-2016 distribution rate base grew at only 4.1% p.a., lagging the 5.9% CAGR in aggregate electric rate base (Exhibit 5) and leaving distribution rate base at its lowest share of aggregate rate base in 25 years (Exhibit 6). Looking forward, distribution capex is likely to benefit from the continued rollout of smart meters and other smart grid technologies designed to collect data from and exercise control over the distribution system; investments to enhance grid reliability in response to a declining tolerance for distribution system outages and to storm harden distribution systems in coastal states; preparations for the integration of distributed solar generation and electric energy storage; and the strengthening of distribution circuits to accommodate charging of a rising number of electric vehicles. (See Electric Vehicles and the Grid: The Impact of EVs on Power Demand, Peak Load and Electric Energy Storage — and the Impact of the Grid on EVs, May 1, 2017.)
  • Since the turn of the century, transmission rate base has grown most rapidly of all, expanding at an 8.5% average annual rate (Exhibit 5). As a result, transmission rate base now constitutes a larger proportion of aggregate rate base than it has at any point over the last three decades (Exhibit 6). While we believe the rate of growth of transmission rate base is likely to slow beyond 2020, transmission capex will continue to be supported by the replacement of obsolete assets, the need to connect isolated sources of renewable generation with load centers, and investments to eliminate transmission bottlenecks so as to better integrate regional power markets. Moreover, the financial benefit of these investment opportunities is compounded by the higher ROEs allowed by the Federal Energy Regulatory Commission (FERC) on investment in interstate transmission assets; these allow utilities to achieve more earnings growth per dollar of investment in FERC-regulated transmission than is possible through investment in most state regulated generation assets.

Exhibit 6: CAGR in Electric Rate Base by Asset Class

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Source: FERC Form 1, Bureau of Economic Analysis, SNL, SSR analysis

Exhibit 7: Annual % Growth in Total Electric Rate Base of Investor Owned Utilities by Asset Class

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Source: FERC Form 1, SNL, SSR analysis

Exhibit 8: Breakdown of Total Electric Rate Base of Investor Owned Utilities by Asset Class (%)

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Source: FERC Form 1, SNL, SSR analysis

Generation Capex Carries Materially Higher Risk than Investment in Transmission and Distribution

Not only does investment in transmission and distribution offer superior prospects for growth, but it presents utilities with much lower construction, operation, regulatory and financial risk than investment in generation.

  • Historically, major generation projects have encountered a combination of risk factors – technical complexity, high cost, long construction periods and focused regulatory oversight — that on occasion have proved crippling to the companies undertaking them. Recent examples include the nuclear power plants being built by Southern (Vogtle) and SCANA (V.C. Summer) and the integrated coal gasification facilities undertaken by Southern (Kemper County) and Duke (Edwardsport). The high cost and long construction periods of these projects imply that, once they encounter technical difficulties, the financial consequences for their owners are necessarily large and prolonged. Regulators, seeking to protect ratepayers, compound utilities’ risk by imposing limits on the recovery of cost overruns.
  • By contrast, the low technical complexity of transmission and distribution projects renders them far less prone to major cost overruns and completion delays. In addition, the much smaller scale and shorter construction periods of these projects implies that the consequences any such delays or cost overruns are far less damaging. The shorter construction times of transmission and distribution projects also allow utilities to respond quickly to unforeseen risks by reducing their capital allocation to similar projects, adopting alternative technologies, or making changes to the choice of contractor.

Even after they have been successfully commissioned, major generation projects still carry much higher risks, both operational and regulatory, than do T&D assets.

  • Time and again, equipment failures at nuclear power plants (e.g., FirstEnergy’s Three Mile Island and Davis Besse, AEP’s Cook, Progress Energy’s Crystal River and Edison International’s San Onofre,) have created multi-year financial burdens for their owners.
  • Nor are the risks associated with generation assets limited to nuclear power plants: the cost of compliance with increasingly stringent environmental regulations has long eroded the financial performance of the U.S. coal fired fleet. The most striking recent example has been the high cost of compliance with the EPA’s Mercury and Air Toxics Standards; this standard, which came into effect in 2015, forced the retirement of ~15% of U.S. coal fired capacity, whose owners deemed the capital expenditures required to comply with the regulation to be unrecoverable over the remaining useful life of the plants.

