The Half-Life of Nuclear Waste: Why Entergy’s Nuclear Business Remains an Overhang, But Not Forever

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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

______________________________________________________________________________

January 12, 2017

The Half-Life of Nuclear Waste: Why Entergy’s Nuclear Business Remains an Overhang, But Not Forever

Entergy, the owner of 10% of the U.S. nuclear fleet, has accounted for 40% of severe violations under the Nuclear Regulatory Commission’s enforcement program since 2013. In this note we examine how Entergy’s underperforming nuclear operations, both regulated and unregulated, continue to depress the value of the stock. We look at what will reduce the risks and valuation discount and how investors can anticipate the change.

Portfolio Manager’s Summary

  • Entergy’s nuclear plants, both regulated and unregulated, have experienced significant operating problems in recent years. Since 2013, Entergy’s plants have accounted for almost 40% of the violations of Severity Level III or higher under the Nuclear Regulatory Commission’s enforcement program, even though it operates only 10% of U.S. nuclear reactors. Alone among the nation’s nuclear operators, Entergy has two plants that are operating under enhanced supervision by the NRC. These plants are classified in column 4 of the NRC’s Reactor Oversight Process (ROP) Action Matrix, a designation earned by only ten of America’s approximately 100 nuclear reactors over the 16 year history of the program; a column 5 classification would require Entergy to shut the plants.
  • To resolve the operating issues at its nuclear fleet, Entergy has over the past 18 months committed increasing amounts of O&M and capex, first at the two most problematic plants and, in the last 9 months, across its nuclear operations. Over the next three years (2017-2019), Entergy plans to increase its regulated nuclear capex and O&M spending by $1.3 billion and merchant nuclear spending by $85 million.
  • If Entergy is unable to resolve the operational and safety issues at its regulated nuclear fleet, some or all of the $1.3 billion to be spent through 2019 could be disallowed in a prudency review.
  • With its deal with the state of New York to shut down by 2021 its 2,000 MW Indian Point nuclear plant, Entergy has now completed laying out its plans to exit its merchant power business, Entergy Wholesale Commodities (EWC). Entergy has not completed its exit from EWC, however. The unit continues to drain cash and Energy remains exposed to power price and operating risks at its remaining plants through 2021, and it must then decommission its nuclear power plants and store the fuel.
  • Entergy currently trades above fair value, which we see as $66-70 based on a 5-10% discount to industry average multiples on 2019 earnings less the discounted cash costs of EWC through 2021. Utilities facing similar operational and regulatory challenges in the past, such as Edison International following the shutdown of its San Onofre nuclear plant, or PG&E following the San Bruno pipeline explosion, have traded at a 5% to 10% discount to peers.
  • To address the operational, regulatory and financial risks at its nuclear fleet Entergy must:
    • Demonstrate improved safety and operations culture across its nuclear fleet, eliminating the pattern of multiple violations and safety findings that has brought intensified NRC scrutiny; and
    • Bring its regulated plant, Arkansas Nuclear One, out of NRC’s Column 4 and back to Column 1 by mid-2018, as planned, reducing the risk of disallowance dramatically.
  • While we believe it is too early to recommend Entergy, if Entergy achieves these milestones at its nuclear operations, it could bring the fair value of its stock up to $77 over the next 12 to 18 months, a price gain of ~7% on top of its 4.8% dividend yield
    • Investors interested can monitor Entergy’s violations and progress at ANO on the NRC website (see footnotes 1, 2 and 3 on pages 4 and 5 below for the key webpages).

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

Details

Entergy’s nuclear plants, both regulated and unregulated, have experienced significant operating problems in recent years. In this note, we review Entergy’s poor nuclear performance, the risks it creates and the impact on Entergy’s value – as well as the potential for a recovery in the stock if key safety and performance milestones are achieved.

