Utilities Sector Outlook Utilities Sector - Michael Brajdic
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Utilities Sector Outlook Utilities Sector - Michael Brajdic Agenda ¡ Overview ¡ Business Analysis ¡ Economic Analysis ¡ Financial Analysis ¡ Valuation Analysis ¡ Recommendation Utilities Sector - Michael Brajdic Agenda ¡ Overview ¡ Business Analysis ¡ Economic Analysis ¡ Financial Analysis ¡ Valuation Analysis ¡ Recommendation Utilities Sector - Michael Brajdic Overview ¡ Four Sub-Groups ¡ Defensive Integrated - regulated, own generation/ transmission/distribution ¡ Distribution – regulated, but stripped of generation assets ¡ Independent Power Producers (IPPs) – not regulated at state level ¡ Hybrid – spun off assets into an unregulated subsidiary Utilities Sector - Michael Brajdic Index Characteristics Constituents 30 Constituent Market Cap (USD Million) Mean Total Market Cap 17,605.43 Median Total Market Cap 13,820.69 Largest Market Cap 50,214.82 Smallest Market Cap 3,766.03 Weight Largest Constituent (%) 9.6 Weight Top 10 Constituents (%) 59.9 Utilities Sector - Michael Brajdic Respective Sector Weight Sector S&P 500 Weight SIM Weight +/- Consumer Discretionary 12.07% 11.30% -0.77% Consumer Staples 9.67% 9.51% -.0.16% Energy 10.29% 9.12% -1.17% Financials 16.43% 14.75% -1.68% Health Care 13.31% 14.93% 1.62% Industrials 10.73% 7.44% -3.29% Information Technology 18.41% 22.31% 3.90% Materials 3.52% 3.01% -0.51% Telecommunication Services 2.49% 2.84% 0.35% Utilities 3.08% 3.41% 0.33% Utilities Sector - Michael Brajdic Largest Ten Companies Company Name Ticker Market Cap SPX Weight Duke Energy Corp DUK 52.31 B .29% NextEra Energy Inc NEE 44.17 B .24% D 41.34 B .22% Southern Co SO 40.34 B .22% Exelon Corp EXC 33.50 B .18% American Electric Power Co AEP 27.16 B .15% Sempra Energy SRE 25.64 B .14% PPL Corp PPL 22.40 B .12% PG&E Corp PCG 22.22 B .12% Public Service Enterprise Group PEG 20.56 B .11% Dominion Resources Inc Utilities Sector - Michael Brajdic Sector Performance Index YTD 1 Year 3 Years 5 Years 10 Years S&P 500 Utilities 13.57% 18.08% 12.68% 14.63% 10.38% S&P 500 4.97% 20.45% 15.15% 18.40% 7.77% Difference 8.60% -2.37% -2.47% -3.77% 2.61% Utilities Sector - Michael Brajdic Agenda ¡ Overview ¡ Business Analysis ¡ Economic Analysis ¡ Financial Analysis ¡ Valuation Analysis ¡ Recommendation Utilities Sector - Michael Brajdic Business Analysis ¡ Three parts of Utilities Business ¡ Generation – generating the power from various sources (coal, natural gas, nuclear, solar, wind) ¡ Transmission – used to carry electricity over long distances ¡ Distribution – most visible and well recognizable part of business; power lines owned by local utilities to deliver electricity to customer ¡ Operated as either regulated or unregulated subject to state ¡ Transmission and Distribution have remained regulated Utilities Sector - Michael Brajdic Porter’s Five Forces Force Threat of New Entrants Level High Effect Very high barriers to entry include regulatory approval and capital expenditures. Power of Suppliers Moderate Power systems supply industry exerts considerate control over pricing to generation companies. Power of Buyers Moderate Buyers can state disapproval at rate cases in regulated states. Buyers can choose different supplier in unregulated. Availability of Substitutes Low No substitute in transmission or distribution. Growing alternatives in generation. Competitive Rivalry High Only way to grow margins is cut costs, which at times can be near impossible. Utilities Sector - Michael Brajdic Life Cycle Alternative Generation Utilities Sector - Michael Brajdic Transmission /Distribution Fuel Pros and Cons Pros Cons Carbon Output Relative to Coal Coal Low Variable Cost Abundance of Coal Reserves High Fixed Cost ($2,200$4,000/kW) Long Build Cycle (4-6 years) 100% Natural Gas (SCGT) Low Fixed Cost ($450-$500/ kW) Quick Build Cycle Inefficient Short Run Time Volatility in Gas Prices 60% Natural Gas (CCGT) Moderate Fixed Cost ($850$1,550/kW) High Efficiency High Variable Cost Oversupply Volatility in Gas Prices 40% Nuclear Low Variable Cost Emission Free Highest Fixed Cost ($4,300$6,300/kW) Longest Build Cycle (10-12yrs) ~0% Wind Very Low Variable Costs Renewable Tax Credits High Fixed Cost ($1,900$2,400/kW) Strong Wind During Non-Peak 0% Solar Very Low Variable Cost Renewable Tax Credits High Fixed Cost ($3,500$7,000/kW) Limited by regional sunlight 0% Utilities Sector - Michael Brajdic Agenda ¡ Overview ¡ Business Analysis ¡ Economic Analysis ¡ Financial Analysis ¡ Valuation Analysis ¡ Recommendation Utilities Sector - Michael Brajdic Economic Highlights ¡ Macroeconomic Outlook ¡ Stronger economic growth (3.0% GDP Growth) ¡ Rising inflation (~200 b.p.) ¡ Higher long term Treasury yields (~100 b.p.) ¡ Unfavorable for Regulated Utility Stocks ¡ Over last 40 years with conditions above regulated utilities underperformed 59% of the time, by an average of 3.5% Utilities Sector - Michael Brajdic Inflation (CPI) Utilities Sector - Michael Brajdic Ten Year Treasury Utilities Sector - Michael Brajdic Real GDP Utilities Sector - Michael Brajdic Consumer Confidence Utilities Sector - Michael Brajdic General Drivers ¡ Load Growth – population growth or increased usage (Assume 1.5%-2%) ¡ Federal Policy – tax credits and emission standards Utilities Sector - Michael Brajdic Defensive Utility Drivers ¡ Capital Investment – companies earn return on rate base ¡ State Regulatory Environment – supportive relationship more likely to yield positive rate case ¡ Rate Cases – determines rate base, ROE, and timing of relief ¡ Dividend Policy – constant policy, reflects visibility of future earnings ¡ Interest Rates – inverse correlation to utility investments Utilities Sector - Michael Brajdic Rate Cases Explained ¡ Regulated utilities file rate case if current rates are no longer providing investors with adequate return ¡ Heard by utilities commission – three to seven members ¡ Testimony heard from both customers and company ¡ Most times commission takes middle ground ¡ Return on Equity is most widely litigated issue in rate case ¡ Typical rate case takes 9 months Utilities Sector - Michael Brajdic Rate Cases Explained ¡ Rate of Return – typical rate around 10% ¡ Rate Base – driven primarily by capital expenditures ¡ NOI Under Current Rate – calculated to find shortcomings in upcoming year *Rate Case Variable Utilities Sector - Michael Brajdic Cost of Capital Estimates Tier 1 Tier 2 Tier 3 Tier 4 Tier 5 FERC Indiana Kansas New Mexico Maryland British Columbia South Carolina Nevada Missouri Maine Kentucky North Carolina Alabama Ohio Vermont Michigan Virginia Minnesota Mississippi Connecticut Wyoming Nova Scotia Oklahoma West Virginia New Hampshire Iowa Wisconsin Pennsylvania Massachusetts Montana Idaho Florida Washington Hawaii Alberta Colorado Illinois South Dakota Arkansas North Dakota Rhode Island Tennessee Louisiana District of Columbia Georgia Utah New Jersey California *Barclays Research Estimates Utilities Sector - Michael Brajdic Dividend Yield Utilities Sector - Michael Brajdic Deregulated Utility Drivers ¡ Commodity Prices – spark spread (natural gas) and dark spread (coal) ¡ Heat Rate – relationship between natural gas and power; shows efficiency of market ¡ Reserve Margin – measure of excess supply, generators want low reserve margin Utilities Sector - Michael Brajdic Coal Price Level Utilities Sector - Michael Brajdic Natural Gas Price Level Utilities Sector - Michael Brajdic Agenda ¡ Overview ¡ Business Analysis ¡ Economic Analysis ¡ Financial Analysis ¡ Valuation Analysis ¡ Recommendation Utilities Sector - Michael Brajdic Financial Analysis ¡ High debt levels dominate the industry, averaging from 40-60% of total financing ¡ Good sign for regulators, with cost of equity much higher than cost of debt ¡ Capital Expenditure precludes revenue growth ¡ Dividend yield best proxy for measuring income generated by utilities Utilities Sector - Michael Brajdic Margins Utilities Sector - Michael Brajdic ROA & ROE Utilities Sector - Michael Brajdic Financial Analysis ¡ Industry redistributes earnings in form of dividends ¡ Margins shrunk in early 2000s, could be attributed to lack of rate cases in changing regulatory environment ¡ Regulatory lag in rate cases impacts income by temporarily (9-18 months) lower earning rate Utilities Sector - Michael Brajdic Agenda ¡ Overview ¡ Business Analysis ¡ Economic Analysis ¡ Financial Analysis ¡ Valuation Analysis ¡ Recommendation Utilities Sector - Michael Brajdic Valuation Analysis ¡ Both historic multiples and technical analysis point to the Utilities Sector as poor investment timing. ¡ Historic multiples are close to 10 year highs, and all above median ¡ S5UTIL Index is trading above the Upper Bollinger Band, a sign of the market being overbought in Utilities ¡ Relative Strength Index of S5UTIL is above 70, deeming it as overbought Utilities Sector - Michael Brajdic Sector Valuation Absolute Basis High Low Median Current S&P 500 P/E 22.6520 11.2946 16.3863 17.9388 S&P 500 Utilities P/E 18.6070 10.4619 15.4150 16.4495 S&P 500 P/B 2.9812 1.6403 2.4126 2.7281 S&P 500 Utilities P/B 2.4818 1.3148 1.6056 1.7592 S&P 500 P/S 1.6987 0.7802 1.3427 1.6987 S&P 500 Utilities P/S 1.6196 0.8269 1.2460 1.6196 S&P 500 P/EBITDA 9.0387 4.1430 6.9807 9.0387 S&P 500 Utilities P/ EBITDA 5.9665 3.3057 4.7876 5.5636 S&P 500 P/CF 19.9372 4.8639 9.2116 9.7226 S&P 500 Utilities P/CF 9.6906 4.7227 6.3881 7.0225 *Last 10 Years Utilities Sector - Michael Brajdic Relative Sector Valuation Relative to SPX High Low Average Current P/E 1.1426 0.5266 0.9239 0.917 P/B 0.1469 .06320 0.1091 0.0981 P/S 0.1055 0.0460 0.0790 0.0913 P/EBITDA 0.3646 0.1692 0.2929 0.3131 P/CF 0.5900 0.2102 0.4212 0.3915 *Last 10 Years Utilities Sector - Michael Brajdic Bollinger Bands Utilities Sector - Michael Brajdic Relative Strength Index Utilities Sector - Michael Brajdic Agenda ¡ Overview ¡ Business Analysis ¡ Economic Analysis ¡ Financial Analysis ¡ Valuation Analysis ¡ Recommendation Utilities Sector - Michael Brajdic Recommendation ¡ I recommend SIM lower its position in Utilities from 3.41% to 2.50% ¡ Both industry multiples and technical analysis show market is overbought in utilities ¡ Historical analysis predicts underperformance in the utilities industry of 3.5% given macroeconomic conditions ¡ Utilities have led the way with 13.57% YTD, and I believe this continued growth is not plausible ¡ The only industry I would feel comfortable investing in is a fast growing Hybrid, with no overexposure to regulated markets Utilities Sector - Michael Brajdic