Finally, the long construction periods and high cost of these projects raises an additional financial risk for utilities from regulatory lag. In jurisdictions where a power plant must be “used and useful” to enter rate base and thus be included in the calculation of the utility’s revenue requirement, costly generation projects with long construction periods can absorb substantial capital and yet generate no cash return for their owners. (To offset this risk, more states in recent years have allowed cash returns on capital invested in large generation projects and, in some cases, approved rate adjustments in advance to allow full cost recovery once the plant has entered service.) By contrast, utilities adding transmission and distribution assets, individually small and quicker to build, are far more likely to be granted prompt rate relief, often through tracking mechanisms and formula rates.

Which Utility Stocks Fail to Capitalize Correctly Their Long-Term Growth Prospects?

In choosing among individual stocks, we favor utilities whose forward PE multiples are at or below the industry average, but whose rate base growth over the next five years is expected to significantly exceed the industry’s, creating the potential for long-term earnings growth that is materially more rapid than their peers. While the stocks we include in our most and least preferred lists are chosen based on a broader set of factors, including these, the screen below is intended to assist investors in identifying potentially attractive investments by highlighting mismatches between valuations and expected rate base growth.

 

In Exhibit 9, therefore, we rank the regulated electric utilities into quintiles based upon (i) their forward PE ratios (price to consensus 2019 earnings), and (ii) the rate of growth in their regulated electric rate base. With respect to both of these criteria, a first quintile ranking is the most favorable and a fifth quintile ranking the least favorable. The table also presents the contribution of regulated electric earnings to each utility’s EBITDA, as well as the percentage of rate base growth from 2018 through 2021 that is attributable to generation, transmission and distribution assets.

Exhibit 9: Which Utilities Offer the Most Rapid & Least Risky Rate Base Growth?

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Source: FERC Form 1, SNL and SSR analysis

We have highlighted in green three utilities whose forward PE multiples rank in the middle quintile or better, but whose estimated rate base growth from 2018 through 2021 ranks in the top quintile among their regulated peers: AEP, DTE, and PCG.

  • The 2019 PE multiples of both AEP and DTE fall within 2% of the arithmetic average of the regulated utilities as a group, yet the estimated rate base growth of both stocks falls in the top quintile among their peers. From 2018 through 2021, we estimate that rate base growth at AEP will average 8.2% p.a., exceeding by 170 basis point p.a. the growth in rate base for the industry as a whole, which we estimate at 6.5% p.a. over the period. Similarly, DTE’s rate base growth from 2018 through 2021 is expected to exceed the industry average by 100 basis points per annum. On the same criteria, PCG appears to be even more attractive, trading at a 2019 PE multiple that is 4% below the industry average yet poised to deliver rate base growth that is 160 basis points above the industry average over 2018-2021.
  • At AEP and PCG, moreover, the contribution of transmission and distribution assets to rate base growth is very high. As illustrated in Exhibit 9, planned increases in transmission and distribution rate base account for almost 80% of AEP’s rate base growth over the five years from 2016 through 2021, significantly mitigating the technical, regulatory and financial risk associated with its investment program. At PCG, planned investments in transmission and distribution account for 100% of expected rate base growth over the next five years. By contrast, DTE’s growth relies much more heavily generation investment, with the planned expansion of generation rate base accounting for 53% of total rate base growth from 2016 through 2021.

We are not adding DTE our list of most preferred regulated utilities at this time. While DTE is a well run company with attractive long term investment prospects, we find AEP to be a more compelling investment, offering materially more rapid rate base growth through 2021 and potentially beyond, a much larger contribution from transmission and distribution to rate base growth, and a management team that has proven itself highly effective in restructuring the company’s operations.