In recent years, the frequency with which the NRC has issued notices of violations and findings of significance to Entergy has been much greater than for all other nuclear operators. Since 2013, Entergy has been the subject of numerous findings under the NRC’s Reactor Oversight Process (ROP) and of enforcement actions for violations of varying degrees of significance throughout its regulated and unregulated nuclear fleet. Since 2013, Entergy’s plants have accounted for almost 40% of the violations of Severity Level III or higher under the NRC’s enforcement program, even though it operates only 10% of U.S. nuclear reactors. Two of these violations were determined to be significant, designated yellow findings. Currently, the only two power plants in Column 4 of the ROP Action Matrix, requiring enhanced supervision by the NRC, are Entergy plants. Only eight other plants have been in Column 4 in the 16 years since the ROP was established. Clearly, the culture across Entergy’s nuclear fleet has deteriorated since the previous decade when Entergy was viewed as one of the top nuclear operators. (Please see Exhibits 2 & 3 and the appendix to this note for an explanation of the NRC’s Reactor Oversight Process and enforcement program, and the meanings of the different types of findings and violations).

Exhibit 2: NRC’s Reactor Oversight Process — Findings with Respect to Entergy Plants Since 2013

Source: NRC, Company documents, SSR Analysis

Exhibit 3: NRC’s Enforcement Actions Against Entergy of Yellow or Severity Level III or Greater

Source: NRC, SSR Analysis

The deterioration of performance at Entergy’s nuclear plants is not of just academic or policy interest – they have a clear cost as well. Since Entergy was forced to address its nuclear deficiencies in early 2015, when Arkansas Nuclear One (ANO) was moved into Column 4 by the NRC, Entergy’s cost estimates have continued to grow. At ANO, estimated costs increased from about $50 million initially to over $100 million by the time a corrective action plan (CAP) to resolve the issues was approved by the NRC at the end of 2015. During the third quarter of 2015, Entergy announced $45 to $60 million of increased costs at its Pilgrim nuclear power plant due to additional NRC inspections. In the second quarter of 2016, Entergy announced that it was preparing a plan that would sustainably improve performance across its nuclear fleet. Finally, in late 2016, Entergy made public its Nuclear Sustainability Plan, with a total cost $1.3 billion of capex and O&M at the regulated nuclear fleet over 2017-19 and $85 million of O&M at the merchant nuclear fleet. (See Exhibit 4).

Exhibit 4: Entergy’s Attempts to Address the Issues and Their Estimated Cost since 2015

Source: Company Documents, SSR Analysis

Moreover, while nuclear performance deficiencies exist, there remains an elevated risk that some or all of the additional capex under the Nuclear Sustainability Plan is disallowed by regulators as imprudent. The plan is being pitched as the required level of spending to achieve and maintain operational excellence and not a temporary boost to restore performance. As such, if Entergy is able to restore ANO back to Column 1 over the next year, we believe that there is only limited risk of disallowance under a prudency review. However, if Entergy fails to restore satisfactory performance at ANO, the risk of disallowance increases substantially. Arkansas regulators have said that they intend to review the capex as it is spent, so there may be a prudency review on the 2017 spending this year, which would give us an early indicator of how they view Entergy’s nuclear plans and performance. Should the increased nuclear capex in Arkansas over the 2017-19 period be disallowed, it would result in a $0.05 reduction in earnings in 2019. If all of Entergy’s additional regulated nuclear capex were disallowed, it would reduce 2019 EPS by $0.15, although we view this as highly unlikely.

Since appointing Chris Bakken, a nuclear industry executive with extensive experience, as the new Chief Nuclear Officer in early 2016, it is evident that Entergy is seriously addressing its poor performance and weak safety culture. The Nuclear Sustainability Plan increases nuclear spending across the company by $1.4 billion over 2017-19 with plans to continue at higher levels beyond 2019. Even stronger notice was given to Entergy’s nuclear staff and the NRC when Mr. Bakken shut down Grand Gulf in the late 2016 because of concerns about employee performance and a lack of safety culture at the plant — without any related findings or notices by the NRC.

