Regulated Utilities

[SI2020]

In a severely negative macro scenario, what is the impact of the crisis on the 100% regulated US utilities? Can they pass through the impact of lower load through higher pricing? Asking for both the short term and long term impact on earnings.

[JRM]

An interesting aspect to many electric utilities is the few large industrial customers subsidize the many small retail customers.  It will be interesting to see how this plays out.  My guess large rate increases will be difficult to push through.

 

These are the main risks I see:

 

Hyperinflation is the enemy of regulated utilities.  Regulatory lag means capex costs more than what can be recovered in rates.  Look for utilities that invested heavily in the last 10 years vs utilities that have assets in need of major capex.

 

Regulated utilities are earning more than they ever have right now.  The spread between allowed rates of return (usually around 10%) and cost of capital is at historic highs.  If I was a regulator I would go after this margin.  Also, tax cuts were passed onto the customer.  Tax increases would be passed on as well.

 

Many of the utilities I'm familiar with sport a 20+ P/E ratio.  Historic average P/E is 10.

 

I don't think its a slam dunk.

[SI2020]

I don't think it's a slam dunk and the starting valuations were high, but I am still surprised they haven't outperformed more given the decline in interest rates. I think the inflation risk is lower with utilities than with bonds. If interest rates were to go up severely, allowed ROEs would likely also go up. In the 80s allowed ROEs were around 15% vs 10% today.

[bizaro86]

I don't think it's a slam dunk and the starting valuations were high, but I am still surprised they haven't outperformed more given the decline in interest rates. I think the inflation risk is lower with utilities than with bonds. If interest rates were to go up severely, allowed ROEs would likely also go up. In the 80s allowed ROEs were around 15% vs 10% today.

 

But how much would rates have to go up before regulators moved? If the 5 year goes from 0.3% to 6% that would exert a lot of gravity on income stock valuations, but I could see state regulators saying that 10% is still an acceptable ROE.

[SI2020]

That is fair, the allowed ROE will likely not go up in such a scenario. However I would argue that the utilities are also not valued on the basis of the 5 year yield being at 0.3% forever. Lets take an example: PSEG. They are expecting $3.40 of EPS in 2020. If we value the unregulated business at 5x P/E (5*0.78), that implies that the regulated business is trading at $42.70 or a P/E of 16.3x. Not crazy cheap but doesn't that seem reasonable for the guaranteed growth on the chart that I attached plus the 4% dividend? Under what scenario do they not get that growth?

 

[JRM]

There are a lot of moving parts.  I have a hard time forecasting what things look like 5-10 years from now.  I think of Enron a lot, who was 10 years early to the game of broadband and video on demand.  Their vision was correct, just early.  I'm wondering if we see something similar with the push to renewables and distributed generation; especially if the economy is disrupted.

 

When you factor in things like interest rates and inflation/deflation I really have no clue.  Electric distribution companies are too difficult for me right now.