In our note of May 12th, California Cost of Capital Proposed Decision: A Year’s Reprieve Before ROEs Drop for EIX and PCG, we removed PCG from our list of most attractive regulated utility stocks, arguing (i) that the most likely impact of California’s 2018 cost of capital proceeding will be to reduce the earnings potential of PCG by ~4.5%, and (ii) that the risk of an unfavorable outcome in this critical proceeding would likely prevent the stock from outperforming its peers until the final decision was known, likely in late 2018. For longer term investors, however, PCG’s favorable combination of below average valuation and well above average rate base growth may render the stock attractive. We note that PCG’s 4.1% discount to the regulated utilities’ average 2019 PE multiple would seem to discount an unfavorable outcome to California’s 2018 cost of capital proceeding. Second, the trends that we believe will cause growth in distribution rate base to accelerate over the long term are particularly evident in California. The backbone of California’s electric and gas delivery systems was built out during the state’s demographic boom of the 1950s and 1960s, and is now in need of critical upgrades to ensure safety and reliability; we therefore expect PCG’s current spending on infrastructure replacement to continue. In addition, California has taken the lead in the deployment of electric vehicles, distributed solar generation, and electric energy storage, implying a need for sustained capital investment in the distribution grid to integrate the capabilities of these new technologies while mitigating their disruptive impact. Third, California’s highly supportive regulatory framework significantly reduces shareholder risk, while enhancing the ability of the state’s utilities to achieve or exceed their allowed ROEs. Key features of this regulatory framework, include triennial, forward looking rate setting proceedings based on a forecast test year; annual increases in rates thereafter to offset the impact of inflation; the use of tracking mechanisms to ensure prompt recovery of fuel and other costs; the pass-through to ratepayers of pension costs; and, critically, the decoupling of allowed revenues from kWh sales, mitigating the risk of demand erosion due economic recession, unanticipated demographic change, energy efficiency, or just milder than normal weather.

We also highlight in Exhibit 9 three utility stocks whose prices appear not to capitalize properly their very poor prospects for rate base growth: ALE, IDA and POR. ALE’s 2019 PE multiple is 9% higher than the average for the regulated utility industry, yet we estimate that its rate base growth from 2018 through 2021 will lag the industry average by 90 basis points p.a. IDA’s 2019 PE multiple is even higher, some 14% above the industry average, but its estimated rate base growth from 2018 through 2021 is expected to lag the industry average by 110 basis points p.a. Nevertheless, we are not adding IDA to our list of least attractive regulated utilities because they are a potential takeover candidate and historically have been effective at achieving in-line utility earnings growth in spite of below average rate base growth. Finally, POR stands out not for its valuation (its 2019 PE multiple is only 3% above the industry average) but for its extremely limited growth prospects: from 2018 through 2021, we estimate that rate base will grow by only 0.5% p.a., lagging the industry average by 6.0% p.a. However, we believe that POR’s rate base growth forecast will likely increase over the next year as they either get approval for their proposed wind project or it is rejected and they redeploy capital into other areas.

The Risks Attending Forecast Growth in Rate Base

As discussed above, we favor utilities whose current rate base and future rate base growth are weighted toward transmission and distribution assets, which we expect to offer superior long-term growth compared to vertically integrated utilities whose rate base and investment are heavily weighted toward generation assets. Equally important, investment in transmission and distribution presents utilities with much lower construction, operation, regulatory and financial risk than investment in generation.

In Exhibit 10, therefore, we break down the forecast growth in electric plant rate base of the publicly traded electric utilities into their generation, transmission and distribution components. Exhibits 11 through 14 graphically illustrate which utilities rely most and least heavily on generation, transmission and distribution capex to achieve their planned rate base growth over 2016-2021. At POR, NWE, GXP and SO, over 60% of planned rate base growth over 2016-2021 is attributable to generation capex (see Exhibit 10). By contrast, at ED, ES, EIX, PCG, and SCG, growth in transmission and distribution rate base accounts for 100% of planned rate base growth over 2016-2021.[2] At WEC, AEE, and AEP, the contribution of transmission and distribution to rate base growth is ~80% over the same period (see Exhibit 11).