Nevertheless, it is too early to declare victory for Entergy on this issue. Rather, we would require clear indicators that performance risk has been substantially reduced. Specifically, we would expect to see no violations of severity level III in 2017.[1] At ANO, we look to the successful completion of the plant’s Corrective Action Plan and exit from Column 4 back to Column 2 by early 2018.[2] Finally, we would monitor the performance of the rest of the fleet, and expect to see no additional reactors move out of Column 1 on the NRC’s ROP Action Matrix. [3] Until such indications are clear there remains a substantial risk of additional incidents at the nuclear fleet, including ones that would cause Entergy to incur substantial additional costs.

Entergy’s Exit from Its Merchant Nuclear Operations

In addition to the poor operational and safety performance of its regulated and unregulated nuclear fleets, Entergy has also been suffering from poor economics at its merchant nuclear business as power prices have declined dramatically over the last several years and operating costs have increased. In response to depressed power prices and some plant specific issues (e.g. challenges relicensing Indian Point, Pilgrim moving into Column 4), Entergy has announced plans to shut down or sell all of its merchant nuclear power plants over the last 18 months. Entergy’s remaining merchant nuclear plants will shut down over the next five years, with one generating unit closing each year through 2021.

Over this period, we estimate the known cash cost of Entergy Wholesale Commodities (EWC), the unregulated arm of Entergy where the nuclear business is housed, at $400-500 million, including paying off the remaining debt (net of the $172 million payment from Consumers Energy for shutting Palisades down early), or about $2-3 per share. However, the cost could actually be significantly higher, reflecting (i) expenses currently not quantified, such as the additional decommissioning expenses Entergy will likely need to contribute to Palisades and Indian Point, and (ii) the unknown risks of other costs, such as a major event at a plant or a further decline in power prices driving cash flows lower.

Finally, we have discussed with the company what portion of EWC costs will persist beyond the shutdown of all of the merchant nuclear plants. These are costs that should be included in the earnings estimates of Entergy’s remaining “utility, plant and other” business when valuing Entergy. Principal among them are the overhead costs allocated by the Entergy parent company to EWC, and the operating loss from EWC’s remaining non-nuclear operations. According to Entergy, there is about $17.5 million of overhead allocated annually by the Entergy parent company to each merchant nuclear plant, or $70 million in total. These are costs that will not go away on their own once the plants shut down. Entergy has stated that they will try to reduce these costs, but we are skeptical they can eliminate them. Similarly, Entergy has said there is a ~$25 million annual operating loss from EWC’s non-nuclear businesses. In our analysis below, in which we adjust the company guidance to reflect these ongoing expenses, we assume that Entergy is able to reduce both expenses by 50%. (See Exhibit 5)

The Value of Entergy Now and in the Future

Entergy currently trades at a 6% discount to the electric utilities as a group on consensus 2019 earnings, the year when Entergy has stated that the temporary drag from the nuclear improvement efforts will no longer be a factor. However, we believe that, for a number of reasons, this valuation still overstates the value of Entergy until it is closer to a resolution of its nuclear operation and safety issues.

First, the company’s utility, parent and other (UP&O) earnings, which are pitched by the company as the true representation of the value of the company due to the plans to exit the merchant nuclear generation business, need to be adjusted for the ongoing expenses at EWC identified above that will persist after the shutdown of all of the nuclear plants. Even if we assume that Entergy is able to cut by 50% the remaining allocated overhead and non-nuclear losses of the unit, there will be an ongoing expense of $47.5 million, or ~$0.17 per share. (See Exhibit 5).