 

Exhibit 10: Breakdown of 2016-2021 Growth in Electric Rate Base by Class of Asset

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Source: FERC Form 1, SNL, SSR analysis

Exhibit 11: Breakdown of 2016-2021 Growth in Electric Rate Base by Class of Asset

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Source: FERC Form 1, SNL, SSR analysis

Exhibit 12: Contribution of Generation to Total Rate Base Growth, 2016-2021 _________________________________

Source: FERC Form 1, SNL, SSR analysis

Exhibit 13: Contribution of Transmission to Total Rate Base Growth, 2016-2021

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Source: FERC Form 1, SNL, SSR analysis

Exhibit 14: Contribution of Distribution to Total Rate Base Growth, 2016-2020

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Source: FERC Form 1, SNL, SSR analysis

Appendix 1: Growth in Rate Base vs. Growth in Regulated Utility Earnings

Growth in rate base is one of the fundamental drivers of long term earnings growth among regulated electric utilities.[3] As set out in Exhibit 15, a regression analysis of the five year CAGR in electric rate base against the five year CAGR of electric operating income of U.S. investor owned utilities results in an r-squared of 0.31, suggesting that rate base growth explains approximately a third of the growth in operating income among electric utilities. Other key drivers of long term earnings growth include the frequency with which individual utilities file rate cases to adjust their regulated revenues to the reflect the rise in rate base; changes in the allowed return on equity used by regulators to set utilities’ allowed revenues in these rate cases; and utilities’ success or failure in realizing that allowed return through the control of operating and financial expenses. Looking ahead, we expect rate base growth will be an even more important driver of earnings growth as the decline of allowed ROEs levels off and the frequency of rate case filings continues at its current high level.

In choosing among regulated utilities, investors particularly value management forecasts of rate base growth not only because of the visibility they provide into the long-term growth of earnings but also because the other earnings drivers listed above are so much more difficult to predict. At the annual financial conference of the Edison Electric Institute in November, rate base forecasts will feature prominently in management presentations and discussions with investors.

Exhibit 15: The Relationship of Rate Base Growth to Operating Income Growth at Investor Owned Electric Utilities in the United States, 1993-2013

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Source: FERC Form 1, SNL, SSR analysis

Appendix 2: The Regulated Utility Stocks We Find Most and Least Attractive

Among the regulated electric utilities, our preferred stocks are American Electric Power (AEP) and Xcel Energy (XEL):

  • AEP’s 2019 earnings multiple of 18.0x is modestly below the regulated utility average of 18.2x, yet we estimate that AEP’s rapid rate base growth over the period from 2018 through 2021 will put it in the first quintile among its regulated utility peers. Over 2018-2021, we estimate that rate base growth at AEP will average 8.2% p.a., exceeding by 170 basis point p.a. the growth in rate base for the industry as a whole, which we estimate at 6.5% p.a. over the period. Also attractive is the fact that almost 80% of this growth will come from low risk, high return investments in transmission assets. In addition, because AEP’s transmission capex is focused on replacing and upgrading aging transmission infrastructure, we expect the growth in AEP’s transmission rate base to continue beyond 2021. 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.
  • Xcel trades at 19.0x 2019 earnings, 4.4% 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 2018-2021 to be strong, putting the company in the second quintile among its regulated utility peers. Over 60% of Xcel’s total rate base growth over 2018-2021 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 it is operating under long term rate settlements, and contribute to earnings growth that we believe will exceed management’s 4% to 6% EPS growth target.

The two regulated utility stocks where we have significant concerns are ALLETE (ALE) and Scana (SCG):