Exhibit 5: Adjusting Entergy’s Guidance for the Remaining Drags on Earnings

Source: Company documents, SSR Analysis

We can estimate the value of Entergy’s regulated utilities by multiplying the adjusted guidance calculated in Exhibit 5 above by the average 2019 P/E multiple of the regulated utilities as a group (15.7x). We estimate that Entergy will earn towards the low end of its 2019 guidance, implying a value of ~$74 for UP&O. We must then deduct the present value of known cash costs of Entergy’s discontinued operations at EWC through 2021. Above, we had estimated these at $2-$3 per share. We now know, however, that Entergy expects some of these costs to continue beyond the shutdown of EWC’s merchant nuclear operations, i.e., parent company overhead allocated to EWC’s nuclear plants and losses at EWC’s non-nuclear businesses, plus some debt and preferred remains at EWC. We have therefore included these costs in our valuation of UP&O, and must now adjust our earlier estimate of EWC costs to reflect this. Subtracting only $1 per share to reflect the present value of cash costs at EWC that will end by 2021, we arrive at an estimated valuation for Entergy as a whole of $73 per share.

However, we believe that Entergy stock deserves a discount to reflect the risk of unknown and potentially significant additional costs such as the possible disallowance of regulated nuclear capex, the potential for dramatically higher decommissioning or other expenses at the merchant nuclear fleet, and the possibility of a major incident at any of the nuclear plants that would require an extended shutdown. To assess the appropriate scale of such a discount, we can look to two comparable companies in similar situations, both in terms of the extended nature of the overhang and the magnitude of the potential negative outcomes: Edison International following the shutdown of its San Onofre nuclear plant, and PG&E following the San Bruno gas pipeline explosion. In the period between the shutdown of SONGS due to boiler leaks and the settlement in the regulatory proceeding to address Edison’s recovery of its investment, Edison traded at ~3-5% discount to the industry average valuation. PG&E, with the much more serious damage and underlying violations at the San Bruno explosion, traded at ~10% discount in the two years following the explosion. When we apply these discounts we get a fair value range for Entergy of $66-70 – 3-8% below the current share price. (See Exhibit 6).

Exhibit 6: Entergy Valuation Estimate Exhibit 7: Value in January 2018 with Improved Nuclear Safety and Performance
Source: Company documents, SNL, SSR Analysis Source: Company documents, SNL, SSR Analysis

Were Entergy able to reverse the pervasively poor performance of its nuclear fleet, the principal risks cited above – the possible disallowance of regulated nuclear capex, and the possibility of a major incident that would force the extended shutdown of a nuclear plant – would be materially reduced. Entergy would then be a far more attractive investment. (See Exhibit 7) Given this more limited range of risks, instead of applying a 5-10% discount to the stock, a lower discount of 3-5% would appear more reasonable. Furthermore, because the cash expenses at EWC are highest in 2017 and there is positive cash flow from the payment from Palisades in 2018, the value of EWC’s known cash flows are near zero in 2018. Applying the current 2 year forward P/E of 16.5x to the lower end of our adjusted 2019 earnings range, and then applying a discount of 5%, results in a fair value estimate of $74 per share. Applying the current 3 year forward P/E and 5% discount to our adjusted 2020 guidance results in a valuation range of $75-81. As a result we see the fair value of Entergy under this scenario as ~$77, the average of these valuations, implying 7% upside over the next 12 months plus the 4.8% dividend yield.

Appendix: The Nuclear Regulatory Commission Reactor Oversight and Enforcement Processes

The NRC is tasked with the oversight of the safety and operations of all civilian nuclear activities in the US. The primary mechanism for safety oversight of nuclear reactors is the Reactor Oversight Process (see Exhibit 8), established in 2000. The purpose of the ROP is to identify problems or potential problems early enough through frequent inspections and assessments that they do not pose a significant safety risk, create a plan to correct the problems and, depending on the severity of the problem, increase the frequency of inspection and oversight of the plant. The NRC has also established an enforcement program to address violations of regulations, both safety and non-safety related.