  • ALLETE is currently trading at 19.7x 2019 consensus earnings estimates, 8.0% above the industry average and placing it in the fifth or most expensive quintile among regulated utilities. Yet ALLETE’s forecast rate base growth from 2018 through 2021 is only 5.6% p.a., 90 basis points below the industry average and placing the fourth quintile among all the regulated electric utilities. We believe ALLETE’s rate base growth will continue to be constrained beyond 2021 by the fact that 65% of its rate base comprises generation assets, the highest percentage among electric utilities, while distribution assets account for only 10%, the lowest percentage among electric utilities. A further concern is ALLETE’s heavy reliance on industrial sales, due to the large concentration of taconite mines in its service territory, which renders its revenues and earnings more cyclical than is the norm for regulated utilities. Earnings growth at ALLETE would benefit from any recovery in the steel industry that the taconite mines supply, as well as from the development of new wind projects at its renewable development subsidiary; however, we believe neither of these will result in earnings growth strong enough to justify its current premium valuation. Finally, we do not see ALLETE as an attractive takeover candidate.
  • While at 12.8x 2019 consensus earnings Scana is trading at a discount of almost 30% to the industry average, we continue to view the stock as one of the least attractive among the regulated electric utilities. While the decision to abandon Summer Units 2 & 3 will significantly reduce shareholder risk, we see little opportunity for investors in this stock given (i) the difficulty SCG faces in achieving its guidance of 4-6% growth off of 2016 normalized EPS over the next 3-5 years and (ii) the significant risk of further downside if the unrecovered investment in Summer were to be securitized or if there were disallowance on a prudency review. Our revised base case forecast is consistent with 2021 earnings power of $4.11, or an 0.7% CAGR off of normalized 2016 EPS of $3.97. SCG’s resulting multiple of price to 2021 earnings is line with the regulated electric utility average, suggesting it is trading at fair value. However, in a downside scenario that envisions securitization of SCG’s unrecovered investment in Summer, 2021 earnings power falls to $3.70, or a -1.4% CAGR off of normalized 2016 EPS, implying SCG is ~11% overvalued compared to the average regulated electric utility on 2021 consensus earnings forecasts. Finally, were the South Carolina Public Service Commission to disallow the $1.5 billion in Unit 2 & 3 costs which have not yet undergone prudency review, we estimate SCG’s 2021 earnings power would fall to $2.96, a -5.7% CAGR off of 2016, implying SCG is ~38% overvalued compared to the industry average. (See our note of August 2nd, SCG: As Rate Base Outlook Crumbles, How Will SCANA’s Earnings Grow?).

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  1. To estimate the beta of the publicly traded, regulated electric utilities in the United States, we have calculated the beta of the Philadelphia Utility Index (UTY), which is primarily comprised of regulated electric utility stocks.
  2. In our previous forecast, SCG had the highest share of rate base growth from generation. However, with the abandonment of the VC Summer nuclear plant, SCG’s generation rate base actually shrinks. This reflects the fact (i) the construction work in progress (CWIP) at VC Summer (which we had been including in 2020 generation rate base as the plant was scheduled to come online in that year) now no longer grows, and (ii) the deferred taxes associated with generation rate base increases to $2.1 billion as the entire investment is written off for tax purposes. (Deferred taxes are an offset to property, plant and equipment in the calculation of rate base.) We have not assumed any securitization or disallowances of the investment in VC Summer, but have incorporated SCG’s guidance.
  3. Rate-regulated utilities are allowed to recover their prudently incurred cost of service in rates, including all costs to procure fuel and purchased power, operation and maintenance expense, depreciation expense, income and other taxes, and a fair return on rate base. Rate base represents the capital invested by a rate-regulated utility monopoly in the supply of a public service (e.g., electricity or gas) and is roughly equivalent to the net depreciated historical value of the utility’s plant, property and equipment. Rate base may be funded by common and preferred equity, long term debt and net deferred tax liabilities. On the debt portion of rate base, utilities are generally allowed to earn a return equivalent to their embedded cost of long term debt. A similar approach is to taken the recovery of the cost of preferred equity. Because a utility’s deferred tax liability largely represents income taxes expensed but not yet paid, and thus does not represent an outlay of capital, regulated utilities are not allowed to earn a return on deferred taxes. As a result, rate base is generally calculated as the net depreciated historical cost of a utility’s property, plant and equipment net of the utility’s deferred tax liability. Finally, on the portion of rate base funded with equity (a proportion set by regulators at a level deemed adequate to sustain an investment grade rating on the utility’s long term debt, and referred to as the “equity ratio”) utilities are allowed to earn a fair return (the utility’s “allowed ROE”) as determined by regulators in periodic rate cases. Given this regulatory framework, it is common for investors to estimate future utility earnings as the product of rate base, the utility’s equity ratio and its allowed ROE.
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