The ROP is structured to monitor performance in three general areas: “reactor safety” (preventing accidents and minimizing their impact if they should occur), “radiation safety” (minimizing exposure to plant workers and the public) and “safeguards” (security). Those are then divided into a total of seven “cornerstones”:

  • Initiating Events: Operations that could lead to an accident, usually involving events that result in a plant shutdown or swings in power output.
  • Mitigating Systems: The functioning and design of safety systems designed to prevent and minimize the impact of accidents
  • Barrier Integrity: Monitoring of the structural integrity of three primary barriers to the release of radioactive material – fuel rods, the reactor vessel and associated piping and the concrete reactor containment building.
  • Emergency Preparedness: Emergency response plans and the results of emergency response exercises.
  • Occupational Radiation Safety: Control, minimization and monitoring of radiation doses received by plant workers.
  • Public Radiation Safety: Minimization of radioactive releases from the plant.
  • Security: Physical protection of the plant including security personnel and security systems. Results of the security assessments are generally not made public.

The focus in identifying and assessing issues is to fix the problems and improve the performance of workers and increase the vigilance of management and staff on safety related issues to prevent recurrences. Therefore, findings are not penalized unless there is an underlying violation of NRC regulations or a willful act by the plant staff. When issues are found, they are categorized into four different levels:

  • Green: There is an issue, but performance is within expected levels and “cornerstone objectives” are being met.
  • White: Cornerstone objectives are still being met, but there is a reduction in safety margin of a minimal level. Frequently this will involve reporting and monitoring issues that did not actually affect the functioning of the systems or delays in fixing a non-safety related situation.
  • Yellow: Cornerstone objectives being met, but there is moderate reduction in safety margin. This often involves minor issues with safety related equipment or more significant issues with non-safety related systems.
  • Red: A significant degradation in safety margin and cornerstone objectives are not being met.

Exhibit 8: NRC’s Reactor Oversight Action Matrix

NRC Response Plan or “Action Matrix”

Source: NRC

Once an issue is found and categorized a determination is then made if it affects the regulatory status of the individual reactor in the ROP’s action matrix. All reactors start in Column 1, referred to as the Licensee Response column and are only moved out with findings of white or higher. They can only return to Column 1 after they have developed and executed on a “Corrective Action Plan” (CAP). A significant emphasis is placed the quantity of the findings, not just the significance. In other words, multiple white findings or just one red finding can put a plant into Column 4. The reason for this is the recognition that lots of small problems can be an indicator of a workplace safety culture issue that can lead to bigger problems.

Green findings are common in the regular inspections and assessments, but white or greater are much rarer. For example, over the last four quarters of inspections there have only been 4 white findings and 2 yellow findings. Unfortunately, both of the yellow findings and one of the white findings have been at Entergy’s plants.

In addition to the ROP, the NRC has implemented an enforcement program that identifies violations of NRC regulations, including violations associated with white, yellow or red findings under the ROP. Non ROP-related violations that are “more than a minor concern” are graded from Severity Level IV for the least severe, up to Severity Level 1 for the most significant. Generally, violations greater than SL III are very rare. SLIII could be viewed, in some ways, as the equivalent of a yellow finding in the ROP, although not safety related. The SLIII findings frequently involve falsification of reports or incorrect material information on significant filings. As with the ROP, the resolution is usually a plan to prevent future violations, although in severe cases there can be monetary penalties assessed.

 

©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.

  1. Enforcement actions can be found for each reactor at: https://www.nrc.gov/reading-rm/doc-collections/enforcement/actions/reactors/
  2. ANO’s progress can be tracked on a page set up by the NRC for ANO’s additional oversight: https://www.nrc.gov/info-finder/reactors/ano/special-oversight.html. Monitoring progress for Pilgrim can be done at: https://www.nrc.gov/info-finder/reactors/pilg/special-oversight.html
  3. Reactors’ positions on the Action Matrix can be found at: https://www.nrc.gov/NRR/OVERSIGHT/ASSESS/actionmatrix_summary.html. Findings under the ROP can be monitored at: https://www.nrc.gov/NRR/OVERSIGHT/ASSESS/pim_summary.html
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